CAPITAL BUDGETING TECHNIQUES: TRADITIONAL METHOD

BEING PAPER PRESENTATION

BY

OKOLI JUDE
16/9696/MSC

In partial fulfillment for the requirement for:

Assessment on Investment Analysis and Portfolio Theory ACC 808
And
Award for Masters of Science (M.S.C) Accounting

UNIVERSITY OF AGRICULTURE MAKURDI

COURSE LECTURER
DR. EPHRAIM KWAGHFAN

INTRODUCTION.
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Capital budgeting can be explained in the context of a firms decision to

invest its current funds in long term activities in anticipation of an expected
flow of benefits over a number of years. The investment decisions could be in
form of acquisition of additional fixed assets, replacements and modifications of
activities or expansion of a plant. Therefore the financial manager would have
to give due consideration to the following factors when capital budgeting
decisions are involved.

Availability of investment capital and it alternative uses

The huge expenditure cash outlay
The gestation period between initial expenditure and returns and
The expectation of higher returns because of factors 1 and 2 above

There are two major techniques of appraising capital projects. These are:
Traditional method and Discounted cash flow method.
However in this context, I shall focus on the traditional method of capital
budgeting:
Traditional method:
This is also known as non-discounted cash flow method since it does not
incorporate the time value of money into decision making process. It is carried
out through the following method:
1. Payback period (PBP) method
2. Accounting rate of return (ARR) method

PAYBACK PERIOD:
The CHARTERED INSTITUTE OF MANAGEMENT ACCOUNTANT
Officials (CIMA) (2000) defines payback period as the time required for the
cash inflows from a capital project to equal the cash outflow. The payback
period is the most basic and simple decision tool. With this method, you are
basically determining time that is required to undergo a project. In order to
calculate this, you would take the total cost of the project and divide it by how
much cash inflow you expect to receive each year; this will give you the total
number of years or the payback period.
As you might surmise, the payback period is probably best served when
dealing with small and simple investment projects. This simplicity should not be
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interpreted as ineffective, however. If the business is generating healthy levels

of cash flow that allow a project to recoup its investment in a few short years,
the payback period can be a highly effective and efficient way to evaluate a
project. When dealing with mutually exclusive projects, the project with the
shorter payback period should be selected.
We will look at two cases:
1. Where the annual cash flows are equal

The pay-back period can be ascertained in the following manner:

a. Calculate annual net earnings (profits) before depreciation and after
taxes; these are called annual cash inflows.
b. Divide the initial outlay (cost) of the project by the annual cash inflow,
where the project generates constant annual cash inflows.
Thus payback period = cash outlay of the project or original cash invested
Annual incash folws
Illustration i.
Determine the payback period of a project whose initial outlay is 200,000 and
returns 50,000 throughout the duration of the project.
Suggested solution
Payback period = 200,000 = 4years
50,000
2. Where annual cash flows are not equal
ILLUSTRATION 2.
PAUL LTD a manufacturing outfit, having a project which involves an
immediate cash outlay of 200,000. The company estimates that cash inflows
from the project will be as follows:
Year:

Cash flows:

20,000

40,000

220,000

80,000

Calculate the payback period:

Suggested Solution.
Year

Cash flows

Cumulative Cash Flows

(200,000)

(200,000)

20,000

(180,000)

40,000

(140,000)

220,000

80,000

80,000

Payback period = 2 years + (140,000/220,000 x 12)

= 2 years 7.6months or 2 years 8 months.

DECISION RULES:
a. Using payback period method, accept all projects whose payback periods
are shorter than the companys predetermined minimum payback period.
b. If mutually exclusive projects are involved, whereby only one of projects
can be undertaken and others rejected, the rules is to accept the project
with the shortest payback period.
Advantages of Pay-Back Period Method:
I.

The main advantage of this method is that it is simple to understand and

II.

easy to calculate.
It saves in cost, it requires lesser time and labour as compared to other

III.

methods of capital budgeting.

In this method, as a project with a shorter pay-back period is preferred to
the one having a longer pay-back period, it reduces the loss through
obsolescence and is more suited to the developing countries, like
Nigeria, which are in the process of development and have quick
obsolescence.
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IV.

