Capital Budgeting Techniques

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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 de cisions. 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

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Uncertainties of future

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Higher degree of risk and

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 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 b usiness 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

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Profitability index method

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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  n

The time of the cash flow

- 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.) C t  -

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

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 NPV