What are Some Effective Capital Budgeting Techniques?

Capital budgeting is a technique that companies use for appraising different products. The accounting and finance technique is used for the appraisal of the potential value of an investment asset.

In this blog post, we will shed light on different types of capital budgeting techniques. Consider hiring outsourced bookkeeping services so that you can focus on capital budgeting to optimize your business investment.

Capital Budgeting: An Overview

Capital budgeting involves determining the value of a project. The management compares between different projects using capital budgeting techniques.

The aim of capital budgeting is to select a project that will result in optimal cash flows. The method helps the management in making the right investment decisions.

The management can use different types of capital budgeting techniques. Here are the common methods that management uses to appraise and budget value of capital projects.  

1. Payback Period

Payback Period is a simple capital budgeting technique. The method involves determining the time that the cash flows generated from an investment will repay the invested amount.

A simple example will help in understanding the capital budgeting technique. Suppose that investment of $10,000 in an asset is expected to generate a cash flow of about $500 per month. This means that you will be able to recoup the investment in about 20 months.

The capital budgeting method provides great insights about the liquidity position of the investment. It provides information about the length of time the invested amount will be recovered. The analysis of the investment includes cash flow during the payback period. So, the method does not tell about the overall profitability from investing in a project.

The payback period only tells you when you will be able to recover the investment. It does not inform you about the net revenues from the project. As a result, the capital budgeting method cannot be used for evaluating two or more projects.

2. Discounted Payback Period

Discounted payback period is an improved version of the payback period as it accounts for the time value of money. The method discounts the cash flows obtained in the future back to the present value. This method of capital budgeting allows comparison of the stream of cash flow and investment at a particular time period.

Every cash flow is discounted over a different period. The discount rate selected for a period represents the potential rate of return from the project. It helps the management in comparing and selecting a project with the optimum discounted cash flows.

3. Profitability Index

Profitability Index involves determining the potential value of the investment. The method involves dividing the present value of the cash generated from the project by the present value of the cash outflows regarding the project.

A profitability index greater than one means a positive cash flow. Contrarily, a profitability index of less than one refers to a negative cash flow. Management will generally accept a project only if the profitability index is greater than one.

Profitability index is calculated using different discount rates. The method allows comparing different projects. While the method does not specify the cash return, it does specify if the investment in a capital project will result in a positive cash flow.

As an example, suppose that you have to decide between two different projects. The first project has a discount rate or profit of 10 percent while the second has a discount rate of 5 percent. The project at 10 percent discount rate returns 95 cents of discounted cash inflow per one unit of cash outflow. In comparison, the second project returns about $1.1 discounted cash inflow per discounted cash outflow. The management will select the second project with a lower discount rate since the discounted net cash flow is higher.

4. Net Present Value

Net Present Value is yet another type of capital budgeting technique. The method involves taking into account the future cash values over the present time. The cash flows can be positive of the cash outflow is more than the cash inflow.

The present value of the investment is the face value since the investment is made at the start of the period. The ending cash flow consists of the remaining value of the asset at the end of the period. The inflows and outflows of the cash over the investment period are then discounted back using a discount rate.

Management will select a project only when the present value of cash inflow exceeds the present value of cash outflows. The benefit of this method is that it can help in comparing different capital projects. The management will select a project that result in the highest net present value.

5. Internal Rate of Return

Internal rate of return is also used by the management for analyzing capital investments. The method involves discounting capital investment using a particular rate. The method helps the management to know about the rate of return or discount rates that will help in recover the invested amount.

The management will select a project with a higher internal rate of return. But it is important to use this method carefully. The method involves determining the surplus and deficit of cash during a period. The method will provide accurate results as long as cash flows are positive. The method will not be accurate if the cash flows fluctuate between positive and negative flows.

Conclusion

Companies can use different types of capital budgeting techniques. The goal of the project appraisal will determine the best type of budgeting technique. If the aim of the management is to find out the period of time when the invested amount can be recovered, the best method include discounted pay back period.

Internal rate of return method is suitable if the management wants to know about the rate of return that will help in recovering the invested amount in a specific number of years. In contrast, the net present value is suitable if the monument wants to compare which projects will provide the highest returns.

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