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Techniques of Capital Budgeting theories & notes with Solved Problems. Financial Management illustrations on Capital Budgeting - NPV, IRR, ARR, Profitability Index, Discounting Payback Period & MIRR. There are different methods adopted for capital budgeting. The traditional methods or non discount methods include: Payback period and Accounting rate of return method. The discounted cash flow method includes the NPV method, profitability index method and IRR. Payback period method: As the name suggests, this method refers to the period in which the proposal will generate cash to recover the initial investment made. It purely emphasizes on the cash inflows, economic life of the project and the investment made in the project, with no consideration to time value of money. Through this method selection of a proposal is based on the earning capacity of the project. With simple calculations, selection or rejection of the project can be done, with results that will help gauge the risks involved. However, as the method is based on thumb rule, it does not consider the importance of time value of money and so the relevant dimensions of profitability. Net present Value (NPV) Method: This is one of the widely used methods for evaluating capital investment proposals. In this technique the cash inflow that is expected at different periods of time is discounted at a particular rate. The present values of the cash inflow are compared to the original investment. If the difference between them is positive (+) then it is accepted or otherwise rejected. This method considers the time value of money and is consistent with the objective of maximizing profits for the owners. However, understanding the concept of cost of capital is not an easy task. Internal Rate of Return (IRR): This is defined as the rate at which the net present value of the investment is zero. The discounted cash inflow is equal to the discounted cash outflow. This method also considers time value of money. It tries to arrive to a rate of interest at which funds invested in the project could be repaid out of the cash inflows. However, computation of IRR is a tedious task. It is called internal rate because it depends solely on the outlay and proceeds associated with the project and not any rate determined outside the investment. Profitability Index (PI): It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one. Accounting rate of return method (ARR): This method helps to overcome the disadvantages of the payback period method. The rate of return is expressed as a percentage of the earnings of the investment in a particular project. It works on the criteria that any project having ARR higher than the minimum rate established by the management will be considered and those below the predetermined rate are rejected.

Capital Budgeting

Techniques of Capital Budgeting

Financial Management illustrations on techniques of Capital Budgeting – NPV, IRR, ARR, Profitability Index, Discounting Payback Period & MIRR

By admin, 2 yearsJune 4, 2022 ago