The firm’s decision to invest its current funds most efficiently in the ling term assets in anticipation of an expected flow of benefits over a series of years.
Importance of capital budgeting decision…
Effects on other projects.
Process of Capital Budgeting…
Evaluation or Analysis.
Financing the selected project.
Execution or implementation.
Review of the project.
Techniques of Investment Evaluation…
Pay back period method.
Accounting Rate of Return or Average rate of Return.- ARR
Modern Techniques or Discounted Cash Flow Techniques.
Net Present Value – NPV
Internal Rate of Return – IRR
Profitability Index - PI
Pay back period method…
Pay back period: that period required to recover the original cash outflow invested in a project.
First Method : when the annual cash flows stream of each year is equal or uniform, the following formula is used to know the pay back period:
PBP = Original Investment /constant annual cash flow after taxes.
Second Method : when the annual cash flows after taxes are unequal or not uniform over the projects life period.
PBP = Year Before Full Recovery + (Unrecovered Amount of Investment + Cash Flow During the Year)
Decision Rule for PBP…
Accept : Cal PBP < Standard PBP
Reject : Cal PBP > Standard PBP
Advantages of PBP…
Simple and easy.
It ignores cash flow after PBP.
Does not consider all cash inflows yielded by the investment.
Does not consider TVM
No rational basis for setting a minimum PBP.
Accounting Rate of Return Method…
It uses accounting information as revealed by financial statements, to measure the profitability of the investment proposals.
Average annual earnings after depreciation and taxes are used to calculate ARR.
It is measured in terms of %.
It is calculated in two ways:
Whenever it is clearly mentioned as Accounting Rate of Return.
Whenever it is clearly mentioned as Average Rate of Return .
Accounting Rate of Return…
ARR = Average Annual EAT or PAT * 100
Original Investment (OI)
OI = Original Investment + Additional NWC +
Installation Charges + Transportation
Average Rate of Return…
ARR = Average Annual EAT * 100
Average Investments (AI)
AI = (Original Investment – Scrap Value)1/2 +
Additional NWC + Scrap Value
Accept : Cal ARR > Predetermined ARR or
Cut off Rate.
Reject : Cal ARR < Predetermined ARR or
Cut off Rate.
Simple and easy.
Information can easily drawn from accounting records.
It considers all profits of the projects life period.
Comparatively less costly.
Ignores the TVM concept.
Ignores retained earnings.
Ignores size of the investment required for each project.
Net Present Value…
It is the process of calculating present values of cash inflows using cost of capital as an appropriate rate of discount and subtract present value of cash out flows from the present value of cash inflow and find the NPV which may be positive or negative.
NPV = Present Value of Benefits – Present Value of Costs.
Accept : NPV > 0
Reject : NPV < 0
It considers the TVM.
It considers all cash inflows occurring over the entire life period of the project.
Useful for selection of mutually exclusive projects.
Difficult to understand when compared with PBP and ARR.
Calculation of required rate or discounting factor or cost of capital is difficult.
Not useful when comparison of two projects with different life periods.
Internal Rate of Return Method…
When the discount rate at which present value of cash inflows equals to present outflows, is IRR.
IRR Computed by Trial and error approach
LDF = Lower discount factor
ΔDF = Difference between low discounting factor and High discounting factor
PVLDF = PV of cash inflows at low discounting factor
PVHDF = PV of cash inflows at high discounting factor