# Capital Budgeting

Capital budgeting (or investment appraisal) is the process of determining the viability to long-term investments on purchase or replacement of property plant and equipment, new product line or other projects.

Capital budgeting consists of various techniques used by managers such as:

- Payback Period
- Discounted Payback Period
- Net Present Value
- Accounting Rate of Return
- Internal Rate of Return
- Profitability Index

All of the above techniques are based on the comparison of cash inflows and outflow of a project however they are substantially different in their approach.

A brief introduction to the above methods is given below:

**Payback Period**measures the time in which the initial cash flow is returned by the project. Cash flows are not discounted. Lower payback period is preferred.**Net Present Value (NPV)**is equal to initial cash outflow less sum of discounted cash inflows. Higher NPV is preferred and an investment is only viable if its NPV is positive.**Accounting Rate of Return (ARR)**is the profitability of the project calculated as projected total net income divided by initial or average investment. Net income is not discounted.**Internal Rate of Return (IRR)**is the discount rate at which net present value of the project becomes zero. Higher IRR should be preferred.**Profitability Index (PI)**is the ratio of present value of future cash flows of a project to initial investment required for the project.

The above techniques are explained in detail in next pages.

Written by Irfanullah Jan and last modified on