Making wise business decisions is the key to a successful business and ensures a long life to it. This is possible by carefully making investment decisions and then comparing the best projects through capital budgeting. The management begins its decision of approval or disapproval of the decided projects. For this, the capital budgeting tools are used.
There are three common capital budgeting tools and they are discussed in simple terms below. Let us take a glance and get a basic understanding of it.
This method is the prime one which is preferred by most of the companies as it is a simple decision tool. This method involves the calculations to find out how long will it take to get back the amount that we invest in a project.
It is simply done by taking the total cost of the project divided by yearly cash flow expected, this will give the number of years in which it can be received back. This is the best method for small project analysis and gives quick solutions. Though it looks simple it is highly effective too.
A company generating accurate cash flows each year can be easily judged for recoupment of profits in years. While dealing with mutual projects the one with shorter payback should be selected.
Net present value method:
This is again an effective method used to calculate the benefits from a project by means of cash flows. The net difference between cash outflows and cash inflows is calculated in this method. This is a very accurate method as it uses discounted analysis on future cash flows speculating the losses that may happen in the due course of the project. Hence that proves for accuracy in this type of calculation.
The rule with this method is that a project with positive value will be approved and that with a negative value will be rejected. In mutually exclusive projects the one with higher NPV is chosen.
The internal rate of return:
In this method, a rate of discount is used to calculate how much value will be lost from the particular project after few years and what will be the then net worth. This internal rate is strictly the discount rate at break-even of a project which means no loss no gain position or when the net present value is zero. Therefore you need to choose the project when the return is more than the cost of financing in terms of percentage.