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A Presentation on Payback MethodGuided By: Prepared By:Prof. Pinakin Jaiswal Bhumi Thakkar (31) Jaimeen Panchal(32) #
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CAPITAL BUDGETING• The term Capital Budgeting refers to long term planning for proposed capital outlays & their financing.• Capital budgeting is a process by which organization evaluates and selects long-term investment projects – Ex. Investments in capital equipment, purchase or lease of buildings, purchase or lease of vehicles, etc.• There are various techniques(methods) used to make capital budgeting decisions. #
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CAPITAL BUDGETING Outcome Large amounts of is uncertain. money involved. Analyzing alternative long- term investments and deciding which assets to acquire or sell. Decision may be Investment involvesdifficult or impossible long-term commitment. to reverse. #
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Capital Budgeting Appraisal Methods1. TRADITIONAL METHOD A. Pay back method B. Average rate o return2. TIME-ADJUSTED METHOD A. Net present value method B. Internal rate of return C. Profitability index method #
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Pay-back method:Payback (period) Method is the exact amount of time required for afirm to recover its initial investment in a project as calculated fromcash inflows. OrIn other words, the payback period is the length of time required torecover the initial cost of the project.
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E.g. If a project requires Rs. 20,000 as initial investment and itwill generate an annual cash inflows of Rs 5000 for 10yrs thepay-back will be 4 years.Payback period = Initial investment Constant Annual cash inflow = 20000/5000 = 4 yearsUnadjusted rate of return = Annual return * 100 Initial investment = 5000 /20000 *100 = 25%
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When the annual cash inflows are un equal:E.g. a proposal requires a cash outflow of Rs. 20,000and is expected to generate cash inflow of Rs 8000,Rs6000, Rs 4000, Rs 2,000 Rs 2,000 over next 5 yearsThe payback period = 4as the sum of cash inflow is 20,000 Year Annual CF Cumulative CF 1 8,000 8,000 2 6,000 14,000 3 4,000 18,000 4 2,000 20,000
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Payback Period – Uneven Cash Flows CumulativeCasey Co. wants to Annual Net Net Cashinstall a machine Year Cash Flows Flowsthat costs 16,000 0 (16,000) (16,000)and has an 8-year 1 3,000 (13,000)useful life with zero 2 4,000 (9,000)salvage value. 3 4,000 (5,000)Annual net cash 4 4,000 (1,000) 5 5,000flows are: 6 3,000 7 2,000 #
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Payback Period – Uneven Cash Flows Cumulative We recover the 16,000 Annual Net Net Cashpurchase price between Year Cash Flows Flows years 4 and 5, about 0 (16,000) (16,000) 4.2 years for the 1 3,000 (13,000) payback period. 2 4,000 (9,000) 3 4,000 (5,000) 4 4,000 (1,000) 4.2 5 5,000 6 3,000 7 2,000 8 2,000 #
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ACCEPT-REJECT CRITERIA• The pay back period can be used as a decision criterion to accept or reject investment proposals.• Application of this technique is to compare the actual pay back with a predetermined pay back.• Actual pay back period is less than the predetermined pay back, the project would be accepted; if not, it would be rejected.• When mutually exclusive projects are under consideration, they may be ranked according to the length of the pay back period.• Thus, the project having the shortest pay back may be assigned rank one, followed in that order so that the project with the longest pay back would be ranked last. #
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ADVANTAGES OF PAYBACK METHOD• Payback period method is simple and easy to calculate and to apply fro small, repetitive investments.• It gives the indication of liquidity. In case a firm is having liquidity problem, this method is good to adopt as it emphasizes earlier cash inflows.• It deals with risk too. The project with a shorter payback period will be less risky as compared to project with a longer payback period.• Payback period method takes into account tax and depreciation. #
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DISADVANTAG OF PAYBACK METHOD• It ignores the time value of money. e.g. There are 2 projects a and b , the cost of project is 30,000 in each case. The cash inflows are as : Year Project A Project B 1 10,000 2,000 2 10,000 4,000 3 10,000 24,000• It completely ignores all cash inflows after the payback period. #
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NET PRESENT VALUE (NPV)• Net Present Value (NPV), defined as the present value of the future net cash flows from an investment project, is one of the main ways to evaluate an investment.• When choosing between competiting investments using the net present value calculation you should select the one with the highest present value. If: NPV > 0, accept the investment. NPV < 0, reject the investment. NPV = 0, the investment is marginal #
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NPV V/S PAYBACK PERIOD• NPV (Net Present Value) is calculated in terms of currency while Payback method refers to the period of time required for the return on an investment to repay the total initial investment.• NPV, payback, and many other measurements form a number of solutions to evaluate project value.• Payback method, v/s NPV method, has limitations for its use because it does not properly account for the time value of money, inflation, risk, financing or other important considerations.• While NPV method considers time value and it gives a direct measure of the dollar benefit on a present value basis of the project to the firm’s shareholders. NPV is the best single measure of profitability. #
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• Payback, v/s NPV, ignores any benefits that occur after the payback period. It also does not measure total incomes.• An implicit assumption in the use of payback period is that returns to the investment continue after payback period.• Payback method does not specify any required comparison to other investments or investment decision making.• It indicates the maximum acceptable period for the investment. While NPV measures the total value of project benefits. NPV, payback period fully considered, is the better way to compare with different investment projects. #
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