BUAD 839 ASSIGNMENT (Group F)

BUAD 839 ASSIGNMENT (GROUP F)
BUAD 839 (Group F)
Give a detailed description of each of the methods of Capital budgeting as applied and practiced in
modern business organizations with relevant examples.
Solution:
CAPITAL BUDGETING TECHNIQUES / METHODS
Capital budgeting is the process that a business uses to determine which proposed fixed asset purchases
it should accept, and which should be declined. This process is used to create a quantitative view of each
proposed fixed asset investment, thereby giving a rational basis for making a judgment.
In today’s upwardly mobile world, we are constantly barraged with a plethora of “one size fits all”
business solutions in the form of work implements, equipment and associated services. As managers, we
must look beyond the aesthetics and ‘promises’ as well as the label price, to determine which of such
equipment to eventually invest in.
Modern firms now use different methods for capital budgeting. Some of these methods include:
Payback period and Accounting rate of return method. The discounted cash flow method includes the
NPV method, profitability index method and IRR.
1. Payback period method:
As the name suggests, this method refers to the period in which the proposal will generate cash to
recover the initial investment made. It purely emphasizes on the cash inflows, economic life of the
project and the investment made in the project, with no consideration to time value of money. Through
this method selection of a proposal is based on the earning capacity of the project. With simple
calculations, selection or rejection of the project can be done, with results that will help gauge the risks
involved. However, as the method is based on thumb rule, it does not consider the importance of time
value of money and so the relevant dimensions of profitability.
Payback period = Cash outlay (investment) / Annual cash inflow
Example:
Project Cost Expected Future Flow Payback

Year 1 Year 2 Year 3 Year 4 Total
A 100,000
B 100,000
* Payback period of project B is shorter than A, but project A provides higher returns. Hence, project A is
superior to B.
2. Accounting rate of return method (ARR):

This method helps to overcome the disadvantages of the payback period method. The rate of return is
expressed as a percentage of the earnings of the investment in a particular project. This works based on
the criteria that any project having ARR higher than the minimum rate established by the management
will be considered and those below the predetermined rate are rejected.
This method takes into account the entire economic life of a project providing a better means of
comparison. It also ensures compensation of expected profitability of projects through the concept of
net earnings. This method however, ignores time value of money and doesn’t consider the length of life
of the projects. Also it is not consistent with the firm’s objective of maximizing the market value of
shares.
ARR= Average income/Average Investment
3. Discounted cash flow method:
This technique calculates the cash inflow and outflow through the life of an asset. These are then
discounted through a discounting factor. The discounted cash inflows and outflows are then compared.
This technique takes into account the interest factor and the return after the payback period.
4. Net present Value (NPV) Method:
This is one of the widely used methods for evaluating capital investment proposals. In this technique the
cash inflow that is expected at different periods of time is discounted at a particular rate. The present
values of the cash inflow are compared to the original investment. If the difference between them is
positive (+) then it is accepted or otherwise rejected. This method considers the time value of money
and is consistent with the objective of maximizing profits for the owners. However, understanding the
concept of cost of capital is not an easy task.
The equation for the net present value, assuming that all cash outflows are made in the initial year (tg),
will be:
An
NPV =¿ ¿−C
( 1+ K ) n
Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost of the investment
proposal and n is the expected life of the proposal. It should be noted that the cost of capital, K, is
assumed to be known, otherwise the net present, value cannot be known
NPV = PVB – PVC
Where,
PVB = Present value of benefits
PVC = Present value of Costs
5. Internal Rate of Return (IRR):
This is defined as the rate at which the net present value of the investment is zero. The discounted cash
inflow is equal to the discounted cash outflow. This method also considers time value of money. It tries
to arrive to a rate of interest at which funds invested in the project could be repaid out of the cash
inflows. However, computation of IRR is a tedious task.
It is called internal rate because it depends solely on the outlay and proceeds associated with the project
and not any rate determined outside the investment.
6. Profitability Index (PI):
It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash
outflow of the investment. It may be gross or net, net being simply gross minus one. The formula to
calculate profitability index (PI) or benefit cost (BC) ratio is as follows.
PI = PV cash inflows/ Initial cash outlay A 1
Or,
PI = NPV (Benefits)/ NPV (Costs)
NB: All projects with PI > 1.0 is accepted.
7. Constraint analysis:
Here, the focus is to identify the bottleneck machine or work center in a production environment and
invest in those fixed assets that maximize the utilization of the bottleneck operation. Under this
approach, a business is less likely to invest in areas downstream from the bottleneck operation (since
they are constrained by the bottleneck operation) and more likely to invest upstream from the
bottleneck (since additional capacity there makes it easier to keep the bottleneck fully supplied with
inventory).
8. Avoidance analysis:
The focus in this technique is to determine whether increased maintenance can be used to prolong the
life of existing assets, rather than investing in replacement assets. This analysis can substantially reduce
a company's total investment in fixed assets.
REFERENCES:
Capital Budgeting (December 8th, 2019). Retrieved from
https://www.accountingtools.com/articles/what-is-capital-budgeting.html#:~:text=Capital%20budgeting
%20is%20the%20process,basis%20for%20making%20a%20judgment.
EduPristine (February 7th, 2018). Capital Budgeting: Techniques & Importance. Retrieved from
https://www.edupristine.com/blog/capital-budgeting-techniques

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BUAD 839 (Group F)

CAPITAL BUDGETING TECHNIQUES / METHODS

1. Payback period method:

Payback period = Cash outlay (investment) / Annual cash inflow

Project Cost Expected Future Flow Payback

2. Accounting rate of return method (ARR):

ARR= Average income/Average Investment

3. Discounted cash flow method:

4. Net present Value (NPV) Method:

NPV = PVB – PVC

PVC = Present value of Costs

5. