Question

Which measures are important when analyzing capital budgeting decisions? Why?

Answer 1

Important measures when analysing Capital Budgeting Decisions are as follows:

1. Payback period - It can be defined as how long will it take to get back the investment made in the project. We need to select such a project whose payback period is the shortest as it would define that we can get back out initial investment made in the project in the shortest span of time.

2. Net Present Value - It can be defined as the difference between cash inflows from the project and cash outflows from the project. A project will be considered viable only when its Net Present Value is positive or its Net Present Value is higher than the other alternatives. When Net Present Value is positive it would add value to the company and the shareholders would be benefitted.

3. Internal Rate of Return - The internal rate of return is the discount rate at which Net Present Value of the project will be zero. Decision making in such cirmcumstances will depend on whether internal rate of return is greater than cost of financing or less than the cost of financing. If the internal rate of return is greater than cost of financing then investment should be made in the project, and vice versa.

4. Accounting rate of return : It is the method by which the profitability of a project is calculated. It is calculated by dividing income from the project with initial investment made in the project. It is the job of the management to set the minimum rate of return from a project and a project shall be accepted if the Accounting rate of return exceeds the minimum rate of return.

5. Profitability Index : It is the method to evaluate investment projects for their profitability. It is calculated by dividing present value of future cash flows with initial investment of the project, A project will only be accepted if Profitability index is greater than 1.