CORPFINCHITHR05 CAPITAL BUDGETING TECHNIQUES Capital budgeting system is used as an effective tool in the process of making investment decisions.

It is also known as Capital expenditure decision or investment decision making. The success and profitability of any business depends on its long run decisions. When a business intends to make a capital investment, it must design and carry out it through a systematic investment decision-making. Capital budgeting is the collection of tools that planners use to evaluate the desirability of acquiring long term assets and investment desions.Long term investment decisions are difficult to be taken because Decisions extends to a long period Uncertainties of future Higher degree of risk and Not logically comparable because of time value of money.

Capital budgeting techniques are those techniques helps us to make decisions in investing money in high risk projects, investments and business proposals. Most commonly used techniques are 1. Pay back period method 2. Accounting rate of return method 3. Discounted cash flow methods Net present value methods Profitability index method Internal rate of return method

1. Pay back period

It is the length of time required to recover the initial cash outlay on the project. This method is based on the principle that every capital expenditure pays itself back within a certain period out of the additional earnings generated from the capital assets. Pay back period =Initial investment/annual cash flows 2. Accounting Rate of Return Accounting rate of returns is calculated based on the accounting concept of profit rather than cash flow. Under this method the average profit after interest, depreciation and tax is calculated and then is divided by the total capital outlay of the project. ARR=Average annual profit/net investment*100 Or ARR=Average annual profit/Average investment*100 3 .Discounted cash flow method The discounted cash flow method refers to any method of investments project evaluation and selection that adjusts cash flows over time for the time value of money. There are three methods of discounted cash flow. They are:Net present value- The sum of the present values of all the cash flows and cash out flows are associated with the project. This is generally considered to be the best method for evaluating the investment proposals.

t - The time of the cash flow n - The total time of the project r - The discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.) Ct - the net cash flow (the amount of cash) at time

The decision rule for a project under NPV method is to accept the project if the NPV is positive and reject if it is negative NPV>ZERO accept NPV<ZERO reject.

Internal rate of returnIt is the actual rate of return expected from an investment. The IRR is the discount rate that makes the investments net present value equal to zero. The internal rate of return method is that rate of return at which the present value of cash flows and cash out flows are equal. This technique is know as yield to investment, marginal efficiency of capital, marginal productivity of capital rate of return and time adjusted rate of return. The internal rate of return is compared with the required rate of return If IRR exceeds cutoff rate-accept the project If IRR is less than cut off rate- reject NET PRESENT VALUE VS INTERNAL RATE OF RETURN NPV The discounted rate is predetermined or known one Cash inflows are reinvested at the cutoff rate. This method is used for the selection of mutually exclusive projects. IRR The discount rate is not a predetermined one Cash inflows are reinvested at the internal rate of return It recognizes time value of money and can be applied in situations with even as well as uneven cash flow at different periods of time It takes into account the earnings over the entire life of the project and the true profitability of the investment proposal can IRR is calculated by locating the PV factor in Annuity table.

be evaluated.

Calculation of NPV and IRR Year 0 1 Rate=10% Project x PV factor= .909 Cash flow=90000 Present value=81810 NPV= Present value of cash inflow=81810 Less-Initial outlay NPV IRR PV Factor= initial outlay/annual cash flow 75000/90000=.8333 =20%( using annuity table) Both the methods are useful in selecting the best possible investment and thereby these methods are widely used. =75000 6810 project X 75000 90000