- 2082 Bhadra · 2+4 marks
Capital budgeting importance and techniques
Short answer
Capital budgeting is important because it commits large funds long-term, decisions are irreversible, and it determines future growth and risk. Techniques include non-discounting methods (payback, ARR) and discounting methods (NPV, IRR, PI), with discounting methods like NPV being more reliable.
Why is capital budgeting important in a project? What are the techniques for evaluating capital budgeting projects?
Importance of capital budgeting
- Large funds are committed for a long period.
- Decisions are irreversible; a wrong decision may cause heavy loss.
- It decides the future growth and profit of the firm.
- It affects the firm's risk and its cost of capital.
- Funds are limited, so projects have to be ranked.
- It needs a long-term forecast of demand, cost and technology.
Techniques for evaluating projects
Non-discounting (traditional) methods: payback period and accounting rate of return (ARR).
Discounting methods: net present value (NPV), internal rate of return (IRR), profitability index (PI) and benefit-cost ratio.
| Method | Rule |
|---|---|
| Payback period | Accept if payback is less than the standard period |
| Accounting rate of return (ARR) | Accept if ARR is more than the required rate |
| Net present value (NPV) | Accept if NPV > 0 |
| Internal rate of return (IRR) | Accept if IRR > required rate (MARR) |
| Profitability index (PI) | Accept if PI > 1 |
| Benefit-cost ratio | Accept if B/C > 1 |
Discounting methods consider the time value of money and are more reliable; NPV is the most commonly recommended.
✓ Answer checked by Claude Opus 5.5 (high effort)
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