What are the different types of decision-making criteria used in capital budgeting?

There are several different types of decision-making criteria used in capital budgeting. These criteria help businesses evaluate and select the most profitable investment opportunities. The main types of decision-making criteria in capital budgeting include:

1. Net Present Value (NPV): NPV is the most widely used criterion in capital budgeting. It measures the difference between the present value of cash inflows and outflows associated with an investment project. A positive NPV indicates that the project is expected to generate more cash inflows than outflows, making it a favorable investment.

2. Internal Rate of Return (IRR): IRR is another commonly used criterion in capital budgeting. It represents the discount rate at which the present value of cash inflows equals the present value of cash outflows. The higher the IRR, the more attractive the investment opportunity is considered.

3. Payback Period: The payback period is the time required for an investment to generate enough cash inflows to recover the initial investment cost. It is a simple and intuitive criterion that focuses on the time it takes to recoup the investment. Generally, a shorter payback period is preferred as it indicates a quicker return on investment.

4. Profitability Index (PI): The profitability index is calculated by dividing the present value of cash inflows by the initial investment cost. It provides a measure of the profitability of an investment relative to its cost. A PI greater than 1 indicates a profitable investment.

5. Accounting Rate of Return (ARR): ARR is based on accounting profits rather than cash flows. It measures the average annual accounting profit generated by an investment project as a percentage of the initial investment cost. A higher ARR is generally preferred.

6. Modified Internal Rate of Return (MIRR): MIRR addresses some limitations of IRR by assuming that cash inflows are reinvested at a specified rate. It provides a more realistic measure of the profitability of an investment.

It is important to note that different decision-making criteria may lead to different investment decisions. Therefore, it is recommended to use multiple criteria and consider other factors such as risk, strategic fit, and market conditions when making capital budgeting decisions.