Accounts Notes: What are the Methods of Capital Budgeting

Tuesday, 5 April 2011

What are the Methods of Capital Budgeting

1. Traditional Methods
Payback period method
Average rate of return (ARR)
2. Discounted Cash Flow Methods or Sophisticated methods
Net present value (NPV)
Internal rate of return (IRR)
Profitability index

Pay back period: Required time to reach actual investment is known as payback period.

= Investment / Cash flow

ARR: It means the average annual yield on the project.

= avg. income / avg. investment
Or
= (Sum of income / no. of years) / (Total investment + Scrap value) / 2)
NPV: The best method for the evaluation of an investment proposal is the NPV or discounted cash flow technique. This metod takes into account the time value of money.
The sum of the present values of all the cash inflows less the sum of the present value of all the cash outflows associated with the proposal.
NPV = Sum of present value of future cash flows – Investment
IRR: It is that rate at which the sum total of cash inflows aftrer discounting equals to the discounted cash outflows. The internal rate of return of a project is the discount rate which makes net present value of the project equal to zero.