This document discusses various methods for evaluating investment proposals and capital budgeting. It describes traditional methods like payback period, rate of return, and improvements to the payback period method. It also covers time-adjusted methods that consider the time value of money, such as net present value, internal rate of return, and profitability index. Specific calculation methods are provided for the payback period, rate of return, and their advantages and disadvantages are summarized.

1. METHODS OF
CAPITAL BUDGETING
EVALUATION OF
INVESTNMENT PROPOSALS
KRISHANARAJ N S
MBAABM
KERALAAGRICULTURAL UNIVERSITY
mynameiskrishnaraj@gmail.com

2. OVERVIEW
MANY PROPOSALS
LIMITED FUNDS
DETERMINATION OF PROFITABILITY
RISK AN PROFITABILITY DIRECTLY RELATED

3. METHODS
TRADITIONAL
1. PAY BACK PERIOD METHOD (PAY OUT / PAY OFF METHOD)
2. IMPROVEMENT OF TRADITIONAL APPROACH TIO PAY BACK PERIOD METHOD
3. RATE OF RETURN METHOD OR ACCOUNTING METHOD
TIME ADJUSTED METHOD (DISCOUNTED METHOD)
1. NET PROFIT VALUE METHOID
2. INTERNAL RATE OF RETURN METHOD
3. PROFITABILITY INDEX METHOD

4. PAY BACK PERIOD METHODS
THE PERIOD IN WHICH THE TOTAL INVESTMENT IN PERMANENT
ASSETS PAYS BACK ITSELF
EVERY CAPITAL EXPENDITURE PAYS ITSELF BACK WITHIN A CERTAIN
PERIOD OUT OF THE ADDITIONAL EARNINGS GENERATED FROM THE
CAPITAL BUDGETING
IT MEASURES THE PERIOD OF TIME FOR THE ORIGINAL COST OF A
PROJECT TO BE RECOVERED FROM THE ADDITIONAL EARNINGS OF
THE PROJECT ITSELF

5. METHOD
1. CALCULATE ANNUAL NET EARNINGS BEFORE DEPRECIATION AND AFTER
TAXES (ANNUAL CASH INFLOWS)
2. DIVIDE INITIAL COST OF THE PROJECT BY ANNUAL CASH INFLOW, WHERE
PROJECT GENERATE CONSTANT ANNUAL CASH INFLOWS
3. WHERE THE ANNUAL CASH INFLOWS ( PROFIT BEFORE TAXES AND AFTER
DEPRECIATION) ARE UNEQUAL, PAY BACK PERIOD CAN BE FOUND BY
ADDING UP THE CASH INFLOWS UNTIL THE TOTAL IS EQUAL TO THE INITIAL
CASH OUTLAY OF PROJECT OR ORIGINAL COST OF ASSET
• PAY-BACK PERIOD = CASH OUTLAY OF PROJECT OR ORIGINAL COST OF ASSET
ANNUAL CASH INFLOWS

6. ILLUSTRATION

7. ADVANTAGES OF
PAY-BACK PERIOD METHOD
 SIMPLE TO UNDERSTAND AND EASY TO CALCULATE
 IT REQUIRES LESSER TIME AND LABOUR AS COMPARED TO OTHER
METHODS OF CAPITAL BUDGETING
 SINCE THIS METHOD PREFERS A PROJECT WITH SHORTER PAY BACK PERIOD
IT REDUCES THE LOSS THROUGH OBSOLESCE AND IS MORE SUITE FOR
DEVELOPING COUNTRIES LIKE INDIA, WHICH ARE IN THE PROCESS OF
DEVELOPMENT AND HAVE QUICK OBSOLESCE
 THIS IS SUITED TO A FIRM WHICH HAS SHORTAGE OF CASH OR WHOSE
LIQUIDITY POSITION IS NOT PARTICULARLY GOOD

8. DISADVANTAGES OF
PAY-BACK PERIOD METHOD
 IT DOESN'T TAKE INTO ACCOUNT THE CASH INFLOWS EARNED AFTER THE PAY BACK
PERIOD AND HENCE THE TRUE PROFITABILITY OF PROJECT CANT BE CORRECTLY
ASSESSED
 THIS METHOD IGNORES THE TIME VALUE OF MONEY AND DOESN’T CONSIDER THE
MAGNITUDE AND TIMING OF CASH INFLOWS
 IT TREATS CASH INFLOWS AS EQUAL THOUGH THEY OCCUR IN DIFFERENT PERIODS
 IT DOESN’T TAKE INTO ACCOUNT THE COST OF CAPITAL
 IT MAY BE DIFFICULT TO ACCEPT THE MINIMUM ACCEPTABLE PAYBACK PERIOD,

9. IMPROVEMENTS IN TRADITIONAL
PAY-BACK PERIOD METHODS
1) POST-PAY BACK PROFITABILITY
METHOD
2) PAY-BACK RECIPROCAL METHOD
3) POST-PAY BACK PERIOD METHOD
4) DISCOUNTED PAY-BACK METHOD

