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Net present value
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Internal rate of return
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Payback period
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Profitability index
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Discounted payback period
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Here’s what else to consider
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Capital budgeting is the process of planning and evaluating long-term investments that can affect the future performance and growth of a business. It involves comparing the expected costs and benefits of different projects and choosing the ones that maximize the value of the firm. To do this effectively, you need to use some capital budgeting tools that can help you estimate the cash flows, profitability, risk, and return of each project. In this article, we will introduce you to the top 5 capital budgeting tools that you can use to make better investment decisions.
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1 Net present value
Net present value (NPV) is the most widely used capital budgeting tool, as it measures the difference between the present value of the cash inflows and outflows of a project. It shows how much value a project adds to the firm, after accounting for the time value of money and the required rate of return. A positive NPV means that the project is profitable and should be accepted, while a negative NPV means that the project is unprofitable and should be rejected. NPV can also be used to rank projects by their value creation potential.
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2 Internal rate of return
Internal rate of return (IRR) is another popular capital budgeting tool, as it calculates the annualized rate of return that a project generates. It is the discount rate that makes the NPV of a project equal to zero. A higher IRR means that the project is more profitable and has a shorter payback period. A project should be accepted if its IRR is greater than or equal to the required rate of return, and rejected otherwise. However, IRR can be misleading when comparing projects with different sizes, durations, or cash flow patterns.
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3 Payback period
Payback period is a simple and intuitive capital budgeting tool, as it measures how long it takes for a project to recover its initial investment. It is the number of years or periods that a project needs to generate enough cash inflows to equal its cash outflows. A shorter payback period means that the project has a lower risk and a faster return of capital. A project should be accepted if its payback period is less than or equal to a predetermined cutoff period, and rejected otherwise. However, payback period does not consider the time value of money, the cash flows beyond the payback period, or the profitability of a project.
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4 Profitability index
Profitability index (PI) is a useful capital budgeting tool, as it measures the ratio of the present value of the cash inflows to the present value of the cash outflows of a project. It shows how much value a project creates per unit of investment. A higher PI means that the project is more efficient and profitable. A project should be accepted if its PI is greater than or equal to one, and rejected otherwise. PI can also be used to rank projects by their profitability and value creation potential.
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5 Discounted payback period
Discounted payback period is a modified version of the payback period, as it takes into account the time value of money and the required rate of return. It is the number of years or periods that a project needs to generate enough discounted cash inflows to equal its initial investment. A shorter discounted payback period means that the project has a lower risk and a faster return of capital. A project should be accepted if its discounted payback period is less than or equal to a predetermined cutoff period, and rejected otherwise. Discounted payback period is more accurate than payback period, but it still ignores the cash flows beyond the payback period and the profitability of a 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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