CAPITAL BUDGETING

Investment Evaluation Techniques:

● Pay Back Period

● Discounted Payback Period
● Accounting Rate of Return
● Net Present Value
● Internal Rate of Return
● Modified Internal rate of Return
● Profitability Index
Payback Period:
The payback period is the length of time required
to recover the initial investment in the project. It is
the period where total cash inflow of the project
equals the total cash outflow. Shorter the payback
period the more desirable is the project. Among
alternative investment proposals the project with
shorter pay back period to be selected.
Merits:
▪ It is simple in concept and application and not involves tedious
calculations.
▪ It is rough and ready made method for dealing with risk as it
favors the project which generates substantial cash flow in earlier
years and rejects the projects which gives substantial cash flow in
later years.
▪ PBP is sensible criterion when the firm is pressed with problems
of liquidity.

Demerits:
▪ It fails to consider the time value of money.
▪ It ignores the cash flow beyond the pay back period.
▪ It is a measure of the projects capital recovery not profitability.
▪ Though it measures a projects liquidity it does not indicate
liquidity position of the firm as a whole which is more important.
 Discounted payback period:
Under this method, cash flows are first converted into their present values
and then added ascertain the period time required to recover the initial out
lay on the project.

Merits:
▪ It is simple in concept and application and not involves tedious calculations.
▪ It is rough and ready made method for dealing with risk as it favors the
project which generates substantial cash flow in earlier years and rejects the
projects which gives substantial cash flow in later years. It ignores the cash
flow beyond the payback period.
▪ PBP is sensible criterion when the firm is pressed with problems of liquidity.

Demerits:
▪ It ignores the cash flow beyond the pay back period.
▪ It is a measure of the projects capital recovery not profitability.
▪ Though it measures a projects liquidity it does not indicate liquidity position
of the firm as a whole which is more important.
Accounting Rate of Return (ARR):
The ARR is also known as Average Rate of Return. ARR is the
percentage of return earned on the investment made in the
investment proposal. The project with higher rate of return is
selected. In case of single investment proposal, the project is
selected if the ARR is higher than the overall cost of capital. In
case of multiple investment alternatives the project with higher
ARR is selected and others are rejected.
▣ ARR = Average profit after tax ÷ Average Investment
▣ Average Investment = Net working capital + Salvage Value + .5
( Initial cost – Salvage value)
Alternatively,
▣ ARR = Average profit after tax ÷ Total investment
Merits:
▪ It is simple to calculate
▪ It is based on accounting information which is readily available
and familiar to businessman.
▪ ARR considers benefits over the entire life of the project.

Demerits:
▪ ARR is based on the accounting profit not cash flows.
▪ ARR does not take into account the time value of money.
▪ The ARR measure is internally inconsistent as the method of
accounting differs.
▪ The ARR create confusion, controversy and problems in
interpretation as there are various types of profit.
Net Present Value (NPV):
The present value of a project is the sum of all the
present values of all the cash in flows that are
expected to occur over the life of the project. Net
present value is the excess of present values of all
the cash in flows over the initial investment. A
project with positive NPV is selected and that of
negative rejected.
Merits:
▪ It recognises time value of money.
▪ It considers benefits arising over the entire life of an asset.
▪ It takes into account cash flows.
▪ It helps in achieving the wealth maximisation objective of
an organisation.

Demerits:
▪ Difficult to calculate
▪ Different discount rate will give different results.
▪ It is not suitable when projects are having different
outlays.
Internal Rate of Return (IRR):
The Internal Rate of Return of a project is the discount
rate which makes its NPV equal to zero. IRR is the
discount rate which equates the present value of
future cash flows with the initial investment.
▣The project whose IRR is higher than cost of capital
selected otherwise rejected.
▣Merits & Demerits as applicable to NPV
Profitability Index:
Profitability Index shows how many times the present value
of cash inflows of an investment proposal is higher than
the initial investment. PI shows the relationship between
the present value of all cash inflows generated by an
investment proposal and initial cash outlay.
PI = P.V of cash inflows ÷ Initial investment
PI > 1 Accepted
PI < 1 Rejected
PI = 1 Indifference point
Merits and Demerits as applicable to NPV.
 PRINCIPLES OF CASH FLOW
ESTIMATION

⮚ Separation principle
⮚ Incremental Principle
⮚ Post tax principle
⮚ Consistency principle