Capital Budgeting: Top 3 Techniques You Can Use to Evaluate the Investment Projects

Investing in a new property is the dream of every business owner but right before they spend their hard earned on a piece of property, it is necessary to perform capital budgeting. An organization always see things from profit or lost point of view. Hence, they implement the capital budgeting to determine the fundamental merits of the investment. The decision of either investing or not in a specific project depend upon the growth initiatives of an organization that includes the return of investment from the project.

The most popular capital budgeting techniques that are used in an organization are as follows:

Payback Period

The payback often known as payout period technique is a popular capital budgeting method that is used to evaluate an investment proposal. It is one of the traditional methods through which the investor defines the merits as the number of years that will be necessary to recover the total investment if the project continuously generates the annual cash flow. The accounting formula of the payback period is: –

Payback Period = Cash outlay (investment) / Annual cash inflow = C / A.

Advantages of Payback Period?

The main advantage of the payback period is: –

•    The company can gain more favours on short-term effects on earning per share by reducing the payback period.
•    The risk factor can be reduced by setting up a short period of payback check.

Disadvantages of payback period?

•    The method fails to analyse the cash flow that will be earned after the payback period.
•    It is not an ideal method to measure the profitability of the investment as it fails to consider the entire cash flow.
•    The method fails to consider the cash flow.

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Accounting Rate of Return method

The second most popular method of capital budgeting that is used to analyse the profitability of an organizational investment. This capital budgeting method considers the accounting information determined through the financial statements to measure the profitability of the project. The accounting method to measure the rate of return is: –

ARR = Average income/Average investment

Advantages of Rate of Return method

The foremost advantages of applying this method is: –

• It is easy to understand and implement.
• It can be easily calculated optimising the accounting data.
• It considers the entire streams of income while calculating the accounting rate.

Disadvantages of Rate of Return method

•    It utilizes accounting rather than focusing on the cash-flow to appraise the project.
•    The method doesn’t value money and treats all occurring profit equally.
•    It doesn’t consider the overall length of the project.
•    It doesn’t consider the fact that reinvestment can be done.

Net present value method

The method refers to the process through which the investors evaluate the current cash flows of the investment project. The accounting equation for calculating the net present value method is: –

In the above equation, A1 and A2 represent, whereas the K is the cost of the capital. C is the cost of the investment proposal and n is expected life. Visit BookMyEssay and hire Capital Budgeting Assignment Help to gain more information about the subject.

Advantages of Net present value method

•    This method was developed by considering the time value of the investment.
•    It includes overall cash flows on which the entire life of the project.
•    The method works with the foremost objective of maximizing the welfare of the investors.

Disadvantages of Net present value method

•    The method is quite difficult to implement.
•    It predefines the discount rates which are usually the firm’s cost of capital.
•    It may not be effective when different types of projects being compared.

The investors can use any of these methods to evaluate the profitability of the proposed projects.

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