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what is capital budgeting and techniques of capital
budgeting.
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Answer Posted / ajaykumar chavan
There are a number of techniques of capital budgeting. Some
of the methods are based on the concept of incremental cash
flows from the projects or potential investments. There are
some other techniques of capital budgeting that are based
on the accounting rules and accounting earnings. However,
the techniques based on the accounting rules are considered
to be improper by the economists. The hybrid and simplified
techniques of capital budgeting are also used in practice.
Capital budgeting is the process of managing the long-term
capital of a firm in the most profitable way. The prime
task of the capital budgeting is to estimate the
requirements of capital investment of a business. The
capital allocation to various projects depending on their
needs and selection of proper project for the business also
fall under the canopy of capital budgeting concept.
Some of the major techniques of capital budgeting are:
Profitability index
Net present value
Modified Internal Rate of Return
Equivalent annuity
Internal rate of return
Profitability Index
The profitability index is a technique of capital
budgeting. This holds the relationship between the
investment and a proposed project's payoff. Mathematically
the profitability index is given by the following formula:
Profitability Index = (Present Value of future cash
flows) / (Present Value of Initial investment)
The profitability index is also sometimes called as value
investment ratio or profit investment ratio. Profitability
index is used to rank various projects.
Net Present value
Net present value (NPV) is a widely used tool for capital
budgeting. NPV mainly calculates whether the cash flow is
in excess or deficit and also gives the amount of excess or
shortfall in terms of the present value. The NPV can also
be defined as the present value of the net cash flow.
Mathematically,
NPV = ?(Ct / (1+r)t) - C0 , where the summation takes the
value of t ranging from 1 to n
Here,
n stands for the total project time
t stands for the cash flow time
r stands for the rate of discount
Ct stands for net cash flow at time t
C0 stands for capital outlay when t = 0
Modified Internal Rate of Return
The Modified Internal Rate of Return (MIRR) gives the
measure of an investment's attractiveness in a business.
The prime use of the modified internal rate of return in
the capital budgeting process is to rank various choices of
projects.
Equivalent Annuity
Equivalent Annual Cost is widely used in capital budgeting
as a decision making tool. This is mainly used to compare
different projects having unequal project lifetime.
Internal Rate of Return
The internal rate of return (IRR) is a metric used by the
capital budgeting in order to determine whether the firm
should make investments or not. The IRR indicates the
efficiency of a particular investment.
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