Understanding Capital Budgeting Techniques: Payback, ARR, NPV, IRR, and Modern Methods, Summaries of Accounting

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Capital Budgeting Techniques

Capital Budgeting Evaluation techniques

Traditional Techniques ► Payback period ► Accounting rate of Return (ARR) Modern techniques ► Net Present Value (NPV) ► Profitability Index (PI) ► Internal Rate of return (IRR) ► Discounted payback period ► Terminal value ► Modified IRR (MIRR)

Accounting rate of Return (ARR)

ARR Accept/ Reject Rule IF ARR> Pre specified or desired rate of return ACCEPT THE PROJECT IF ARR<Pre specified or desired rate of return REJECT THE PROJECT

Payback period

Payback Period Method

► Payback Period is the length of time required to recover the initial investment made in a project. ► Payback Period is the duration of time required to equal the cumulative cash

inflows to it's cash outflows.

Calculation of Pay back period

when equal cash inflows are generated every year Payback period: initial investment/ Annual cash inflow Initial Cash Outflow or Initial Investment Life Annual Cash Inflows 50000 5 years 12500 Payback Period= 50000/12500= 4 years

Payback period Computation of Cumulative cash Inflow Years Cash inflows Cumulative 1 10000 10000 2 12000 22000 3 10000 32000 4 7000 39000 5 5000

Payback period= 4+ balance amount left to be recovered in the

year of final recovery/cash inflow of the year of the final recovery

=4.2 years

Payback period

Payback Period

Accept/ Reject Rule

IF Payback Period< Predetermined or desired Payback Period ACCEPT THE PROJECT IF Payback Period> Pre specified or desired Payback period

REJECT THE PROJECT

Net Present Value (NPV)

Accept/ Reject Rule

When NPV>0 OR positive

ACCEPT THE PROJECT

When NPV<0 OR Negative

REJECT THE PROJECT

Profitability Index

► Profitability Index: it is the ratio of present value of all cash

inflows associated with a project to the present value of its

cash outflows.

► Accept/Reject Rule

When PI>1 Accept

When PI<1 Reject

Internal Rate of Return

Hence at IRR

► PV of Net Cash inflows-PV of Cash outflows = 0

► FURTHER IRR is defined as

PV of Net cash inflows/ PV of cash Outflows = 1

► IRR can be defined as the discount rate at which NPV of an

Investment is Zero.

► IRR can be defined as the discount rate or rate of return at

which PI index or Benefit Cost ratio is equal to 1.

Internal Rate of Return Steps for computing IRR when Annual net cash inflows are equal: ► Calculate Payback period of the project Payback period: initial investment/ Annual cash inflow ► Find the discount factors closest to payback period value against the life period row of the project and interest rate thereof. ► Look at annuity table and find two values one smaller and other greater than calculated payback period. ► Find Interest rate corresponding to these two values and apply formula

Internal Rate of Return ► When Annual Net Cash inflows are unequal ► Calculate average annual cash flow to determine the fake annuity and fake payback period. ► Fake Payback period = Initial Investment / Average annual CFAT ► Find the discount factors closest to fake payback period value against the life period row of the project and interest rate thereof. ► Look at annuity table and find two values one smaller and other greater than calculated fake payback period. ► Find Interest rate corresponding to these two values and apply formula

Internal Rate of Return

Discounted Payback period ► One of the limitation of traditional payback period is that it ignore the time value of money. ► It gives equal weightage to all cash flows occurring at different points of time. ► Under discounted payback period, cash flows are discounted at a certain rate to find out their present values. ► Discounted payback period will be computed by using present value of cash inflows to recover the initial cost that is present value of cash outflows.

Terminal Value Method ► The terminal value method is an improvement over the net present value method of making capital investment decisions. ► Under this method, it is assumed that each of the future cash flows is immediately reinvested in another project at a certain (hurdle) rate of return until the termination of the project. ► In other words, the net cash flows and outlays are compounded forward rather than discounting them backward as followed in net present value (NPV) method.