Capital Budgeting Techniques

Capital Budgeting Techniques: NPV, PI, IRR, and Payback
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Organizations use various capital budgeting techniques to assess the viability of investment projects. Each of the techniques has its strengths and limitations, but the Net Present Value (NPV), is the most widely used approach. The NPV determines the value of an investment focusing on discounting the ash flows while the IRR and PI measure the return of profitability, while the payback period represents the risk in investing in a project in a given time. When the techniques have different conclusions on the choice of an investment project then the NPV is used. A comparison of different capital budgeting techniques and highlighting on their features gives a clearer picture on the strength and weaknesses of each one of them.
The NPV takes into account cash inflows and outflows getting the difference between the two after discounting (Drake, 2006). As such, the technique focuses on the time value of money and maximizing shareholder wealth. It is preferred than the payback period which does not incorporate all the cash flows in capital budgeting analysis. Additionally, the NPV gives priority to the profitability and riskiness of projects. The decision criterion for the NPV is to accept those with positive NPV and reject projects with negative cash flows. B when there is more than one projects, then the one with the highest NPV is chosen as it is associated with more value for the organization. Nonetheless, the discount rate in NPV cannot be accurately predicted.
The profitability index is a ratio of the investment payoff in aproject taking into account the costs and benefits of the investment (Drake, 2006). The technique also relies on discounted cash flows and is potential useful to understand the impact of resource constraints. The technique also utilizes the initial outlay to assess whether an investment project is ...