Capital Budgeting is the process of evaluating various projects and investment ideas based on their future net cash flow.
- An investment is considered viable only if it is profitable, capital budgeting helps to find the profitability of a project and compare two projects for the better one.
- There are various methods to calculate and compare the profitability of various projects and support the Investment Decision of an organization. These methods may be used individually or two of them may be combined to get a better picture of the investment profile, the methods are as discussed below:
- Net Present Value Criteria: Net Present Value is the difference between the initial amount of an investment and the present value of all future tax-free cash flows. If the NPV of an investment is positive, then that investment is profitable. NPV is superior to all other available mechanisms to help make investment decisions.
- Internal Rate of Return (IRR): IRR is the discount rate for which NPV = 0. A project is profitable only if IRR > Required Rate of Return.
- Profitability Index: Profitability Index measures the ratio between the present value of future cash flows to the initial investment. A project is said to be profitable if PI > 1
- Payback Period: Payback period is the time required to recover the original capital employed at the beginning of the project. Projects with a shorter payback period are preferred.
- Discounted Payback Period: Discounted Payback period is the time required to recover the original capital employed at the beginning of the project considering the impact of the time value of money. Projects with shorter discounted payback periods are preferred.
- Accounting Rate of Return (ARR): ARR is the average net income expected by a project divided by the average capital cost. A project is said to be viable if ARR > Returns Expected.
