2 Methods of capital budgeting

In earlier articles, we have discussed the capital budgeting and its types. Today we will discuss the methods of capital budgeting:

(I)Traditional methods

i) Pay back period method: this method means the period in which the total investment in the permanent assets pays back itself. This method is based upon the concept that every capital expenditure pays itself back within a certain period of time. Thus, this method measures the period of time means the time taken where the cost of project is recovered from the earning of the project itself.

Decision rule: the investment with a shorter pay back period is accepted and the one which has a longer pay back period is rejected.

Pay back period= original cost of asset/ cash inflow

 Advantages of Pay back period method:

  1. it is easy to calculate, simple to understand.
  2. it saves cost.
  3. a firm having less funds can select the shorter time period for pay back

Disadvantages of Pay back period method:

  1. it fails to take in account cash inflow earned after pay back period.
  2. it does not take into account salvage value of asset.

ii) Improvement to traditional approach to pay back method:

a) Post pay back profitability method: the main disadvantage of pay back method is that it fails to take in account cash inflow earned after pay back period so true profitability of the project can not be ascertained. An improvement to this method can be done only by taking into account the return received after the pay back period.

Post pay back profitability= post pay back profit *100/inveastment

 b) Pay back reciprocal method: this method is used to find out the internal rate of return generated by a project. It is used when equal cash inflow is generated every year.

Pay back reciprocal = annual cash inflow*100/ total investment

c) Post pay back period method: the limitation of the pay back method was that it ignores the life of the project beyond the pay back period. But this method takes into account the

life of the project beyond the pay back period. Hence the project which gives the greatest post pay back period is accepted.

d) Discounted pay back method:  the pay back method ignores the time value of money. Discounted pay back method is an improvement over this method. Under this method the present value of all cash inflow and cash outflow is calculated at an appropriate discount rate. Discounted pay back period is the period at which the present value of cash inflow = present value of cash outflow. The project with the shorter time period is accepted.

iii) Rate of return method or accounting method: this method takes into account the earning expected from the investment over their whole life. This is called accounting method as it used the accounting concept of profit after tax and depreciation.

Decision rule: the project with higher rate of return is accepted and the project with the lower rate of return is rejected.

a) Average rate of return method: under this method average profit after tax and depreciation is calculated and then it is divided by total investment.

Average rate of return= average annual profit after tax and depreciation*100/net investment

b) Return per unit of investment method: it is slightly different from the above method. under this method total profit after tax and depreciation is divided by total investment.

Return per unit of investment = total profit after tax and depreciation *100/net investment

c) Average return on average investment: it is a good method of finding out rate of return on investment.

Average return on average investment = average annual profit after tax and depreciation*100/aveage investment

Advantages of rate of return method:

1. It is easy to calculate, simple to understand.

2. It gives better view of profitability.

3. It is based upon the accounting concept.

Disadvantages of rate of return method:

1. It fails to take in account cash flow.

2. It does not take into time value of money.

(II)Time adjusted or discounted method:

The main drawback of the traditional method is that it gives equal value to the present and future flow of incomes and do not take into consideration the time value of money. A rupee earned today has more value than the rupee earned after five years. This method is also called modern method of capital budgeting.

i) Net present value method: this method takes into account the time value of money which means the return on investment is calculated by introducing the time element. This method realizes the concept that a rupee earned today has more value than the rupee earned after five years. To calculate net present value the following steps are used:

a) First of all determine the appropriate rate of interest selected as minimum rate of return or discount rate.

b) Compute the present value of cash outflow at determined discount rate.

c) Compute the present value of cash outflow at determined discount rate.

d) Calculate the net present value of each project by subtracting the present value of cash inflow from the present value of cash outflow.

Decision rule: if the net present value is positive or zero or than project is accepted otherwise rejected.

NPV is + accepted

NPV is zero accepted

NPV is – rejected

The project having maximum positive value is accepted among various proposals.

Present value = 1/ (1+r)n

 Advantages of net present value method:

1. It takes into account maximum profitability.

2. It gives better view of profitability.

3. It recognizes the time value of money.

Disadvantages of net present value method:

1. It is difficult to understand.

2. It is difficult to determine the discount rate.

ii) Internal rate of return method: this method is also known as time adjusted rate of return, discounted rate of return, yield method, discounted cash flow, and trial and error method. Under this method cash flow of a project is discounted at a suitable rate by hit and trial method. It is the rate where present value of cash inflow= present value of cash outflow. To calculate internal rate of return the following steps are used:

a) Determine the future net cash flow.

b) Determine the discount rate at which cash inflow = cash outflow.

Decision rule: IRR > minimum required rate of return than accept the proposal

IRR < minimum required rate of return than reject the proposal

IRR = minimum required rate of return than indifferent

Advantages of internal rate of return method:

1. It takes into account maximum profitability.

2. It gives better view of profitability.

3. It recognizes the time value of money.

Disadvantages of internal rate of return method:

1. It is difficult to understand.

2. The result of NPV and IRR differs.

iii) Profitability index or benefit cost ratio: it is the relationship between present value of cash inflow and present value of cash outflow.

Profitability index = present value of cash inflow/ present value of cash outflow

Or

Profitability index = net present value/ initial cash outlay

Net profitability index = profitability index – 1

Decision rule: if PI > 1 accepts the project

if PI < 1 reject the project

if PI = 1 indifferent.

 Advantages of profitability index method

1. This method takes into consideration all the requirements of sound investment decisions.

2. It recognizes the time value of money.

Disadvantages of profitability index method

1. It is difficult to understand.

2. This method does not take into account size of investment.


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