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Every business faces a situation where it needs to take a decision on long-term investments. Capital Budgeting techniques help decision making long-term investment decisions. Some of the examples of long-term investment decisions that modern corporations faces are:
- Whether to install a new machinery or build a new plant/factory?
- Should we increase the Capacity of an existing plant?
- Whether to outsource or in-built a part of the product or process (Buy or Make)?
- Whether to launch a new product or not?
- Which investment opportunities to choose from multiple choices?
And the list goes on. Any investment decision will need an analysis using Capital budgeting techniques.
So what are these techniques? Here is the answer:
- Net Present Value (NPV) is the sum of the present values (PVs) of the individual cash flows of the same entity.
- Internal Rate of Return (IRR) is the discount rate that gives a net present value (NPV) of zero and is commonly used to measure investment efficiency.
- Payback Period is the period of time required for the return on an investment to cover the sum of the original investment.
- Discounted Payback Period is a period of time it takes to break even from undertaking the initial expenditure.
- Profitability Index is the ratio of payoff to the investment of a proposed project.
- Accounting Rate of Return is a financial ratio that does not take into account the concept of time value of money.
All the above methods are unique in itself and serve a different purpose. The suitability of the method depends on the type of investment decisions and other constraints of the business. However, all the methods can be applied to every investment decision. On the popularity chart, NPV is at the top followed by IRR and Payback Period.
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