The Capital budgeting techniques discussed here focus on financial considerations, although, there are financial and non-financial considerations that should be taken into account when selecting a project for capital expenditure.
There are unsophisticated (simple) and sophisticated (advanced) techniques.
1 – Unsophisticated techniques include payback period (PB, also called payback method) and average rate of return(ARR).
2 – Sophisticated techniques include net present value (NPV), internal rate of return (IRR), equivalent annual annuity (AEE) and profitability index (PI).
Out of this range of techniques, payback period is the most popular unsophisticated technique. From the sophisticated techniques, the most popular methods are net present value (NPV) and internal rate of return (IRR).
Capital budgeting techniques used to select most profitable projects for capital expenditure, which is aligned with enterprise’s objective of maximizing shareholder’s wealth. Sophisticated techniques are considered to be the most effective means of selecting the most appropriate projects for capital expenditures. Such techniques take into account risk, the time value of money and focus on cash flows rather than on accounting profits.
The result of educated usage of capital budgeting techniques knowledge generated on which projects and in which order should be accepted based on the available funds for investment.