What are the different methods used for capital budgeting?

There are several different methods used for capital budgeting, each with its own advantages and limitations. The most commonly used methods include:

1. Payback Period: This method calculates the time required to recover the initial investment. It is a simple and easy-to-understand method, but it does not consider the time value of money and ignores cash flows beyond the payback period.

2. Net Present Value (NPV): NPV calculates the present value of all cash inflows and outflows associated with a project, using a discount rate. It considers the time value of money and provides a measure of the project's profitability. A positive NPV indicates a profitable investment.

3. Internal Rate of Return (IRR): IRR is the discount rate that makes the NPV of a project equal to zero. It represents the project's rate of return and is used to compare different investment opportunities. A higher IRR is generally preferred, as it indicates a higher return on investment.

4. Profitability Index (PI): PI is the ratio of the present value of cash inflows to the present value of cash outflows. It helps in ranking projects based on their profitability per unit of investment. A PI greater than 1 indicates a profitable investment.

5. Accounting Rate of Return (ARR): ARR calculates the average annual profit generated by a project as a percentage of the initial investment. It is a simple method but does not consider the time value of money and ignores cash flows beyond the payback period.

6. Modified Internal Rate of Return (MIRR): MIRR addresses the limitations of IRR by assuming that cash inflows are reinvested at a specified rate and cash outflows are financed at a different rate. It provides a more realistic measure of the project's profitability.

7. Real Options Analysis: This method considers the flexibility and potential future opportunities associated with an investment. It evaluates the value of managerial flexibility to delay, expand, or abandon a project based on changing market conditions.

It is important to note that each method has its own assumptions and limitations, and the choice of method depends on the specific characteristics of the project and the preferences of the decision-makers.