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An overview of various capital budgeting techniques, including traditional methods such as Payback Period and Accounting Rate of Return (ARR), and modern techniques like Net Present Value (NPV), Profitability Index (PI), Internal Rate of Return (IRR), Discounted Payback Period, Terminal Value, and Modified IRR. Learn the formulas, calculations, and acceptance rules for each technique.
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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)
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 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
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
IF Payback Period< Predetermined or desired Payback Period ACCEPT THE PROJECT IF Payback Period> Pre specified or desired Payback period
Net Present Value (NPV)
When NPV>0 OR positive
When NPV<0 OR Negative
Profitability Index
Internal Rate of Return
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.