Techniques of Capital Budgeting

CAPITAL BUDGETING

Capital Budgeting is a long-term planning for making and financing proposed capital outlays of the company.

The term capital budgeting means planning for capital assets, it denotes a situation where the funds are invested in the initial stages of a project and the returns are expected over a long period of time.

Some of the capital budgeting decisions may be to purchase land, buildings, plant, and machinery or to undertake a program of research and development or to diversify into a new product line or a promotional company,s, etc. The benefit which may arise from capital budgeting decisions may be either in the form of increased revenues or reduction in costs.

A capital budgeting decisions require the evaluation of a proposed project to forecast the expected return from the project and determine whether the return from the project is adequate or not.

 

TECHNIQUES OF CAPITAL BUDGETING

#TRADITIONAL METHODS

As the name suggests that these techniques do not discount the cash-flows, it consists of two techniques, they are

01. Payback Period

payback period is the time required to recover the initial investment in a project. it refers to the length of the duration required to recover the initial cost of the project.

02. Accounting Rate of Return

This method takes into account the earnings expected from the investment over their whole life. It is also known as Rate of return method. The project with the higher rate of return is selected as compared to the one with a lower rate of return.

#MODERN METHODS

MOdern methods of capital budgeting techniques take the discount of cash flows to evaluate the capital budget decisions. It consists of 3 types, they are as follows

01. Net Present Value (NPV)

Net Present Value is the difference between the total present value of future cash inflows and the total present value of future cash outflows. NPV is calculated using the Time-gap and the Required rate of return.

02. Profitability Index (PI)

Profitability Index is also called as Benefit Cost Ratio or Present Value Index. It is calculated by dividing the Present value of cash flows by present value of cash outflows.

03. Internal Rate of Return (IRR)

An Internal Rate of Return(IRR) of a project is the discount rate which makes its NPV=0 or it is the discount rate which equates the present value of future cash flows with the initial investment. In this method, the rate of return is calculated by trial and error method.

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