Capital Budgeting – What is?, Various Techniques or Methods

Capital Budgeting– When we study about Financial Management, we often consider taking choices concerning investing in which task out of the different available options. To make this decision simpler & more meaningful, we might embrace a variety of methods. These strategies are called– The Capital Budgeting Techniques.

Let us have a look on what is capital budgeting & what are the various strategies involved in it.

Capital Budgeting– What is?, Numerous Techniques or Methods

What is Capital Budgeting?

Capital budgeting refers to long-term planning for proposed capital outlays and their funding.

What are the different Capital Budgeting Techniques?

• Payback Duration
• Net Present Value
• Success Index
• Internal Rate of Return

Let us now a quick look on each of these methods.

Payback Period Method:

• The Repay duration is the quantity of time needed for the company to recuperate its preliminary financial investment in a task, as computed from money
• Payback duration = Total initial capital investment/ Annual anticipated after tax money inflow

Decision Requirements:

• If the payback period is less than the optimum appropriate repayment period, accept the job.
• If the payback duration is greater than the maximum acceptable payback period, decline the job.

NET PRESENT VALUE:

• The Net Present Value (NPV) is found by subtracting a job’s preliminary investment (Initial Cash Outflow) from the present value of its money inflows discounted at a rate equivalent to the company’s cost of capital

Decision Criteria:

• If the NPV is higher than 0, accept the task.
• If the NPV is less than 0, reject the task.

For additional details on Net Present Value, you can refer my article Net Present Worth

PROFITABILITY INDEX:

• The success index (PI) is simply equal to today value of cash inflows divided by the initial money outflow.
• PI = Present Value of Money Inflows/ Present Value of Money Outflows

Decision Criteria

• If PI > 1 then accept the job
• If PI < 1 then turn down the job

For further details on Profitability Index, you can refer my short article success index

INTERNAL RATE OF RETURN:

• The Internal Rate of Return (IRR) describes the rate which equates today worth of money inflows and present value of cash outflows. In other words, it is the rate at which net present worth of the financial investment is absolutely no.

Choice Requirements

• If the IRR is higher than the cost of capital, accept the task.
• If the IRR is less than the cost of capital, reject the project.

For more details on Internal Rate of Return, you can refer my article

Internal Rate of Return

Apart from the techniques pointed out above, there are other methods also like Surplus Life over Payback Duration, Average Rate of Return, Expense Advantage Ratio, etc. which can be utilized for various particular circumstances.