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Net Present Value (NPV)
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2
Internal Rate of Return (IRR)
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3
Payback Period (PP)
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4
Profitability Index (PI)
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5
Discounted Payback Period (DPP)
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Here’s what else to consider
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Capital budgeting is the process of evaluating and selecting long-term investments that align with the strategic goals of an organization. It involves comparing the expected costs and benefits of different projects, such as acquiring new equipment, expanding into new markets, or developing new products. Capital budgeting methods are the tools that financial managers use to assess the feasibility and profitability of these projects. In this article, we will discuss the top 5 capital budgeting methods for financial management and their advantages and disadvantages.
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1 Net Present Value (NPV)
Net present value (NPV) is the difference between the present value of the cash inflows and the present value of the cash outflows of a project. It measures how much value a project adds to the firm's wealth. A positive NPV means that the project is worth more than its cost, and a negative NPV means that the project is worth less than its cost. NPV is considered the most reliable and accurate capital budgeting method, as it accounts for the time value of money, the risk-adjusted discount rate, and the cash flow pattern of the project.
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2 Internal Rate of Return (IRR)
Internal rate of return (IRR) is the discount rate that makes the NPV of a project equal to zero. It represents the annualized rate of return that a project generates over its lifetime. A higher IRR means that the project is more profitable, and a lower IRR means that the project is less profitable. IRR is often used to compare and rank projects with similar scales and durations. However, IRR has some limitations, such as assuming that the cash flows are reinvested at the same rate, ignoring the size and timing of the cash flows, and producing multiple or no solutions for some projects.
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3 Payback Period (PP)
Payback period (PP) is the amount of time it takes for a project to recover its initial investment. It measures how quickly a project breaks even and starts generating positive cash flows. A shorter PP means that the project is less risky and more liquid, and a longer PP means that the project is more risky and less liquid. PP is easy to calculate and understand, and it helps to filter out projects that take too long to pay off. However, PP does not consider the time value of money, the cash flows beyond the payback period, and the profitability of the project.
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4 Profitability Index (PI)
Profitability index (PI) is the ratio of the present value of the cash inflows to the present value of the cash outflows of a project. It measures how much value a project creates per unit of investment. A PI greater than one means that the project is profitable, and a PI less than one means that the project is unprofitable. PI is useful for ranking projects with different scales and durations, as it shows how efficient a project is in using the available funds. However, PI may not be consistent with NPV when there are mutually exclusive projects or capital rationing.
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5 Discounted Payback Period (DPP)
Discounted payback period (DPP) is the amount of time it takes for a project to recover its initial investment in present value terms. It measures how quickly a project recovers its cost and starts generating positive NPV. A shorter DPP means that the project is less risky and more desirable, and a longer DPP means that the project is more risky and less desirable. DPP is an improvement over PP, as it accounts for the time value of money and the risk-adjusted discount rate. However, DPP still does not consider the cash flows beyond the discounted payback period and the profitability of the project.
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6 Here’s what else to consider
This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?
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Financial Management
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