Techniques Of Capital Budgeting

Capital budgeting is done in various ways. Some of the techniques used are:

  • The internal rate of return
  • Net present value
  • Profitability index
  • Real options valuation
  • Payback period
  • Accounting rate of return
  • Equivalent annual cost
  • Average accounting return
  • The modified internal rate of return

There are different methods adopted for capital budgeting.

Some Techniques and methods of capital budgeting explained

  • The payback period method

In this method, the word period refers to the time in which the proposal will start to generate cash to recover the initial investments that have been made. The method lays a lot of emphasis on the economic life of the project and the cash inflow. The investments that are made into the project is also emphasized on and there is no use of the time value of money in this method. The method helps to select a proposal based on what the earning capacity of the project is. There is some simple calculation involved which helps to select or reject a project and the result helps to determine what the risk involved is.

  • Accounting rate of return method – ARR

This method takes care of the shortcomings of the payback period method. The rate or return is expressed as what percentage it is of the earnings of the investment on a particular project. As per this method, any project that has an ARR that is higher than the minimum rate that is established will be considered and those that are below the minimum rate established gets rejected.

The method takes into consideration the complete economic life of the project and thus allows better comparison.The method, however, does not consider the time value of money as well as the length of the projects life.

  • The discounted cash flow method

The technique calculates the cash inflow as well as cash outflows throughout the assets life. This then gets discounted a discount factor is used to do the same. The discounted cash inflow, as well as the outflow, is compared and this method considers the interest as well as the return factor after the payback period.

  • The net present value of NPV method

The method is popular and it helps to evaluate the proposal of capital investment. The cash inflow that is expected in different time periods in the future is discounted at a rate. The present value of the cash inflow is compared to the original investment made. The difference needs to be positive for it to be accepted. The time value of money is considered and this is done in order to maximize the profit of the owner.