Capital Budgeting Techniques:

1. Payback period
2. Discounted payback period
3. Profitability Index
4. Average Accounting Rate of return (ARR)
5. Net Present Value (NPV)
6. Internal Rate of Return ( IRR)

1. Pay back period

Pay back period is the number of years required to recover the original investment in a project.

Years 0 1 2 3 4 5
Cash flow -10,000 2,500 2,500 3,000 3,000 3,000
Cumulative -10,000 =-10,000+2500 =-7,500+2,500 =-5,000+3,000 =-2,000+3,000 =1,000+3,000
cashflow = -7,500 =-5,000 =-2,000 =1,000 =4,000

Whenever you are making an investment or there is an cash outflow, it is always represented by
negative sign while cash inflows are always positive.

3 years and ……months

Payback period = 3.67 years

=2000 / 3000 = .67

Project A

0 1 2 3 4 5
Cashflow -50,000 15,000 15,000 20,000 10,000 5,000
Cumulative -50,000 =-50,000+15,000 =- =-35,000+15,000 = -20,000+
Cashflows 35,000 = -20,000 20,000 = 0

Payback period A = 3 years

Project B

0 1 2 3 4 5
Cashflow -10,000 2,000 1,000 2,000 1,000 2,000
Cumulative -10,000 =-10,000 =- =-7,000+2,000 =-5000+1000 =-4000+2000=-
Cashflows +2,000 = 8,000+100 = -5,000 = -4000 2000
-8,000 0 = -7,000

Payback period B = Beyond 5 years

Project C

0 1 2 3 4 5
Cashflow - 30,000 30,000 30,000 30,000 30,00
100,00 0
0
Cumulativ - =- =- =- =-
e 100,00 100,000+30,00 70,000+30,00 40,000+30.00 10,000+30,00
Cashflows 0 0 = -70,000 0 = -40,000 0 = -10,000 0 = 20,000

Payback period C = 3+(10,000/30,000) = 3.3 years

Projects Payback Period Individual Mutually Exclusive

A 3 years Accept Accept
B Beyond 5 years Reject
C 3.3 years Accept

In individual projects, investor is looking at projects individually without comparing it with any
other project. If a project is able to produce payback period within the useful life of the
investment then project can be accepted, otherwise rejected.
Mutually exclusive projects and projects which are selected after comparing with other projects.
One project is selected. If payback period is the criteria for making the decision then, project
which has smallest payback period is selected.
Discounted Payback Period
It is an extension of payback period and it also takes into account, time value of money

FV = PV (1+i) n
PV = FV / (1+i) n

Assuming that cost of capital is 10% of project A, 10% of project B and 10% of project C

Calculate Discounted Payback Period of following projects and assess their acceptability on
individual as well as mutually exclusive projects.

Project A

0 1 2 3 4 5
Cashflow -50,000 15,000 15,000 20,000 10,000 5,000
Discounted -50,000 =15,000 / =15,000 / =20,000 / =10,000 / =5,000 /
Cashflow (1+0.1)1 = (1+0.1)2 = (1+0.1)3 = (1+0.1)4 = (1+0.1)5 =
13,636.36 12,396.69 15,026,30 6,830.13 3,104.61
Cumulative -50,000 =- =-23966.94 =-8,940.65 =-2,110.51 =994.10
Cashflows 50,000+13,636.
36 = -36,363.64

Discounted Payback period A = 4.68 (cumm cash flow of previous year from positive/disc
cashflow of positive year)

Project B

0 1 2 3 4 5
Cashflow -10,000 2,000 1,000 2,000 1,000 2,000
Discounted
Cashflow
Cumulative
Cashflows

Discounted Payback period B =

Project C

0 1 2 3 4 5
 Cashflow - 30,000 30,000 30,000 30,000 30,000
100,00
0
Discounted
Cashflow
Cumulative
Cashflows

Discounted Payback Period C

Projects Discounted Payback Individual Mutually Exclusive

Period
A
B
C