Techniques of Capital Budgeting
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 IndexThe 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 valueNet 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.
NPV = ?(Ct / (1+r)t) - C0 , where the summation takes the value of t ranging from 1 to n
- 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