10. POST-PAY BACK PROFITABILITY
METHOD
THE RETURNS RECEIVABLE BEYOND THE PAYBACK PERIOD IS
CALCULATED
THEY ARE CALLED PAY-BACK PROFITS
POST PAY-BACK PROFITBILITY INDEX =
POST PAY-BACK PROFITS
X 100
INVESTMENT

11. ILLUSTRATION

12. PAY-BACK RECIPROCAL METHOD
• POSSIBLE ONLY WHEN
1. EQUAL CASH INFLOWS PER YEAR
2. PROJECT HAS A LONGER LIFE , MUST BE TWICE THE PAY-BACK
PERIOD
PAY-BACK RECIPROCAL=
ANNUAL CASH INFLOW
TOTAL INVESTMENT

13. POST PAY-BACK PERIOD METHOD
• ALSO KNOWN AS SURPLUS LIFE OVER PAY-BACK
METHOD
• THE PROJECT WHICH GIVES THE GREATEST POST
PAY-BACK PERIOD MAY BE ACCEPTED

14. DISCOUNTED PAY-BACK METHOD
• PRESENT VALUES OF ALL CASH INFLOWS AND OUTFLOWS ARE
COMPUTED AT AN APPRORIATE DISCOUNT RATE
• PRESENT VALUES OF ALL INFLOWS CUMULATED OVER TIME
• TIME PERIOD AT WHICH CUMULATED PRESENT VALUE OF
CASH INFOWS EQUALS THE PRE. VALUE OF CASH OUTFLOWS
IS KNOWN AS DISCOUNTED CASH PAY-BACK PERIOD
• PROPOSAL WITH SHORTER PAYBACK PERIOD IS ACCEPTED

15. ILLUSTRATION

16. RATE OF RETURN METHOD
• ALSO KNOWN AS ACCOUNTING RATE OF RETURN METHOD (ACCOUNTING
CONCEPT OF PROFIT IS USED INSTEAD CASH INFLOWS)
• IT ACCOUNTS THE EARNINGS EXPECTED FROM THE INVESTMENT OVER
THEIR WHOLE LIFE
• PROPOSAL WITH HIGHER RATE OF RETURN IS SELECTED
1) AVERAGE RATE OF RETURN METHOD
2) RETURN PER UNIT OF INVESTMENT METHOD
3) RETURN ON AVERAGE INVESTMENT METHOD
4) AVERAGE RETURN ON AVERAGE INVESTMENT METHOD

17. AVERAGE RATE OF RETURN
METHOD
• AVAERAGE PROFIT AFTER TAXES AND DEPRECIATION IS
CALCULATED AND IT IS DIVIDED BY TOTAL OUTLAY / TOTAL
INVESTMENT
AVAERAGE RATE OF RETURN =
TOTAL PROFIT (AFTER TAXES AND DEPRECIATION X 100
NET INVESTMENT OF THE PROJECT X NO. OF YEARS OF PROFIT
OR
AVERAGE ANNUAL PROFITS X 100
NET INVESTMENT IN THE PROJECT

18. ILLUSTRATION

19. RATE PER UNIT OF INVESTMENT
METHOD
• TOTAL PROFIT AFTER TAX AND DEPRECIATION IS DIVIDED BY
THE TOTAL INVSTMENT
• RETURN PER UNIT OF INVESTMENT =
TOTAL PROFIT (AFTER DEPRECIATION AND TAXES) X100
NET INVESTMENT IN THE PROJECT

20. RETURN ON AVEREAGE INVESTMENT
METHOD
ORIGINAL INVESTMENT IS RECORDED OVER THE LIFE OF THE
ASSET ON ACCOUNT OF DEPRECIATION CHARGES
TOTAL PROFIT AFTER DEPRECIATION AND TAXES
TOTAL NET INVESTMENT X 100
2

21. AVARAGE RETURN ON AVERAGE
INVESTMENT METHOD
AVG. PROFIT AFTER DEPRECIATION AND TAXES IS DIVIDED BY
THE AVERAGE AMOUNT OF INVESTMENT
AVG. RETURN ON AVG. INVESTMENT =
AVERAGE ANNUAL PROFIT
NET INVESTMENT X100
2

22. ILLUSTRATION

23. ADVANTAGES OF RATE OF RETURN
METHOD
VERY SIMPLE TO UNDERSTAND AND EASY TO
OPERATE
IT USES ETIRE EARNINGS OF TE PROJECT TO
CALCULATE PROFITABILITY AND NOT THE EARNINGS
UPTO PAY-BACK PERIOD
IT IS BASED ON ACCOUNTING CONCEPT OF PROFIT

24. DISADVANTAGES OF RATE OF
RETURN METHOD
IT IGNORES TIME VALUE OF MONEY
IT DOESN’T TAKE INTO CONSIDERATION THE CASH
FLOWS WHICH ARE MORE IMPORTANT THAN
ACCOUNTING PROFITS
THE METHOD CANNOT BE APPLIED TO A SITUATION
WHERE INVESTMENT IN A PROJECT IS TO BE MADE
IN PARTS

25. THANK YOU