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Techniques of Capital Budgeting

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
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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Last Updated on : 27th June 2013

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