List of Top 5 Capital Budgeting Techniques (with examples)
You are free to use this image on your website, templates, etc, Please provide us with an attribution linkArticle Link to be Hyperlinked Let us discuss this one by one in detail along with examples – #1 – Profitability IndexProfitability Index is one of the essential techniques, and it signifies a relationship between the investment of the project and the payoff of the project. The formula of profitability indexThe Profitability Index is calculated by dividing the present value of all the project's future cash flows by the initial investment in the project. Profitability Index = PV of future cash flows / Initial investment read more given by:- Profitability Index = PV of future cash flows / PV of initial investment Where PV is the present value. It is mainly used for ranking projects. According to the rank of the project, a suitable project is chosen for investment. #2 – Payback PeriodThis method of capital budgeting helps to find a profitable project. The payback period is calculated by dividing the initial investment by the annual cash flows. But the main drawback is it ignores the time value of money. By the time value of moneyThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment.read more, we mean that money is more today than the same amount in the future. So if we payback to an investor tomorrow, it includes an opportunity costThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It's essentially the cost of the next best alternative that has been forgiven.read more. As already mentioned, the payback period disregards the time value of money. It is calculated by how many years it is required to recover the amount of investment done. Shorter paybacks are more attractive than more extended payback periods. Let’s calculate the payback period for the below investment:- ExampleFor example, there is an initial investment of ₹1000 in a project, and it generates a cash flow of ₹ 300 for the next five years. Therefore the payback period is calculated as below:
Therefore it will take 3.33 years to recover the investment. #3 – Net Present ValueNet Present ValueNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not.read more is the difference between the present value of incoming cash flow and the outgoing cash flow over a particular time. It is used to analyze the profitability of a project. The formula for the calculation of NPV is as below:- NPV = [Cash Flow / (1+i)n ] – Initial Investment Here i is the discount rate, and n is the number of years. ExampleLet us see an example to discuss it. Let us assume the discount rate is 10%
We can also calculate it by basic excel formulasThe term "basic excel formula" refers to the general functions used in Microsoft Excel to do simple calculations such as addition, average, and comparison. SUM, COUNT, COUNTA, COUNTBLANK, AVERAGE, MIN Excel, MAX Excel, LEN Excel, TRIM Excel, IF Excel are the top ten excel formulas and functions.read more. There is an in-built excel formula of “NPV” which can be used. The discounting rate and the series of cash flows from the 1st year to the last year are considered arguments. We should not include the year zero cash flow in the formula. We should later subtract it.
As NPV is positive, it is recommended to go ahead with the project. But not only NPV but IRR is also used for determining the profitability of the project. #4 – Internal rate of returnThe Internal rate of return is also among the top techniques that are used to determine whether the firm should take up the investment or not. It is used together with NPV to determine the profitability of the project. IRR is the discount rate when all the NPV of all the cash flows is equal to zero. NPV = [Cash Flow / (1+i)n ] – Initial Investment =0 Here we need to find “i” which is the discount rate. ExampleNow we shall discuss an example to understand the internal rate of returnInternal rate of return (IRR) is the discount rate that sets the net present value of all future cash flow from a project to zero. It compares and selects the best project, wherein a project with an IRR over and above the minimum acceptable return (hurdle rate) is selected.read more in a better way. While calculating, we need to find out the rate at which NPV is zero. This is usually done by error and trial method else we can use excel for the same. Let us assume the discount rate to be 10%. NPV at a 10 % discount is ₹ 574.730. So we need to increase the discount percentage to make NPV as 0. So if we increase the discount rate to 26.22 %, the NPV is 0.5, which is almost zero. There is an in-built excel formula of “IRR,” which can be used. The series of cash flows is taken as arguments.
Therefore in both ways, we get 26 % as the internal rate of return. #5 – Modified Internal Rate of returnThe main drawback of the internal rate of return that it assumes that the amount will be reinvested at the IRR itself, which is not the case. MIRRMIRR or Modified Internal Rate of Return refers to the financial metric used to assess precisely the value and profitability of a potential investment or project. It enables companies and investors to pick the best project or investment based on expected returns. It is nothing but the modified form of the Internal Rate of Return (IRR).read more solves this problem and reflects the profitability in a more accurate manner. The formula is as below:- MIRR= (FV (Positive cash flows* Cost of capital)/ PV(Initial outlays * Financing cost))1/n −1 Where,
ExampleWe can calculate MIRR for the below example: Let us assume the cost of capitalThe cost of capital formula calculates the weighted average costs of raising funds from the debt and equity holders and is the total of three separate calculations – weightage of debt multiplied by the cost of debt, weightage of preference shares multiplied by the cost of preference shares, and weightage of equity multiplied by the cost of equity.read more at 12%. In MIRR, we need to consider the reinvested rate, which we assume as 14%. In Excel, we can calculate as the below formulae
A MIRR in excelMIRR or (modified internal rate of return) in excel is an in-build financial function to calculate the MIRR for the cash flows supplied with a period. It takes the initial investment, interest rate and the interest earned from the earned amount and returns the MIRR.read more is a better estimation than an internal rate of return. ConclusionTherefore capital budgeting methods help us to decide the profitability of investments that need to be done in a firm. There are different techniques to decide the return of investment. Recommended ArticlesThis has been a guide to Capital Budgeting Techniques. Here we will discuss the Top 5 methods of Capital Budgeting along with formula, explanation & examples. You can learn more about accounting from the following articles –
Which method of capital budgeting uses time value of money?The specific time value of money calculation used in Capital Budgeting is called net present value (NPV). NPV is the sum of the present value (PV) of each projected cash flow, including the investment, discounted at the weighted average cost of the capital being invested (WACC).
Which of the following methods is taken in account time value of money?Rate of return method takes into account the time value of money.
What is the 4 techniques for capital budgeting?Payback Period, Net Present Value Method, Internal Rate of Return, and Profitability Index are the methods to carry out capital budgeting.
Which two capital budgeting techniques use TVM?Methods of Applying Time Value of Money
Two of the most popular methods are net present value and internal rate of return, or IRR. In the first method, you add up the present values of all cash flows involved in a project.
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