Capital Budgeting is the procedure by which the house decides which long-run investings to do. Capital Budgeting undertakings, i.e. , possible long-run investings, are expected to bring forth hard currency flows over several old ages. The determination to accept or reject a Capital Budgeting undertaking depends on an analysis of the hard currency flows generated by the undertaking and its cost.
To happen the attraction of any investing proposal, the fiscal director should maintain in head undermentioned things ; –
The sum expended
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The possible benefits
Economic life of undertaking
Traditional or non-discounting techniques
Traditional method does non see clip value of money. It considers that prset value is equal to future value. Traditional method is besides called not discounted or unsophisticated method.
There are two methods of rating: –
Pay back period method
Payback period is defined as the figure of old ages required for the proposal ‘s cumulative hard currency influxs to be equal to its hard currency escapes.
In other words, the payback period is the length of clip required to retrieve the initial cost of the undertaking.
It can be computed in two ways.
When one-year influxs are equal: – When the hard currency influxs being generated by a proposal clip period which means the hard currency influxs are in the signifier of rente, the payback period can be calculated by spliting the hard currency escape by the sum of rente.
When the one-year hard currency influxs are unequal: – In hard currency the hard currency influxs from the proposal are non in rente signifier so the cumulative hard currency influxs are used to calculate the payback period.
The determination regulation: – Payback period does non give clear indicant of the determination regulation. If the payback period is more than the mark period, so proposal should be rejected and frailty versa.
Advantages of payback period
It is really simple to understand and easy to cipher.
This method is inexpensive, fast and cost of labor is really less.
It reduces the loss through obsolescence as a undertaking which have shorter payback period is ever preferred.
This method is best suited for those houses whose liquidness place is non good.
Disadvantages of payback period
By this method true profitableness of the undertaking can non be assessed.
This method does non take into history the magnitude and timing of hard currency influxs.
It does non see the cost of capital, which is needed to do good investing determinations.
It is non practical in nature as it treats every plus separately in isolation with other assets.
Accounting rate of return: –
This method uses the construct of accounting net income instead than hard currency influxs.
It takes into history the net incomes from the investing over the whole life span. Harmonizing to this method, undertakings are ranked in order of the rate of net incomes or rate of return.
Calculation of ARR=
( Average one-year net income / mean investing in the undertaking ) *100
Decision regulation: –
The undertaking with higher mean rate of return is selected and will hold higher precedence while undertaking with last mean rate of return will be assigned lowest precedence.
Advantages and disadvantages of ARR: –
This method is really easy to cipher and gives true value of profitableness.
It is based upon accounting net income and hence it can be easy calculated from fiscal informations.
The drawbacks of this method are: –
It does non see clip value of money, and hard currency flows and ignores the period in which the net income has been earned.
Time adjusted or discounted hard currency flows
This method considers the clip value of money. It is a more practical attack to determination devising. This method assumes that present value of any sum is much more deserving than future value. So, before measuring any undertaking foremost of all the estimated hard currency flows must be converted into present value. This is called discounted value.it makes determination and hence it is called discounted method.
The undermentioned methods are used under discounted method.
Net Present Value
Internal Rate of Return
Net present value: – NPV is a new method for measuring investing proposals. It takes into history the clip value of money and attempts to cipher the return on investing by utilizing clip component. The NPV of all hard currency ( influxs and escapes ) during the whole continuance of undertaking is determined twelvemonth by twelvemonth by dismissing these flows with houses cost of capital or predetermined rate.
Calculation of NPV: – ( PV of hard currency inflows- PV of hard currency escapes )
Decision regulation: – Undertaking should be accepted when value of NPV of the undertaking is 0 or positive or hard currency influxs are greater than the present value of hard currency escapes.
Advantages and disadvantages of NPV: This method can be used in state of affairs with unvarying hard currency escapes uneven influxs and it besides recognizes the clip value of money. It gives the true position of profitableness of the investing, and considers the aims of maximal profitableness.
It is hard to understand and run and does non give good consequences while comparing undertakings with unequal investing of financess.
Profitability index method: – It is besides a time-adjusted method of measuring the investing proposals. PI besides called benefit cost ratio or desirableness factor is the relationship between present value of hard currency influxs and the present values of hard currency escapes.
Calculation of PI: – ( PV of hard currency influxs / PV of hard currency escapes )
Decision regulation: – If the PI of a undertaking is more than 1 so accept it and reject the proposal if it is less than 1.
Advantages and Disadvantages of PI: –
Unlike net nowadays value, the profitableness index method is used to rank the undertakings even when the costs of the undertakings differ significantly. And besides gives the true position of the profitableness of the investing.
It is hard to understand and run.
Internal rate of return
This method is an of import technique of capital budgeting that takes into history the clip value of money. It is besides known as clip adjusted rate of return or test and mistake output method. The hard currency flows are discounted at a rate by hit and test method which equates the net present value to the sum of investing.
IF IRR & A ; gt ; K so accept the undertaking, K= cost of capital
If IRR & A ; lt ; K so reject the undertaking
Calculation of IRR: –
When one-year hard currency flows are equal over the life of the plus
Factor = ( initial spending / one-year hard currency influxs )
When the one-year hard currency flows are unequal over the life of the plus
( PV of hard currency influxs at lower rate – PV of hard currency escapes )
PV of hard currency influxs at lower rate – PV of hard currency influxs at higher rate
Advantage and Disadvantages of IRR: –
This method considers the profitableness of the undertakings for its full economic life and finding of cost of capital is non a pre necessity for the usage of this method.
The consequence of NPV and IRR methods may differ when the undertakings under rating differ in their life and timings of hard currency flows.
Calculation of payback period method: –
Machine 1 machine 2 machine 3
Initial investing ( A ) Rs 300000 Rs. 300000 Rs 300000
Gross saless ( B ) 500000 400000 450000
Direct Material 40000 50000 48000
Direct Labor 50000 30000 36000
Factory Overhead 60000 50000 58000
Depreciation 130000 91667 90000
Administrative costs 20000 10000 15000
Selling Costss 10000 10000 10000
Entire Costss ( C ) 310000 241667 257000
Net income before Tax ( B-C ) 190000 158333 193000
Less: revenue enhancement @ 40 % 76000 63333 77200
PAT 114000 95000 151800
Attention deficit disorder: Depreciation 130000 91667 90000
Net hard currency flow ( D ) 244000 186667 205800
Payback period ( A/D ) 1.23 1.61 1.46
Machine 1 has lowest wage back period, so it may be preferred over the other two Machines.
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