Know About the Techniques of Capital Budgeting
Capital budgeting is an essential process that consists of evaluating potential long-term investments and deciding what kind of projects to pursue. It is important for organizations to take better capital budgeting decisions by involving necessary techniques of capital budgeting to ensure that they get only their resources wisely and also accomplish their long-term goals.
Several organizations use capital budgeting to evaluate major projects and investments, such as new plants or equipment. For instance, the construction of a latest plant or a huge investment in an outside venture that will need capital budgeting before they are been approved or rejected.
In this article, let’s understand the various capital budgeting techniques with examples that are helpful to enable one’s career in accounting and finance.
Capital Budgeting Technique – Payback Period
The payback period is the easiest capital budgeting technique. It measures the time it requires for a project to recover from its initial investment. This technique is famous among the small businesses or organizations with limited resources. However, it won’t consider the time value of money.
Example: Suppose an organization invests USD 100,000 in a project that generates USD 30,000 per year. The payback period would be 3.33 years (USD 100,000/30,000).
- Capital Budgeting Technique – Discounted Payback Period
The discounted payback period is quite a like to the payback period techniques of capital budgeting but considers the time value of money. It calculates the time it takes for a project to recover its initial investment, such as the present value of future cash flows. The discounted payback period can be calculated are as follows:
Discounted Payback Period = Number of Years before the Cumulative Discounted Cash Flows is equal to the Initial Investment
Example: Suppose an organization invests USD 100,000 in a project that generates USD 30,000 per year for the next five years. The discount rate is 10 percent and the discounted payback period is 4.15 years.
- Capital Budgeting Technique – Net Present Value (NPV)
The Net Present Value (NPV) technique considers the time value of money and calculates the present value of future cash flows minus the initial investment. A project with a positive NPV is considered as profitable.
Example: Suppose an organization invests USD 100,000 in a project that generates USD 30,000 per year for the next five years. The discount rate is 10 percent The NPV would be USD 9,218.
- Capital Budgeting Technique – Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is among the top techniques that are helpful to determine whether the organization is required take up the investment or not. It is used together with the NPV of a project equal to zero, to determine the profitability of the project. A project with an IRR higher than the cost of capital is considered as profitable.
Example: Suppose an organization invests USD 100,000 in a project that generates USD 30,000 per year for the next five years. The IRR would be 14.31 percent.
- Capital Budgeting Technique – Profitability Index (PI)
The profitability index (PI) is one of the essential techniques, where the ratio of the present value of future cash flows to the initial investment. It signifies a relationship between the investment of the project and the payoff of the project. A project with a PI greater than one is usually profitable.
Example: Suppose an organization invests USD 100,000 in a project that generates USD 30,000 per year for the next five years. The discount rate is 10 percent. The PI would be 1.09.
- Capital Budgeting Technique – Modified Internal Rate of Return (MIRR)
The Modified Internal Rate of Return (MIRR) is a modification of the IRR techniques of capital budgeting that assumes that cash flows are reinvested at the cost of capital. It is more realistic approach than the traditional IRR technique.
Example: Suppose an organization invests USD 100,000 in a project that generates USD 30,000 per year for the next five years. The cost of capital is 10 percent. The MIRR would be 12.08 percent.
Parting Thoughts
Capital budgeting is a very important process for organizations that are looking to make long-term investments. By considering the several different techniques of capital budgeting as well as factors, organizations can make informed and rightful investment decisions, which get aligned with their organizational objectives and goals. While there is no one-size-fits-all approach to capital budgeting, a thorough evaluation of the investment’s characteristics and potential risks can help organizations make sound investment decisions. Ultimately, these investment decisions are useful to reach long-term financial stability and growth.
