METHODS OF CAPITAL BUDGETING

EVALUATION OF INVESTNMENT PROPOSALS

KRISHANARAJ N SMBA ABM

KERALA AGRICULTURAL UNIVERSITYmynameiskrishnaraj@gmail.com

OVERVIEW

MANY PROPOSALS

LIMITED FUNDS

DETERMINATION OF PROFITABILITY

RISK AN PROFITABILITY DIRECTLY RELATED

METHODSTRADITIONAL

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)

4. NET PROFIT VALUE METHOID

5. INTERNAL RATE OF RETURN METHOD

6. PROFITABILITY INDEX METHOD

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

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

ILLUSTRATION

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

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,

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

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

ILLUSTRATION

PAY-BACK RECIPROCAL METHOD

• POSSIBLE ONLY WHEN

1. EQUAL CASH INFLOWS PER YEAR2. PROJECT HAS A LONGER LIFE , MUST BE TWICE THE PAY-BACK

PERIOD

PAY-BACK RECIPROCAL=

ANNUAL CASH INFLOW TOTAL INVESTMENT

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

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

ILLUSTRATION

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 METHOD2) RETURN PER UNIT OF INVESTMENT METHOD3) RETURN ON AVERAGE INVESTMENT METHOD4) AVERAGE RETURN ON AVERAGE INVESTMENT METHOD

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 100NET INVESTMENT OF THE PROJECT X NO. OF YEARS OF PROFIT

OR

AVERAGE ANNUAL PROFITS X 100NET INVESTMENT IN THE PROJECT

ILLUSTRATION

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) X100NET INVESTMENT IN THE PROJECT

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

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

ILLUSTRATION

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

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

THANK YOU