Question

Discuss at least three (3) of the capital budgeting techniques. Also, include the circumstance from which its use is preferred.

Answer 1

1) Payback period method :- This method is used to calculate the period in which the initial investment is recovered by the company.This method doesn't give importance to time value of money it focuses only on cash inflows, initial investment and economic life of the project.In this method the proposal selection is based on the earning capacity of the firm.

Formula of payback period = Cash outflow (Investment)/Annual cash inflow

2) NPV method (Net present value) :- In this method expected future cashflows is discounted at specific rate and the present value of cash inflows is subtracted with the initial investment in order to arrive at net present value of the project.This method considered the time of money concept and wealth maximization objection of shareholders.This method is most widely used method as if the NPV is positive project should be accepted otherwise rejected.

NPV = Present value of discounted cash inflows - Cash outflows (Initial Investment)

3) Profitability Index (PI) :- This method calculates the ratio of present value future cash inflows discounted at the required rate of return to the initial investment.This ratio indicates if ratio is positive project should be accepted otherwise rejected.It is similar to NPV method but the only difference is it is indicated in terms of ratio.

PI = NPV(Benefits)/NPV(Costs)