Capital Budgeting Techniques

Capital Budgeting is a process in which a firm determines whether projects such as building a new plant or investing in a long-term venture are worth pursuing. Oftentimes, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the returns generated meet a sufficient target benchmark. Ideally, businesses should pursue all projects and opportunities that enhance shareholder value. However, because the amount of capital available at any given time for new projects is limited, management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period of time.

Capital budgeting techniques includes:

• NPV
• IRR
• Payback Period
• Profitability index

NPV:

           The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project. NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.

NPV can be calculated by using Excel Spreed sheet,

IRR:

          The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first.

Here is the graph explaining the NPV and IRR profiles of two projects A & B,

IRR of the project can be calculated using excel spreed sheets,

 

Payback Period:

                                 Payback Period is defined as the length of time required to recover the cost of an investment.

Payback Period of the project can be calculated using excel spreed sheets,
 

But there are two main problems with the payback period method:

1. It ignores any benefits that occur after the payback period and, therefore, does not measure profitability.
2. It ignores the time value of money.

Because of these reasons, other methods of capital budgeting like net present value, internal rate of return or profitability index are generally preferred.

Profitability Index:                    

                                   An index that attempts to identify the relationship between the costs and benefits of a proposed project through the use of a ratio calculated as:

A regulation for evaluating whether to proceed with a project or investment. The profitability index rule states: If the profitability index or ratio is greater than 1, the project is profitable and may receive the green signal to proceed. Conversely, if the profitability ratio or index is below, the optimum course of action may be to reject or abandon the project.

 Profitability Index of the project can be calculated using excel spreed sheets,

Conclusion:

                      Management can use any of these techniques to evaluate the future projects. Payback Period is used for quick judgment that project is feasible or not. NPV & IRR are rather complex techniques to evaluate the projects. But they also provide better decision making tools. Hence management should take into consider the NPV & IRR of the project before deciding whether to accept or reject the project.