That used to good growth for the student and more useful this document. For exam and for read and tech.

2.  Time adjusted Method which evaluates the
investment Proposals. Also called Benefit Cost
Ratio.
 Profitability Index is the ratio of the present value
of cash inflows, at the required rate of return to
the initial cash outflow of the investments.
PI = PV of cash inflows/Initial cash outlay
= PV(Ct)/Co

3.  Acceptance Rule:
PI>1 ; Accept the project
PI<1 ; Reject the project
Pi=1 ; May accept the project or reject
 This method requires same calculation as that of
NPV method.
 The project with positive NPV will have PI greater
than 1.
 PI less than 1 means that the project’s NPV is
negative.

4. Capital Rationing:
 In real situations, many concerns have limited funds and as
such all profitable investment proposals may not be accepted.
 Limited funds have to be allocated to various acceptable
proposals in such a way it maximizes the long time returns.
 Capital rationing may refer to the situation where the
management has more acceptable investment proposals
requiring more amount of finance than available to the
concern.
 All investment proposals falling into acceptable criterion
should be ranked according to profitability (I.R.R or P.I.)
 Such ranking is done in descending order of I.R.R or P.I. until
the funds are exhausted.

5.  This method of capital budgeting measures the rate
of return which earnings are expected to yield on
investments.
 This method is used when
1.)Cost of Investment Given/
2.) annual cash inflows Known
and unknown rate of earning (r) duly recognizing the
time value of money is needed to be calculated.
 This rate of return(r) represents the rate at which
NPV of the Project is equal to zero

6. t = no. of years.
Ct = annual cash inflow
Co = initial investment
r = rate of interest ( Internal rate of Return)
Value of r is calculated by trial and error method.
 Proposal will be accepted if I.R.R > cut off
rate(generally cost of capital)
 Proposal will be rejected if I.R.R < cut off rate(generally
cost of capital)
 I.R.R is used as benchmark. A project with more higher
value of I.R.R will be preferred.
 This method gives the same acceptance rule as N.P.V
method
0
1
NPV = 0
(1 + )
n
t
t
t
C
C
r
 

7.  PAYBACK:
 Number of Years required to recover the original
cash outlay invested in a project.
Case 1: Even cash inflows
Payback= Initial Investment/Annual Cash Inflow
= Co/C
Case 2: Uneven Cash Inflows
add up the cash inflows until the total is equal to
initial cash outlay.

8. Acceptance Rule:
• Firm compares the payback calculated with a standard
predetermined payback.
• Project accepted if the payback calculated is less than
the standard payback.
Merits:
1.) Simplicity
2.) cost effective
3.) early recovery of investment
Demerits:
1.) Cash flows after payback ignored.
2.) does not focus on profit to be earned after recovery of
investment
3.) ignores time value of money.

9. The Following details about project X
Cost of the project = Rs. 50,000
Operating Savings after tax & before
depreciation
Calculate Pay back period.
Soln.
Ist year 5,000
2nd year 20,000
3rd year 30,000
4th year 30,000
5th year 10,000
year Annual sav Cum. Savings
Ist 5,000 5,000
2nd 20000 25,000
3rd 30,000 55,000

10. Thus up to 2 years 25,000
During 10 months of 3rd year 25,000
TOTAL 50,000
Pay back period = 2 years + 50,000 –
25,000/30,000 yrs.
= 2 + 5/6 years
= 2 years 10 months

11. Discount pay back period :
Discounted payback = 3 years + (50,000-
43615)/20,490
= 3 + 1/3 yrs. Apprx
= 3 yrs + 4 months
Years Savings P.V.Factor Discounted
Savings
Cum.
Discounted
Savings
1st 5000 0.909 4,546 4,546
2nd 20,000 0. 8265 16,530 21,076
3rd 30,000 0.7513 22,539 43,615
4th 30,000 0.683 20,490 64,105

12. • Measures the return on a project in terms of income
as opposed to using cash flow
◦ Formula:
12
Accounting Rate of Return
Average income / Initial investment
Accounting Rate
of Return
=
• Average income is not the same as cash
flows
◦ Formula:
∙ Add net income for each year of the project and divide by
the number of years

13. • Measures the return on a project in terms of income
as opposed to using cash flow
◦ Formula:
13
Accounting Rate of Return
Average income / Initial investment
Accounting
Rate of
Return
=
• Average income is not the same as cash
flows
◦ Formula:
∙ Add net income for each year of the project
and divide by the number of years

14.  Managers compare the accounting rate of
return to company’s required minimum rate
of return for investments of similar risk
 If the ARR is less than the required minimum,
the investment is rejected
Copyright © 2008 Prentice Hall All
rights reserved
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14

15. Copyright © 2008 Prentice Hall All
rights reserved
9-
15
DECISION RULE:
Invest in capital
assets?
Is expected accounting rate
of return > the required
rate of return?
Invest
Is expected accounting rate
of return < the required
rate of return?
Do not invest