7.5 : Capital Budgeting Techniques

Capital budgeting techniques are essential tools that businesses use to evaluate and select investment projects. Four of the most common methods are Net Present Value (NPV), Internal Rate of Return (IRR), Payback Period, and Profitability Index (PI).

Net Present Value (NPV) evaluates the difference between the present value of future cash inflows and the initial investment cost. A positive NPV suggests the project is likely profitable, making it a favorable investment option.

Internal Rate of Return (IRR) determines the discount rate that results in an NPV of zero. A higher IRR indicates an investment produces more value than its cost and is typically compared to the company's desired rate of return to assess its viability.

The Payback Period is the time required to recover the initial investment from the project's cash inflows. While it provides a quick measure of risk, it does not account for the profitability beyond the payback period.

Profitability Index (PI) measures the ratio of benefits to costs. A PI greater than 1 indicates that the investment generates more value than it costs, making it a viable option.

Each technique offers valuable insights into an investment's potential profitability and risks, helping businesses make informed decisions.