This Article tells us about what Capital Budgeting is and what are the various methods used to evaluate projects.
Capital Investment is spending on long-lived assets.
Capital Budgeting is choosing which project to put money. Its not just choosing best project. It involves identifying potential projects, choosing best out of alternatives and implementing it.
Key parameter for decision making:
1) Payback Period: In this method we choose between the projects based on the time taken to recover the initial investment. We choose the project which has the shortest time period.
Limitations with this method is that it does not take into account the time value of money. also, it is not dependent on the initial investment and ignores the cash flow occurring after the payback period
2) Accounting rate of return(ARR): In this method, we find the ratio of accounting profit, i.e. EBIT and average assets. Whichever project has higher ARR, we take that project.
Limitations with this method is that it also ignores time value of money. Moreover, accounting profit is an ambiguous term. It can vary as per the accounting principles followed.
3) Net Present Value(NPV): In this method, we bring all the cash flows to occur in future at the present value.(discounting them using cost of capital) If the net cash flow comes out to be positive, then project is accepted. Project having higher NPV is selected.
Advantage of this method is that it takes into account the time value of money
4) Internal rate of Return(IRR): this is one of the most widely used method. In this we find out the rate or the cost of capital, at which NPV becomes zero. This rate is known as IRR. In normal cases, i.e. positive cash flows occurring in future, if IRR is higher than present cost of capital, project is accepted. Project having higher IRR is selected.
Limitation of this method is that in case, cash flows sign changes, we get multiple values of IRR which creates problem in taking decisions
5) Profitability Index: this is the ratio of present value of cash inflows to cash outflows.
Capital Investment is spending on long-lived assets.
Capital Budgeting is choosing which project to put money. Its not just choosing best project. It involves identifying potential projects, choosing best out of alternatives and implementing it.
Key parameter for decision making:
- Simplicity of method of arriving at decision
- Cash Flows from project
- Accounting for time value of money
- Risk-return management
- Stockholder's value
1) Payback Period: In this method we choose between the projects based on the time taken to recover the initial investment. We choose the project which has the shortest time period.
Limitations with this method is that it does not take into account the time value of money. also, it is not dependent on the initial investment and ignores the cash flow occurring after the payback period
2) Accounting rate of return(ARR): In this method, we find the ratio of accounting profit, i.e. EBIT and average assets. Whichever project has higher ARR, we take that project.
Limitations with this method is that it also ignores time value of money. Moreover, accounting profit is an ambiguous term. It can vary as per the accounting principles followed.
3) Net Present Value(NPV): In this method, we bring all the cash flows to occur in future at the present value.(discounting them using cost of capital) If the net cash flow comes out to be positive, then project is accepted. Project having higher NPV is selected.
Advantage of this method is that it takes into account the time value of money
4) Internal rate of Return(IRR): this is one of the most widely used method. In this we find out the rate or the cost of capital, at which NPV becomes zero. This rate is known as IRR. In normal cases, i.e. positive cash flows occurring in future, if IRR is higher than present cost of capital, project is accepted. Project having higher IRR is selected.
Limitation of this method is that in case, cash flows sign changes, we get multiple values of IRR which creates problem in taking decisions
5) Profitability Index: this is the ratio of present value of cash inflows to cash outflows.
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