Advantages Of Capital Budgeting Techniques

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Capital budgeting ask the question is it worth it to put money into a project before you actually do. It asks is it worth it to use money to buy a new machine or to start a new business. There are four capital budgeting techniques and they all consist of a series of calculations and a set of decision rules. They will help you decide if you will lose money or will you make money on your project. The four budgeting techniques are Net Present Value (NPV), Profitability Index (PI), Internal Rate of Return (IRR), and Payback.
The first technique we will look at is NPV applies the idea that the present value of future cash flows is what counts when making decisions based on value. When you have a capital spending program that maximizes the NPV of projects undertaken it will contribute to maximizing shareholder’s wealth. The advantages of NPV are it tells whether the investment will increase the firm’s value, it considers all the cash flows, it considers the tie value of money and considers the risk of future cash flows. The disadvantages of NPV are that they require an estimate of the cost of capital in order to calculate the net present value and the terms are expresses in dollars, not as percentage.
The second budgeting technique, Profitability
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Using it we calculate the amount of time it takes for a project’s planned cash flows to “pay back” the initial outlay. This time period is the guide used for making comparisons. Decision rules in the payback technique are based on the idea that it’s better to recover invested money sooner than later. There are some disadvantages of the Payback period such as it ignores the time value of money leaving future dollars and current dollars looked at equally. It also ignores cash flows beyond the payback period and the risk of future cash flows. The reason company’s use payback even with these weaknesses is that it is a good screen test for the

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