Posted by: CIEL on Mon, Apr 23rd, 2018
Capital Budgeting Techniques for Beginners - 5 Methods
Large investments and purchases like a new manufacturing plant, property acquisition or shares in a new venture require an equal amount of forethought and analysis. You need to know if they are actually worth the time, effort and money and that they will add value to your business, long-term. And that’s where capital budgeting techniques prove useful in accounting.
These techniques show the benefits and drawbacks of any investment you make. If one or more such projects are being considered, capital budgeting techniques can be applied to each to determine which project is profitably viable in the long term.
An Introduction to Capital Budgeting Techniques
Ideally, businesses prefer taking on projects and investments that increase shareholder value and encourage growth. There are various capital budgeting techniques that are used to calculate a project’s future accounting profit. There are five main methods used, namely:
- Payback Period
- Net Present Value (NPV)
- Accounting Rate of Return (ARR)
- Internal Rate of Return (IRR)
- Profitability Index (PI)
Let’s look at each of these techniques in more detail.
1. Payback Period:
Often used as a starting off point for capital budgeting analysis, this method is possibly the simplest all capital budgeting techniques. As the name states, this technique measures the time a company will take to recover its initial investment. It can be calculated using the following formula:
Payback Period = Cash Outlay (Investment) / Annual Cash Inflow
If the payback period is too long, very often a business will choose not to invest in a particular project. A major drawback of this method is that it does not take into account the time value of money.
2. Net Present Value (NPV):
This is a Discounted Cash Flow method of analysis. In this method, the present values of the cash inflow are compared to the initial investment. First, the net cash flows (which can be even or uneven) of a project over its lifetime are estimated and which are then discounted at the hurdle rate. A big advantage of this method is that the time value of money is factored in. If the NPV is positive, businesses normally take up the project.
3. Accounting Rate of Return (ARR):
This method calculates the profitability of an investment as a ratio of the average income after taxes to the average investment made in the project. The formula used is:
ARR= Average Income/Average Investment
The management determines the minimum rate and any project above that rate is considered as a good option for investment. However, this method too does not consider the time value of money nor does it factor in the reinvestment of profits.
4. Internal Rate of Return (IRR):
A simple way to explain Internal Rate of Return is the rate of growth a project is expected to generate. This slightly advanced technique is the discount rate at which the NPV of an investment is zero or the discount rate which equates the present value of the future cash flows of an investment with the initial investment. Projects are considered for investment only if the IRR is equal to, or exceeds the target value.
5. Profitability Index (PI)
PI is calculated by dividing the present value of future cash flows of a project by the initial investment. Therefore:
PI = Present Value of Future Cash Flows/ Initial Investment Required
Any project with PI > 1.0 is acceptable.
The decision on whether to invest in a particular project is a weighty one and needs careful consideration. Knowing how and when to apply these techniques is a crucial skill for accountants and decision making authorities. A simple way to learn to do this is by doing an online capital budgeting course. A carefully planned, and a thoroughly analyzed project can take your business to new heights!