Capital budgeting Techniques:

The capital budgeting appraisal methods are techniques of evaluation of investment proposal
will help the company to decide upon the desirability of an investment proposal depending
upon their; relative income generating capacity and rank them in order of their desirability. The
most widely accepted techniques used in estimating the cost-returns of investment projects can
be grouped under two categories.
1. Traditional methods (Non-Discounted Cash flow methods)
2. Modern Methods (Discounted Cash flow methods)
Traditional methods
These methods depend upon the accounting information available from the books o accounts
of the company. These will not take into account the concept of ‘time value of money’, which
is a significant factor to determine the desirability of a project in terms of present value.
Pay-back period method: It is the most popular and widely recognized traditional method of
evaluating the investment proposals. It can be defined, as ‘the number of years required to
recover the original cash outlay invested in a project’.
According to Weston & Brigham, “The payback period is the number of years it takes the
firm to recover its original investment by net returns before depreciation, but after taxes”.
According to James. C. Vanhorne, “The payback period is the number of years required to
recover initial cash investment.
Decision Rule:
The PBP can be used as a decision criterion to select investment proposal.
If the PBP is less than the maximum acceptable payback period, accept the project.
If the PBP is greater than the maximum acceptable payback period, reject the project.
Merits:
• It is one of the earliest methods of evaluating the investment projects.
• It is simple to understand and to compute.
• It is a cost-effective method which does not require much of the time of finance
executives as well as the use of computers.
• It is a method for dealing with risk. It favours projects which generates substantial cash
inflows in earlier years and discriminates against projects which brings substantial
inflows in later years. Thus PBP method is useful in weeding out risky projects.
Demerits
• This method fails to take into account the cash flows received by the company after the
payback period.
• It fails to consider the pattern of cash inflows i. e., the magnitude and timing of cash
inflows.
• It is a measure of projects capital recovery, not profitability so this cannot be used as
the only method of accepting or rejecting a project.
• It is not consistent with the objective of shareholders’ wealth maximization. The PBP
of the projects will not affect the market price of equity shares
Accounting (or) Average rate of return method (ARR):
It is an accounting method, which uses the accounting information repeated by the financial
statements to measure the probability of an investment proposal. It can be determined by
dividing the average income after taxes by the investment
ARR = Average Annual Profit After Tax/ Initial Investment 100
Decision Rule:
If the ARR is higher than the minimum rate established by the management, accept the project.
If the ARR is less than the minimum rate established by the management, reject the project.
Merits:
• It is simple to calculate.
• It is based on accounting information which is readily available and familiar to
businessman.
• It considers benefit over entire life of the project.
Demerits:
• It is based upon accounting profit, not cash flow in evaluating projects.
• It does not take into consideration time value of money so benefits in the earlier years
or later years cannot be valued at par.
• This method does not take into consideration any benefits which can accrue to the firm
from the sale or abandonment of equipment which is replaced by a new investment.
ARR does not make any adjustment in this regard to determine the level of average
investments.
• Though it takes into account all year’s income but it is averaging out the profit.

Net Present Value Net present value method is one of the modern methods for evaluating the
project proposals. In this method cash inflows are considered with the time value of the money.
Net present value describes as the summation of the present value of cash inflow and present
value of cash outflow. Net present value is the difference between the total present value of
future cash inflows and the total present value of future cash outflows.
Decision criteria If the present value of cash inflows is more than the present value of cash
outflows, it would be accepted. If not, it would be rejected
Merits
• It recognizes the time value of money.
• It considers the total benefits arising out of the proposal.
• It is the best method for the selection of mutually exclusive projects.
• It helps to achieve the maximization of shareholders’ wealth.
Demerits
• It is difficult to understand and calculate.
• It needs the discount factors for calculation of present values.
• It is not suitable for the projects having different effective lives.
 Profitability Index (PI):
Profitability Index (PI) or Benefit-cost ratio (B/C) is similar to the NPV approach. PI
approach measures the present value of returns per rupee invested. It is a relative measure
and can be defined as the ratio which is obtained by dividing the present value of future
cash inflows by the present value of cash outlays.
PI = Present value of cash inflow = Initial cash outlay
Decision Rule: Using the PI ratio,
Accept the project when PI>1
Reject the project when PI1
May or may not accept when PI=1, the firm is indifferent to the project.
Merits:
• PI considers the time value of money as well as all the cash flows generated by the
project. At
• times it is a better evaluation technique than NPV in a situation of capital
rationing especiall
• It is consistent with the shareholders’ wealth maximization
Demerits:
• When cash outflow occurs beyond the current period, the PI is unsuitable as a
selection criterion.
• It requires estimation of cash flows with accuracy which is very difficult under ever
changing world.
• It also requires correct estimation of cost of capital for getting correct result.
• When the projects are mutually exclusive and it has different cash outlays, different
cash flow pattern or unequal lives, it may not give unambiguous results