Question

There are 4 methods to analyze capital budgets. Which are they and what are their main characteristics?

Answer 1

Different methods to analyze capital budgets are as follows

- Payback period

- Net present value

- Internal rate of return

- Profitability index

(1) Payback Period

- It measures the time in which initial cash flow is rerurned by the project. Lower payback period is preferred by this method. Another variation of this method is discounted payback period in which cash inflows are discounted and then payback period is found.

(2) Net present value

- It is calculated by deducting discounted cash outflow from discounted cash inflow. Higher NPV is preferred and project is only viable if NPV is positive.

(3) Internal rate of return

- It is the discount rate at which net present value of project becomes zero. This discount rate is compared with hurdle rate or cost of capital. If IRR is greater than hurdle rate or cost of capital, the project is selected

(4) Profitability Index

- It is the ratio of present value of cash inflows and initial investment required in the project. Higher the profitability index, better the project. Also it should be more than 1 for project to get selected.