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)
- Profitability index
- Payback period
- Net present value
- Internal rate of return
- Modified rate of return
Let us discuss these capital budgeting techniques one by one in detail along with examples –
#1 – Profitability Index
Profitability Index is one of the most important techniques of capital budgeting and it signifies a relationship between the investment of the project and the payoff of the project.
The formula of profitability index given by:-
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.
#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 time value of money, we mean that money is more today than the same value in the future. So if we payback to an investor tomorrow, it includes an opportunity cost. 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 longer payback periods. Let’s calculate the payback period for the below investment:-
For example, there is an initial investment of ₹1000 in a project and it generates a cash flow of ₹ 300 for the next 5 years.
Therefore the payback period is calculated as below:
- 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 Value is the difference between the present value of incoming cash flow and the outgoing cash flow over a certain period of time. It is used to analyze the profitability of a project.
The formula for the calculation of NPV is as below:-
Here i is the discount rate and n is the number of years.
Let us see an example to discuss it.
Let us assume the discount rate is 10%
- 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 excel formula.
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 is taken as arguments. We should not include the year zero cash flow in the formula. We should later subtract it.
- = 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 capital budgeting 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.
Here we need to find “i” which is the discount rate.
Now we shall discuss an example to understand the internal rate of return 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.
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 that 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.
- =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. MIRR solves this problem and reflects the profitability in a more accurate manner.
The formula is as below:-
- N = the number of periods
- FVCF = the future value of positive cash flow at the cost of capital
- PVCF = the present value of negative cash flows at the financing cost of the company.
We can calculate MIRR for the below example:
Let us assume the cost of capital at 12%. In MIRR we need to take into account the reinvested rate which we assume as 14%. In Excel, we can calculate as the below formulae
- MIRR= (cash flows from year 0 to 4th year, cost of capital rate, reinvestment rate)
- MIRR= (-1000: 600, 12%, 14%)
- MIRR= 22%
A modified rate of return is a better estimation than an internal rate of return.
Therefore capital budgeting methods help us to decide the profitability of investments which needs 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 following articles –