Capital budgeting is a mode of assessing prospective investment openings and pronouncements based on whether to undertake a certain project or not; it is taken founded on certain budgeting modes.
Net Present Value
Net Present value is a budgeting method computed as a variance between the present value of cash inflows and cash outflows. The pronouncements for projects founded on NPV are taken as accepting a project that bears an NPV greater than zero and rejecting projects with an NPV that is less than zero (Kulakov & Kastro, 2017). Independent projects are considered assets of projects whereby the acceptance or rejection of a specific project does not significantly impact decisions based on other projects. If every project adheres to NPV criteria, therefore more than one development may be accepted.
On the other hand, mutually exclusive projects are various projects whereby the development with the greatest NPV is acknowledged, and the others are disregarded. Approval of a certain project impacts other developments, and additional developments are not chosen.
Internal Rate of Return
Based on the Internal Rate of Return, it is considered the rate at which a project’s Net Present value is zero. IRR assesses an investment’s attractiveness. A project with an IRR higher than the cost of capital for a developed ought to be acknowledged. IRR is correlated to NPV as it is the frequency in which the NPV is zero (Patrick & French, 2016). In this case, the NPV is the preferred technique used on capital budgeting decisions as it takes into account the time value for money and illustrates the value of the project. In most instances, the NPV and IRR result in similar pronouncements. Nonetheless, if a variance in the cash flow pattern is experienced, NPV and IRR may exhibit diverse pronouncements.
Additional Budgeting Techniques
Additional capital techniques such as discounted payback period, accounting rate of return, and the profitability index exist. Foremost, the payback period’s key disadvantage is that it fails to consider time value for money. The drawback is made certain by the additional techniques that entail the discounted payback period. Nonetheless, it fails to consider and lead to the dollar value earned by the project and therefore may not be completely be relied upon. Secondly, the accounting rate of return fails to consider the time value for money. Third, the main drawback of the profit index technique is failing to offer accurate decisions during comparisons with mutually exclusive projects.