by Capital budgeting techniques are analytical tools used to evaluate and select long-term investment projects. These techniques help management assess the profitability, risk, and financial viability of investment proposals by analyzing expected cash flows and costs. Since capital investments involve large funds and long-term commitment, scientific evaluation is essential to avoid wrong decisions. Capital budgeting techniques provide a rational basis for comparing alternative projects and selecting those that maximize shareholders’ wealth. These techniques are broadly classified into Traditional (Non-Discounted) Techniques and Modern (Discounted Cash Flow) Techniques.
1. Traditional Techniques of Capital Budgeting
- Payback Period Method
The Payback Period method calculates the time required to recover the initial investment from the project’s cash inflows. It is simple and easy to understand, making it popular among managers. Projects with shorter payback periods are preferred as they reduce risk and improve liquidity. However, this method ignores cash flows after the payback period and does not consider the time value of money, making it less reliable for long-term decision-making.
- Accounting Rate of Return (ARR) Method
The Accounting Rate of Return measures the average profit earned on an investment as a percentage of the average investment. It is based on accounting profits rather than cash flows and is easy to compute using financial statements. ARR is useful for comparing profitability of projects. However, it ignores the time value of money and cash flow timing, which limits its effectiveness in evaluating long-term investments accurately.
2. Modern (Discounted Cash Flow) Techniques
- Net Present Value (NPV) Method
Net Present Value is the difference between the present value of cash inflows and the present value of cash outflows, discounted at the cost of capital. A project with positive NPV is considered acceptable as it adds value to the firm. NPV considers the time value of money, risk, and total profitability. It is regarded as one of the most reliable capital budgeting techniques for maximizing shareholders’ wealth.
- Internal Rate of Return (IRR) Method
The Internal Rate of Return is the discount rate at which the present value of cash inflows equals the present value of cash outflows. It represents the expected rate of return of a project. A project is accepted if IRR exceeds the cost of capital. IRR considers time value of money and profitability but may give conflicting results when comparing mutually exclusive projects or projects with unconventional cash flows.
- Profitability Index (PI) Method
Profitability Index is the ratio of the present value of future cash inflows to the initial investment. A PI greater than one indicates a profitable project. This method is useful when capital is limited, as it helps rank projects based on value created per unit of investment. While PI considers time value of money, it may not always give correct rankings for mutually exclusive projects.
- Discounted Payback Period Method
The Discounted Payback Period method calculates the time required to recover the initial investment using discounted cash inflows. It improves upon the traditional payback method by considering the time value of money. This technique is useful for assessing project liquidity and risk. However, like the simple payback method, it ignores cash flows after the recovery period.
- Comparison of Techniques
Traditional techniques focus on simplicity and liquidity but ignore time value of money. Modern techniques provide more accurate results by considering discounted cash flows and profitability. In practice, firms often use a combination of techniques to make balanced and informed capital budgeting decisions.
