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Capital Budgeting Ratios

Capital budgeting is the analysis that a business undertakes when evaluating new projects and new opportunities for investment. Firms use capital budgeting to determine if these opportunities are worth investing in. However, when a firm uses a capital budgeting model such as net present value, it might come up with several projects, all with a positive net present value.

To compare these projects, or provide additional information about a single project, there are a number of analysis tools available other than net present value. We call these tools capital budgeting ratios. The most popular capital budgeting ratio is the internal rate of return (IRR) and payback period. 

For example, the internal rate of return can be used (1) to evaluate whether a project should be accepted or not. We might do this by comparing the internal rate of return of a project to a hurdle rate that the firm's managers agree should be passed in order to accept a project. We might also (2) use IRR to compare potential projects. For example, two mutually exclusive projects might have an identical net present value, but one project might have a higher IRR than another. In this case, we might chose to accept the project with the higher IRR. 

Mutually exclusive projects include projects that are considered to perform the same function. If one is chosen, the others are automatically rejected. 

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Categories within Capital Budgeting Ratios

Internal Rate of Return (IRR)

Postings: 216

A discount rate that is calculated such that if applied to all future cash flows, the net present value will be zero. This is used to compare investment projects.

Equivalent Annual Annuity (EAA)

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An approach that is used to compare two separate projects that have cash flows lasting for different period of time.

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