Capital budgeting Techniques
Capital budgeting Techniques includes;
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Profitability Index
- Payback Period
Net Present Value
NPV is the abbreviation of net present value and it’s the difference between the present value of cash inflows and present value of cash outflows over a period of time. NPV is used in capital budgeting to analyze the profitability of a projected investment or project.
Strengths of NPV
- Calculation of NPV is easy and the interpretation of resulted figure is also easy. The resulted NPV figure shows how the wealth of the company or wealth of shareholder will change if the positive NPV projects are accepted.
- The positive NPV projects theoretically increase the wealth of Shareholder this concept is consistent with shareholder wealth maximization concept.
Weakness of NPV
- When the NPV calculation is based on wrong estimation this may result in the acceptance of wrong projects especially when the company decides about many projects.
Internal Rate of Return
IRR is the abbreviation of internal rate of return and it’s the method of calculating IRR of the company. The term internal refers to the fact that the internal rate excludes factors such as inflation the Cost of capital, or various financial risks. It is also called the discounted cash flow rate of return.
- The major strength of IRR is that it is generated by the project itself.
- The acceptance criteria if the IRR is equal or greater to the required rate of return.
- The IRR acceptance criteria are consistent with shareholder wealth maximization.
- IRR is difficult to calculate.
- Thorough finance knowledge is required to understand IRR.
- It is possible that multiple IRR exist of a project. So decision on the basis of IRR would be difficult.
- The multiple IRR sometimes requires the re estimation of Cash flows.
Profitability index also known as profit investment ratio and value investment ratio is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment.
Strengths of Profitability Index
- The Profitability index number is easy to understand simply it is saying how many dollars you get by investing how many dollars.
- It is consistent with the shareholder wealth maximization.
- Very useful when the company uses capital rationing.
Weakness of Profitability Index
- The major weakness is if the initial cash flow in a project is not an out flow but inflow then the calculation of profitability index would difficult.
- In case of mutually exclusive projects the Profitability index would be difficult to apply.
Payback period is the length of time required for an investment to recover its initial out lay in terms of profits or saving.
Strengths of Payback Period
- Easy to calculate and does not require Finance calculation or knowledge.
Weakness of Payback Period
- It is not based on discounted cash flow.
- The method is applicable for small business only in order to solve the major weakness we calculate discounted payback period.
The DCF techniques are good techniques for apply in the project decision making but precautions should be taken to apply these techniques because there are times when one technique output is better for some reason as compared to other.
December 06, 2018