Q2Managerial Economics & Financial Accounting
Question
What are the capital budgeting techniques explain with suitable example.
Answer
Capital budgeting techniques include traditional methods like Payback Period and ARR, and Discounted Cash Flow methods like NPV and IRR.
Capital budgeting is the process of evaluating long-term, large-scale investment projects. The techniques are divided into two main categories:
- Payback Period: Calculates how quickly an investment recovers its initial cash outlay. Example: A machine costs 25k per year. The payback period is 4 years. Shorter is better. - Accounting Rate of Return (ARR): Uses accounting profit instead of cash flows. Example: Average annual profit of 100k yields a 10% ARR.
- Net Present Value (NPV): Discounts all future cash inflows back to today's present value (using a discount rate) and subtracts the initial cost.
Example: If PV of inflows is $120k and cost is $100k, NPV = +$20k. Accept if NPV > 0.
- Internal Rate of Return (IRR): Finds the exact percentage discount rate that forces the NPV to be exactly zero.
Example: If a project's IRR is 14% and the company's cost of capital is 10%, the project is profitable.