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Capital budgeting is the process of assessing the profitability and financial viability of the long term ventures or investments of any given organization. The assessment is done through various methods and often a combination of these is used to arrive at a conclusion. Some of the most predominantly used capital budgeting methods are :-
Accounting Rate of Return
Accounting rate of return is a financial ratio derived on the basis of the average profit earned by the enterprise upon the average investment made by it in the project. ARR is one of the most widely used methods of capital budgeting analysis and project appraisal. The rate of return should be at least equal to or more than the rate of investment for a given project to be financially viable for an organization. This ratio has one limitation that it does not take into consideration the changes in the value of money over time when calculating the profitability ratio.
Net Present Value
Net Present Value (NPV) refers to the difference in cash flows between all incoming and outgoing cash flows of a given organization over a certain period of time. It calculates the possible value of money in the future by taking into account inflation and returns. So NPV is the stipulated value of a given amount of money or investment. Discount rates are used to evaluate the NPV of a project with preference being given to use of varied discount rates rather than uniform ones as market variability would inevitably affect the profitability of a given project.
Internal Rate of Return
The Internal Rate of Return is the discount rate on the net present value of a particular investment which is zero. The IRR of non mutually exclusive project amounts to the same as would in NPV given that they’re conducted in a unconstrained environment and negative cash flows (investment) would be followed positive cash flows (returns on investment).Between NPV and IRR the latter is the preferred choice although it doesn’t take into account external factors like inflation or changes in currency values.
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