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What is Capital Budgeting?
Capital budgeting is a process that companies or businesses use to evaluate projects or investments. Usually, these techniques relate to long-term projects that require heavy investments. When there is a long-term plan involved, companies need to use capital budgeting to evaluate whether it will be successful.
There are various capital budgeting techniques that companies may use for decision-making. Some of these techniques may use the profits of a company for evaluation. However, most others use cash flows for a better assessment of the potential profitability of a project.
What are Capital Budgeting techniques?
As mentioned, there are several capital budgeting techniques that companies may use for their internal analysis. Of these, which ones a company uses depend on its requirements. Some of the commonly used capital budgeting techniques include the following.
Payback period
The payback period is a technique used to determine how much time a company takes to recover its initial cash flows from a project. It is one of the most common capital budgeting techniques that companies can use. Its simplicity also comes because it does not require the discounted cash flows. The decision rule for this technique is that the lower the payback period is, the more feasible the project is as well.
Discounted Payback period
The discounted payback period is similar to the payback period. However, instead of using the cash flows from a project, companies use discounted cash flows. They calculate the discounted cash flows based on the time value of money concept. The decision rule for the discounted payback period is similar to the payback period.
Net Present Value
The ‘Net Present Value’ (NPV) technique is the most preferred technique among capital budgeting techniques. The NPV of a project is the difference between its initial cash outflow and the sum of its discounted cash flows after it. While not as simple as the payback period, the NPV technique has a definite rule. It allows companies to make more reliable decisions based on the discounted cash flows of a project.
The decision rule for the NPV technique used for capital budgeting is simple. If the NPV of a project is positive, the project is considered feasible. This technique can also help in comparisons between various projects. For comparisons, the project with the higher NPV is better. In its simplest form, the formula to calculate the NPV of a project is as follows.
Net Present Value = Initial cash outflows – Sum of discounted cash flows after the initial outflow
Internal Rate of Return
The Internal Rate of Return (IRR) technique shows the discount rate at which the NPV of a project becomes zero. Therefore, the IRR technique also considers the NPV of a project and follows the time value of money concept. The decision rule for this technique is that the higher the IRR of a project is, the better it is. However, it should still be higher than the company’s required rate of return. The formula to calculate the IRR is as follows.
IRR = Lower rate of return + [(NPV at lower rate / (NPV at lower rate – NPV at higher rate)) x (Higher rate of return – Lower rate of return)]
Accounting Rate of Return
The Accounting Rate of Return (ARR) is different from the IRR. The ARR of a project shows its profitability calculated as projected total net income divided by the project’s initial or average investment. This technique uses profits instead of cash flows. The formula to calculate the ARR of a project is as below.
ARR = Projected net income / Initial or Average investment
Conclusion
Capital budgeting is a process used by companies to evaluate the profitability of various projects. There are several capital budgeting techniques they can use, as discussed above.
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