Capital Budgeting and its Types

Before studying types of Capital Budgeting Decision, you should know what is actually capital budgeting technique. Students Explore has briefed it in previous post in very easy language to understand the idea and concept of Capital Budgeting Decision, you must visit that post first. Then you come on this post learn its types.

 

What is Capital Budgeting

Capital budgeting is a process of evaluating investments and huge expenses in order to obtain the best returns on investment.

 

Types of Capital Budgeting Techniques

Finding out whether or not a project will be profitable is one of a company’s first jobs when faced with a capital budgeting Techniques.

The company needs an installation plan, operating staff, and of course a financial plan. A cash-based notion, budgeting. Despite a company’s over $10 million in annual sales, a purchase may be challenging to complete if there is no cash on hand. For your budgeting needs, you should take into account three different sorts of capital budgeting strategies.

 

  • The payback period (PB)
  • Internal rate of return (IRR)
  • Net present value (NPV) methodologies

 

The traditional methods or non discount methods include: Payback period and Accounting rate of return method.

The discounted cash flow method includes: The NPV method, profitability index method and IRR.

There will be a preference for one strategy over another based on management preferences and selection criteria. Nonetheless, there are common advantages and disadvantages associated with these widely used valuation methods.

 

Payback Period

The simplest way to set aside money for a new asset is in this way. Determine how long it will take a business to pay off an asset using the payback technique. For instance, a business intends to invest $500,000 in a new IT server that is expected to provide $50,000 in revenue annually. The assumption made in this capital budgeting example is that the purchase can be repaid in 10 years.

The total purchase price of $500,000 equals $50,000 in cash flows over a ten-year period.

The corporation can recoup the cost of the new piece of equipment more quickly the shorter the payback period is.

 

Net Present Value (NPV)

With one major exception, the Net Present Value (NPV) method is similar to the payback method: money loses value over time. This approach involves calculating the discrepancy between the asset’s cost and its discounted cash flows. Future cash flows lose value over time, hence the term “present value.” The project is anticipated to be profitable when the discounted future cash flows are greater than the asset’s cost. However, such project is not anticipated to be profitable if the costs exceed the projected cash flows. The fact that the NPV technique takes into account the dollar’s declining value over time gives it a significant advantage over the payback method.

 

Internal Rate of Return (IRR), Capital Budgeting

The most difficult of the three is the internal rate of return (IRR) technique. With this approach, the project’s financing costs are contrasted with the asset’s return. To determine the rate of return, it is comparable to and includes the net present value technique. The project is anticipated to be profitable if the IRR is higher than the cost. However, the project is anticipated to lose money if the costs outweigh the return.

This approach is predicated on the notion that percentage results are regarded as more significant than monetary results. This idea of percentage increase compared to dollar growth is illustrated in the graphic below.

capital budgeting

capital budgeting

3 Responses

  1. November 20, 2022

    […] Types of Capital Budgeting […]

  2. November 26, 2022

    […] Types of Capital Budgeting […]

  3. January 1, 2023

    […] Types of Capital Budgeting […]

Leave a Reply