CAPITAL BUDGETING DECISION

NATURE AND SIGNIFICANCE

TECHNIQUES OF CAPITAL BUDGETING

I NON-DISCOUNTED CASH FLOW TECHNIQUES

i) Pay Back Period

ii) Accounting Rate of Return (ARR)

II DISCOUNTED CASH FLOW TECHNIQUES

i) Net Present Value (NPV)

ii) Internal Rate of Return (IRR)
iii) Profitability Index (PI)

DISCOUNTED CASH FLOW TECHNIQUES

1. Payback Period: The number of years required to recover the original cash outlay
invested in a project.

Payack period (PBP) =Cash outlay (investment)

Annual Cash Inflow

Acceptance Rule : Accept - Reject / Ranking of projects

Evaluation:

Advantages:

1. Simple to understand and easy to calculate

2. Less Expensive

Disadvantages:

1. It ignores cash flows beyond the PBP

2. It is a measure of project’s capital recovery, not its profitability.
3. It fails to consider the magnitude and timing of cash flows.
4. Notational basis for setting maximum PBP.
5. Not consistent with the objective of maximising the market value of the firm’s
shares.
2. Accounting Rate of Return:

Average income (after taxes)

ARR = ________________________
Average investment

Average investment = (Original investment + Salvage value)

Or

Total of book values after / Life of the project

After Depreciation

Acceptance Rule =

Evaluation:

Advantages:

1. Simple to calculate
2. It is based on accounting information which is readily available with
businessmen.
3. It considers benefits over the entire life of the project.

Disadvantages:

1. It is based on accounting profit, not cash flow.

2. It does not take into account the time value of money
3. It does not consider the length of project lines.

DISCOUNTED CASH FLOW TECHNIQUES

i) Net Present Value:

NPV = PV of Cash inflows – PV of Cash outlay

= [ A1 + A2 + A3 + …… + Aη ]-C
(1+K) (1+K)2 (1+K)3 (1+K) n

= n At - C
∑ (1+K)ι
ι =1

Where A1, A2 …………. Represent cash inflows

K is the firm’s cost of capital
C is the Investment outlay (cost of the investment proposal)
η is the expected life of the project.

Acceptance Rule:

Advantages:

1. It recognises the time value of money

2. It considers all cash hours over the entire life of the project
3. It is consistent with the objective of maximisation of wealth

Disadvantages:

1. Assumption that discount rate is known.

2. It may not give satisfactory answer where the projects being compared involve
different amounts of investment.
3. It may mislead when dealing with alternative projects or limited funds under
the condition of unequal lives.

ii) Internal Rate of Return

A Rate which equates the present value of cash inflows with the present value of cash
outflows of an investment.

η Αι -C
o= ∑ (1+r)t
t= 1

Acceptance Rule:

If IRR is higher than or equal to the minimum required rate of return (cost of
capital or hurdle rate) then accept the project. Otherwise, reject.

EVALUATION:

Advantages:

1. Considers the time value of money.

2. It considers the cash flow stream in its entirety.
3. It is more acceptable to businessmen who want to think in terms of rate of
return.
4. Unlike the NPV method, the calculation of cost of capital is not a pre-
condition for this method.
5. It is compatible with the objective of wealth maximisation.
Disadvantages:

1. Difficult to use in practice due to complicated computations.

2. It may yield results inconsistent with the NPV method if the projects differ in their
(a) expected liver, or (b) cash outlays, or (c) timing of cash flows.
3. It implies that intermediate cash flows generated by the project are reinvested at
the internal rate of the project, whereas NPV method implies reinvestment at cost
of capital. The later assumption seems to be more appropriate.
 iii) PROFITABILITY INDEX OR BENEFIT-COST RATIO

It is the ratio of the present value of future cash benefits, at the required rate of
return to the initial cash outflow of the investment.

i.e., PI = PV of Cash Inflows

or Initial Cash outlay

η
= ∑ Aι
ι =1 ( 1+) τ
C

EVALUATION

Advantages:

1. Considers time value of money

2. Under unconstrained conditons, pi criteria will accept and reject the same
project as the net present value criterion.
3. When the capital budget is limited in the current period, the pi criteria may
rank use of capital.

DISADVANTAGES:

1. Its use is not recommended beause it propvides no means for aggregating several smaller
projects into a packagethat can be compared with a large project.
2. when cash outflows occur beyondthe current period, the pi criterion is unsuitable as a selection
criterion.
CHOICE OF METHOD:
NPV VS. PI

NPV Vs. IRR