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CAPITAL BUDGETING TECHNIQUES CAPITAL BUDGETING TECHNIQUES
Capital budgeting system is used as an
Capital budgeting system is used as an effective tool in the process of making investmenteffective tool in the process of making investment decisions. It is also known as Capital expenditure decision or investment decision
decisions. It is also known as Capital expenditure decision or investment decision making. The success and
making. The success and profitability of any business depends on its long run deprofitability of any business depends on its long run de cisions.cisions. When a business intends to make a capital investment, it must design and carry out it When a business intends to make a capital investment, it must design and carry out it through a systematic investment decision-making.
through a systematic investment decision-making.
Capital budgeting is the collection of tools that planners use to evaluate the desirability of Capital budgeting is the collection of tools that planners use to evaluate the desirability of acquiring long term assets and investment desions.Long term investment decisions are acquiring long term assets and investment desions.Long term investment decisions are difficult to be taken because
difficult to be taken because
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• Decisions extends to a long periodDecisions extends to a long period •
• Uncertainties of futureUncertainties of future •
• Higher degree of risk andHigher degree of risk and •
• Not logically comparable because of time value of money. Not logically comparable because of time value of money.
Capital budgeting techniques are those
Capital budgeting techniques are those techniques helps us to make decisions intechniques helps us to make decisions in investing money in high risk projects, investments and b
investing money in high risk projects, investments and b usiness proposals. Mostusiness proposals. Most commonly used techniques are
commonly used techniques are 1. Pay back period method 1. Pay back period method
2. Accounting rate of return method 2. Accounting rate of return method 3. Discounted cash flow methods 3. Discounted cash flow methods
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• Net present value methods Net present value methods •
• Profitability index methodProfitability index method •
• Internal rate of return methodInternal rate of return method
1. Pay back period 1. Pay back period
It is the length of time required to recover the initial cash outlay on the project. This method is based on the principle that every capital expenditure pays itself back within a certain period out of the additional earnings generated from the capital assets.
Pay back period =Initial investment/annual cash flows
2. Accounting Rate of Return
Accounting rate of returns is calculated based on the accounting concept of profit rather than cash flow. Under this method the average profit after interest, depreciation and tax is calculated and then is divided by the total capital outlay of the project.
ARR=Average annual profit/net investment*100 Or
ARR=Average annual profit/Average investment*100
3 .Discounted cash flow method
The discounted cash flow method refers to any method of investments project evaluation and selection that adjusts cash flows over time for the time value of
money.
There are three methods of discounted cash flow. They
are:-Net present value- The sum of the present values of all the cash flows and cash out flows are associated with the project. This is generally considered to be the best method for evaluating the investment proposals.
t - The time of the cash flow n - The total time of the project
r - The discount rate (the rate of return that could be earned on an investment in
the financial markets with similar risk.)
The decision rule for a project under NPV method is to accept the project if the NPV is positive and reject if it is negative
• NPV>ZERO accept • NPV<ZERO reject.
Internal rate of
return-It is the actual rate of return expected from an investment. The IRR is the discount rate that makes the investment’s net present value equal to zero.
The internal rate of return method is that ‘rate of return at which the present value of cash flows and cash out flows are equal.’ This technique is know as yield to investment, marginal efficiency of capital, marginal productivity of capital rate of return and time –adjusted rate of return.
The internal rate of return is compared with the required rate of return If IRR exceeds cutoff rate-accept the project
If IRR is less than cut off rate- reject
NET PRESENT VALUE VS INTERNAL RATE OF RETURN
NPV IRR
The discounted rate is predetermined or known one
Cash inflows are reinvested at the cutoff rate.
This method is used for the selection of mutually exclusive projects.
It takes into account the earnings over the entire life of the project and the true
profitability of the investment proposal can
The discount rate is not a predetermined one
Cash inflows are reinvested at the internal rate of return
It recognizes time value of money and can be applied in situations with even as well
as uneven cash flow at different periods of time
IRR is calculated by locating the PV factor in Annuity table.
be evaluated.
Calculation of NPV and IRR
Year project X 0 75000 1 90000 Rate=10% Project x PV factor= .909 Cash flow=90000 Present value=81810
NPV= Present value of cash inflow=81810 Less-Initial outlay =75000
NPV 6810
IRR
PV Factor= initial outlay/annual cash flow 75000/90000=.8333
=20%( using annuity table)
Both the methods are useful in selecting the best possible investment and thereby these methods are widely used.
