In this note, we will learn about some Basic Techniques in Capital Budgeting like – Payback period method, Net Present Value method, and Internal Rate of Return method. Welcome to Poly Notes Hub, a leading destination for Engineering Notes.
Author Name: Arun Paul.
Basic Techniques in Capital Budgeting
There three basic techniques in capital budgeting –
1. Payback Period Method
This strategy focuses on calculating how long it takes for an investment to generate adequate cash flows to cover its initial cost. It is determined by dividing the initial investment by the annual cash inflow. The shorter the payback period, the better the investment is viewed. However, this strategy does not account for cash flows after the payback period and overlooks the time value of money.
2. Net Present Value (NPV) Method
The NPV technique examines the time value of money by discounting all future cash flows to their present value using a predetermined discount rate. The NPV is computed by deducting the original investment from the total present value of all cash inflows. A positive NPV shows that the project will yield more cash flows than the initial investment, making it financially appealing. A negative net present value (NPV) signifies that the investment may not be profitable enough to cover its costs.
3. Internal Rate of Return (IRR) Method
The IRR is the discount rate at which the net present value of an investment equals zero. In other words, the rate of return determines whether the current value of cash inflows equals the initial investment. The bigger the IRR, the better the investment. It is frequently compared to the cost of capital; if the IRR exceeds the cost of capital, the venture is deemed financially viable. However, IRR can sometimes produce many answers, making interpretation difficult.