Capital budgeting (or investment appraisal) is the process of determining the viability to long-term investments on purchase or replacement of property plant and equipment, new product line or other projects.
Capital budgeting consists of various techniques used by managers such as:
- Payback Period
- Discounted Payback Period
- Net Present Value
- Accounting Rate of Return
- Internal Rate of Return
- Profitability Index
All of the above techniques are based on the comparison of cash inflows and outflow of a project however they are substantially different in their approach.
A brief introduction to the above methods is given below:
- Payback Period measures the time in which the initial cash flow is returned by the project. Cash flows are not discounted. Lower payback period is preferred.
- Net Present Value (NPV) is equal to initial cash outflow less sum of discounted cash inflows. Higher NPV is preferred and an investment is only viable if its NPV is positive.
- Accounting Rate of Return (ARR) is the profitability of the project calculated as projected total net income divided by initial or average investment. Net income is not discounted.
- Internal Rate of Return (IRR) is the discount rate at which net present value of the project becomes zero. Higher IRR should be preferred.
- Profitability Index (PI) is the ratio of present value of future cash flows of a project to initial investment required for the project.
The above techniques are explained in detail in next pages.
Written by Irfanullah Jan