What is Capital Budgeting

The planning process taken up by business firms and other governmental organizations to decide whether owning a particular fixed asset like the machinery, land etc is worth pursuing is called capital budgeting. Capital refers to fixed assets. The investment involved for capital assets is high; hence the right planning is essential for the right investment. There are different techniques that are used by the business firms for capital budgeting, they are mentioned as under: –

Profitability Index
This index is also known as the profit investment ratio. This formula helps us to calculate the amount of return generated by each unit of investment made on the capital asset. Here future estimates of the revenue generated by the capital assets are taken into consideration.

Internal Rate of Return
This technique is used mainly to measure the profits generated by the investment. Other name given to this method is the rate of return method or the discount cash flow rate of return method. This technique makes the decision making easier as the internal rate of return indicates the yield generated by the investment. The investment with the highest yield or return is selected.

Average Rate of Return
This technique is a financial ratio that is used to calculate the percentage of return generated from the propose capital investment. In this method, the time value involved for money is not taken into consideration.

Net Present Value
This technique which is used in capital budgeting is also widely used in many other areas of economics. This method is one of the standard technique of capital budgeting. A project or an investment with slightly higher risk with a positive NPV is suggested for investment to the firm.

Equivalent Annuity
This technique of capital budgeting is used to estimate the costs of those specific projects which have similar cash inflows. Here the net present value of considered on a annual basis by its division with the present annuity factor.

Modified Internal Rate of Return
This technique is similar to the internal rate of return method to estimate the efficiency of the investments. But, there are certain modifications in the method used for arriving at the final decision.

These are the various techniques which are used in different situation for capital budgeting. Each has its own advantages and should be used according to the situation.

Ranking of the projects is the real value provided by capital budgeting. The projects owned by the organizations might be rewarding, but it is beneficial to identify the highest rewarding projects. The budgeted capital can hence be invested in those projects till the capital is expended.