Capital Budgeting Techniques
Capital budgeting is a crucial process that companies use to evaluate potential investments and projects. Below are the key techniques along with their merits and demerits.
1. Net Present Value (NPV)
- Merits:
- Considers the time value of money.
- Provides a clear metric for profitability.
- Demerits:
- Requires accurate cash flow estimates.
- Sensitive to discount rate changes.
2. Internal Rate of Return (IRR)
- Merits:
- Easy to understand and communicate.
- Considers the time value of money.
- Demerits:
- Can give multiple values for non-conventional cash flows.
- May not reflect the actual cost of capital.
3. Payback Period
- Merits:
- Simple to calculate and understand.
- Useful for assessing liquidity and risk.
- Demerits:
- Ignores cash flows after the payback period.
- Does not consider the time value of money.
4. Profitability Index (PI)
- Merits:
- Useful for ranking projects.
- Takes into account the time value of money.
- Demerits:
- Can be misleading if used alone.
- Requires accurate cash flow estimates.
5. Modified Internal Rate of Return (MIRR)
- Merits:
- Addresses some limitations of IRR.
- Provides a more realistic measure of profitability.
- Demerits:
- More complex to calculate.
- Still sensitive to cash flow assumptions.
Understanding these techniques helps businesses make informed investment decisions by balancing potential returns against associated risks.