Capital Budgeting Techniques

Updated on March 20, 2024
Article byPritha Banerjee
Edited byPritha Banerjee
Reviewed byDheeraj Vaidya, CFA, FRM

What is Capital Budgeting Techniques?

Capital budgeting technique is the company’s process of analyzing the decision of investment/projects by taking into account the investment to be made and expenditure to be incurred and maximizing the profit by considering following factors like availability of funds, the economic value of the project, taxation, capital return, and accounting methods.

List of Top 5 Capital Budgeting Techniques (with examples)

  1. Profitability indexProfitability IndexThe profitability index shows the relationship between the company projects future cash flows and initial investment by calculating the ratio and analyzing the project viability. One plus dividing the present value of cash flows by initial investment is estimated. It is also known as the profit investment ratio as it analyses the project's profit.read more
  2. Payback period
  3. Net present value
  4. Internal rate of returnInternal 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
  5. Modified rate of return
Capital Budgeting Techniques

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Source: Capital Budgeting Techniques (wallstreetmojo.com)

Let us discuss this one by one in detail along with examples –

#1 – Profitability Index

Profitability 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 indexFormula 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.

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#2 – Payback Period

This 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 moneyTime 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 costOpportunity 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:-

Example

For example, there is an initial investment of ₹1000 in a project, and it generates a cash flow of ₹ 300 for the next five years.

payback period example 1

Therefore the payback period is calculated as below:

payback period example 1.1
  • Payback period = no. of years – (cumulative cash flow/cash flow)
  • Payback period = 5- (500/300)
  • = 3.33 years

Therefore it will take 3.33 years to recover the investment.

#3 – Net Present Value

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.

Example

Let us see an example to discuss it.

Let us assume the discount rate is 10%

npv example 1.1
  • NPV = -1000 + 200/(1+0.1)^1 + 300/(1+0.1)^2+400/(1+0.1)^3+600/(1+0.1)^4+ 700/(1+0.1)^5
  • = 574.731

We can also calculate it by basic excel formulasBasic 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.

npv example 1.2
  • = NPV (Discount rate, cash flow of 1st year: cash flow of 5th year) + (-Initial investment)
  • = NPV (10%, 200:700) – 1000
  • = 574.731

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 return

The 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.

Example

Now we shall discuss an example to understand the internal rate of returnInternal 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.

irr example 1

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.

capital budgeting techniques irr example 1.1
  • =IRR (Cash flow from 0 to 5th year)
  • = 26 %

Therefore in both ways, we get 26 % as the internal rate of return.

#5 – Modified Internal Rate of return

The 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. MIRRMIRRMIRR 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,

Example

We can calculate MIRR for the below example:

Let us assume the cost of capitalCost 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

capital budgeting techniques mirr example 1
  • MIRR= (cash flows from year 0 to 4th year, cost of capital rate, reinvestment rate)
  • MIRR= (-1000: 600, 12%, 14%)
  • MIRR= 22%

A MIRR in excelMIRR 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.

Conclusion

Therefore 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.

This 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 –