\n| Payback<\/td>\n | 2 years<\/td>\n | <\/td>\n | 1 year<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n <\/center>Payback period of project B is shorter than A, but project A provides higher returns. Hence, project A is superior to B.<\/em><\/strong><\/p>\n<\/p>\nNeed Guidance? Ask from Experts!<\/b><\/div>\n<\/center><\/p>\n \n- Accounting rate of return method (ARR):<\/strong><\/li>\n<\/ul>\n
This method helps to overcome the disadvantages of the payback period method. The rate of return is expressed as a percentage of the earnings of the investment in a particular project. It works on the criteria that any project having ARR higher than the minimum rate established by the management will be considered and those below the predetermined rate are rejected.<\/p>\n This method takes into account the entire economic life of a project providing a better means of comparison. It also ensures compensation of expected profitability of projects through the concept of net earnings. However, this method also ignores time value of money and doesn\u2019t consider the length of life of the projects. Also it is not consistent with the firm\u2019s objective of maximizing the market value of shares.<\/p>\n ARR= Average income\/Average Investment<\/strong><\/p>\n<\/center><\/p>\n \n- Discounted cash flow method:<\/strong><\/li>\n<\/ul>\n
The discounted cash flow technique calculates the cash inflow and outflow through the life of an asset. These are then discounted through a discounting factor. The discounted cash inflows and outflows are then compared. This technique takes into account the interest factor and the return after the payback period.<\/p>\n \n- Net present Value (NPV) Method:<\/strong><\/li>\n<\/ul>\n
This is one of the widely used methods for evaluating capital investment proposals. In this technique the cash inflow that is expected at different periods of time is discounted at a particular rate. The present values of the cash inflow are compared to the original investment. If the difference between them is positive (+) then it is accepted or otherwise rejected. This method considers the time value of money and is consistent with the objective of maximizing profits for the owners. However, understanding the concept of cost of capital is not an easy task.<\/p>\n The equation for the net present value, assuming that all cash outflows are made in the initial year (tg), will be:<\/p>\n ![\"Net](\"https:\/\/i1.wp.com\/content.edupristine.com\/images\/blogs\/Net_Present_Value_Method_for_Capital_Budgeting.png?w=525&ssl=1\") <\/center>Where A1, A2\u2026. represent cash inflows, K is the firm\u2019s cost of capital, C is the cost of the investment proposal and n is the expected life of the proposal. It should be noted that the cost of capital, K, is assumed to be known, otherwise the net present, value cannot be known.<\/p>\nNPV = PVB \u2013 PVC<\/strong><\/p>\n<\/center>where,<\/strong><\/p>\nPVB = Present value of benefits<\/strong><\/p>\nPVC = Present value of Costs<\/strong><\/p>\n\n- Internal Rate of Return (IRR):<\/strong><\/li>\n<\/ul>\n
This is defined as the rate at which the net present value of the investment is zero. The discounted cash inflow is equal to the discounted cash outflow. This method also considers time value of money. It tries to arrive to a rate of interest at which funds invested in the project could be repaid out of the cash inflows. However, computation of IRR is a tedious task.<\/p>\n It is called internal rate because it depends solely on the outlay and proceeds associated with the project and not any rate determined outside the investment.<\/p>\n It can be determined by solving the following equation:<\/p>\n ![\"Internal](\"https:\/\/i0.wp.com\/content.edupristine.com\/images\/blogs\/Net_Present_Value_Method_for_Capital_Budgeting_1.png?w=525&ssl=1\") <\/center>If IRR > WACC then the project is profitable.<\/strong><\/p>\nIf IRR > k = accept<\/strong><\/p>\nIf IR < k = reject<\/strong><\/p>\n\n- Profitability Index (PI):<\/strong><\/li>\n<\/ul>\n
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. It may be gross or net, net being simply gross minus one. The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows.<\/p>\n PI = PV cash inflows\/Initial cash outlay A,<\/strong><\/p>\n<\/center> ![\"Profitability](\"https:\/\/i2.wp.com\/content.edupristine.com\/images\/blogs\/Net_Present_Value_Method_for_Capital_Budgeting_2.png?w=525&ssl=1\") <\/center>PI = NPV (benefits) \/ NPV (Costs)<\/em><\/strong><\/p>\n<\/center>All projects with PI > 1.0 is accepted.<\/em><\/strong><\/p>\n<\/span>IMPORTANCE OF CAPITAL BUDGETING<\/span><\/h2>\n1)\u00a0Long term investments involve risks:\u00a0<\/strong>Capital expenditures are long term investments which involve more financial risks. That is why proper planning through capital budgeting is needed.<\/p>\n2)\u00a0Huge investments and irreversible ones:\u00a0<\/strong>As the investments are huge but the funds are limited, proper planning through capital expenditure is a pre-requisite. Also, the capital investment decisions are irreversible in nature, i.e. once a permanent asset is purchased its disposal shall incur losses.<\/p>\n3)\u00a0Long run in the business:<\/strong>\u00a0Capital budgeting reduces the costs as well as brings changes in the profitability of the company. It helps avoid over or under investments. Proper planning and analysis of the projects helps in the long run.<\/p>\n<\/span>SIGNIFICANCE OF CAPITAL BUDGETING<\/span><\/h2>\n\n- Capital budgeting is an essential tool in financial management<\/li>\n
- Capital budgeting provides a wide scope for financial managers to evaluate different projects in terms of their viability to be taken up for investments<\/li>\n
- It helps in exposing the risk and uncertainty of different projects<\/li>\n
- It helps in keeping a check on over or under investments<\/li>\n
- The management is provided with an effective control on cost of capital expenditure projects<\/li>\n
- Ultimately the fate of a business is decided on how optimally the available resources are used<\/li>\n<\/ul>\n
<\/span>Example of Capital Budgeting:<\/span><\/h2>\nCapital budgeting for a small scale expansion involves three steps: recording the investment\u2019s cost, projecting the investment\u2019s cash flows and comparing the projected earnings with inflation rates and the time value of the investment.<\/p>\n For example, equipment that costs $15,000 and generates a $5,000 annual return would appear to “pay back” on the investment in 3 years. However, if economists expect inflation to rise 30 percent annually, then the estimated return value at the end of the first year ($20,000) is actually worth $15,385 when you account for inflation ($20,000 divided by 1.3 equals $15,385). The investment generates only $385 in real value after the first year.<\/p>\n |