Capital Budgeting Techniques

Capital Budgeting
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Institutional Affiliation
Capital Budgeting
Capital budgeting is considered one of the basic aspects of financial management in that it is very basic even to nonfinancial organizations. This paper will rely on the definition of capital budgeting by Al- Mutairi et.al (2018), which indicates that capital budgeting is the mechanism(s) employed by any organization whether financial or non-financial, to evaluate decisions on how to allocate the right resources to any investment to improve productivity (Michelon et al., 2020). For instance, a textile company in need of replacing a manual machine with an automatic one, or a textile company opening a new branch in a different country. To elaborate more on this concept, below is an analysis of five different approaches.
Net present Value (NPV)
This is the change between the present value of all cash flows of a project and the cost of the individual project. If the difference is positive then the interpretation is that the project will add worth to the firm thus increasing the prosperity of the stakeholders. The main limitation of this approach is it’s the inability to distinguish between the best investment size given two to choose from (Chris, 2020). For instance, an investment of a high NPV does not always translate to high profits.
Profitability Index (PI)
This technique measures the gains per unit cost in terms of the time value of money. This implies that if an investment gives a PI value greater than 1, then the venture should be acknowledged. The basic limitation of this approach is that it may lead to wrong decisions when comparing equally exclusive venture.
Internal Rate of Return (IRR)
This is a useful approach that reviews the merit of a project. The project is to be acknowledged if the IRR is more than the expected return. The limitations of this approach are that there is a possibility of multiple IRRS when dealing with non-conventional cash flows (Capital Budgeting Bases, 2018). For example, a two sign reversals cash flow leads to two IRR that are both viable but one is unable to know which to use in making the decision.
Payback Period
It indicates the dur...