Define the most important capital budgeting techniques. Name at least two capital budgeting techniques (for example, NPV, IRR, Payback Period, et cetera) and describe how they are used to arrive at investment decisions.
Capital budgeting is a process for evaluating investment decisions, which are large in amount such as opening a new plant, purchase of machinery, research, and development, etc.
Capital Budgeting Methods:
Net Present Value: The net cash flows are determined, and they are discounted back to present values. The project with the highest net present value is selected.
Payback Period: The time period to recover the initial cost of investment is calculated. The lower the payback period, the better.
Profitability Index: It is a ratio of the discounted cash flow to the initial cash flow of the project.
Internal Rate of Return: It is a discount rate at which the net present value of the project is equal to zero.
Importance of the Cost of Capital:
Sources of capital: It helps to determine the cost of the various sources of capital. The source has the lowest cost of capital is selected.
Financial performance: The cost of capital helps to determine the financial performance of projects by measuring the profitability with the cost of capital. If the profitability of the project is more than the cost of capital, then the project is termed as being successful.
Financial Decisions: The cost of capital is used to make other financial decisions such as payment of dividends.
Expected income and risks: Cost of capital helps to determine the expected income and inherent risks.
Capital Structure: The cost of capital helps to determine the optimum capital structure. It helps to choose a mix of debt and equity that minimizes the cost of capital.