Question

Define the most important capital budgeting techniques. name at least two (2) capital budgeting techniques (e.g., NPV, IRR) that you used to arrive investment decision.

Answer 1

The Capital Budgeting evaluation criteria –

1.         Payback Period (PBP)

            One of the most popular and widely recognized traditional methods of evaluating capital investment proposal is the payback period. It is the number of years it takes a firm to recover its original investment from net cash flows. The payback period of an investment is the length of time required for the cumulative total net cash flows from the investment to equals to total initial cash outlays.

General Rule – Earlier the better.

2.         Net Present Value (NPV)

            It is the Present value of the projects net cash flows discounted at the company’s cost of capital to the time of the initial capital outlay, minus that initial capital outlay.

General Rule – Higher the NPV, better it is.

3.         Internal rate of Return (IRR)

            IRR is the rate of return at which present value of cash inflows equals to present value of cash outflows.

General Rule – Higher the better.

4.         Profitability Index (PI)

            It is ratio of present value of cash inflows and outflows.

General Rule – Higher the better.

5.         Discounted Payback period

            It refers to the period to the period within which the present value of cash inflows completely recovers the present value of cash outflows.

General rule – Earlier the better.

6.         Accounting Rate of Return

ARR is the ratio of Profit(net of accounting depreciation) to capital invested. Accounting rate of return is calculated by dividing the average income after taxes by the initial or average investment.

General Rule – Higher the better.

Hope this will help, please do comment if you need any further explanation. Your feedback would be highly appreciated.