Due to its short term approach, this method is particularly suited to a

firm which has shortage of cash or whose liquidity position is not
particularly good.

Disadvantages of Pay-Back Method:

Though pay-back period method is the simplest, oldest and most frequently
used method, it suffers from the following limitations:
I.

It does not take into account the cash inflows earned after the payback
period and hence the true profitability of the projects cannot be correctly

II.

assessed.
This method ignores the time value of money and does not consider the
magnitude and timing of cash inflows. It treats all cash flows as equal
though they occur in different periods. It ignores the fact that cash
received today is more important than the same amount of cash received

III.

after, say 3 years.

It does not take into consideration the cost of capital which is a very

IV.

important factor in making sound investment decisions.

It may be difficult to determine the minimum acceptable pay-back period;

V.

it is usually, a subjective decision.

It treats each asset individually in isolation with other assets which is not

VI.

feasible in real practice.

Pay-back period method does not measure the true profitability of the
project as the period considered under this method is limited to a short
period only and not the full life of the asset.

In spite of the above mentioned limitations, this method can be used in

evaluating the profitability of short term and medium term capital investment
proposals.
Rate of Return Method:

This method takes into account the earnings expected from the
investment over their whole life. It is known as Accounting Rate of Return
method for the reason that under this method, the Accounting concept of profit
(net profit after tax and depreciation) is used rather than cash inflows.
According to this method, various projects are ranked in order of the rate of
earnings or rate of return. The project with the higher rate of return is selected
as compared to the one with lower rate of return. This method can also be used
to make decision as to accepting or rejecting a proposal. The expected return is
determined and the project which has a higher rate of return than the minimum
rate specified by the firm called the cut off rate is accepted and the one which
gives a lower expected rate of return than the minimum rate is rejected.
The return on investment method can be used in several ways as follows:
ARR = Estimated average profits
X 100
Estimated average investment
ARR = Estimated total profits
X 100
Estimated initial investment
ARR = Estimated average profit
X 100
Estimated initial investment
There are arguments in favour of each method; the most important point is that
the method selected should be used consistently.
Illustration 3
A company has a target rate of return of 20% and is considering the following
project.
Capital cost of asset
80,000
Estimated life
4 years
Estimated profit before depreciation
Year 1
20,000
Year 2
25,000
Year 3
35,000
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Year 4
25,000
The capital asset would be depreciated by 25% of its cost each, and will have no
residual value.
Solution
Profit after depreciation is as follows:
Year
profit before depreciation
Annual depreciation
Annual
profit
1
20,000
20,000
0
2
25,000
20,000
5,000
3
35,000
20,000
15,000
4
25,000
20,000
5,000
Depreciation= 80,000 0 = 20,000
4
Average annual profit after depreciation = 0+5,000+15,000+5,000 = 6,250
4
Average net book value over four years period =80,000+0 = 40,000
4
ARR = 6,250 = 15.625%
40,000
Decision:
The project would not be undertaken because it fails to yield the target return on
investment of 20%.
However, in a mutually exclusive project, where only one project can be
undertaken, the project with the higher ARR would be selected (provided that
expected ARR is higher than the companys ARR.
Advantages of Rate of Return Method:
I.
II.

It is very simple to understand and easy to operate.

It uses the entire earnings of a project in calculating rate of return and not
only the earnings up to pay-back period and hence gives a better view of

III.

profitability as compared to pay-back period method.

As this method is based upon accounting concept of profits, it can be
readily calculated from the financial data.
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Disadvantages of Rate of Return Method:

I.

This method also like pay-back period method ignores the time value of
money as the profits earned at different points of time are given equal
weight by averaging the profits. It ignores the fact that a naira earned

II.

today is of more value than a naira earned any year after, or so.
It does not take into consideration the cash flows which are more

III.

important than the accounting profits.

It ignores the period in which the profits are

IV.

This method cannot be applied to a situation where investment in a

project is to be made in parts.

REFERENCES
Adeniyi A. A. (2011), An insight into Management Accounting, 5th edition,
Value analysis publishers
Arnold J. and Scapen .R. (1995), Topics in management Accounting. Philip
Allan press
CIMA (2000) Management Accounting Official Terminology
ICAN STUDY PACK (2009) Management Accounting. VI publishers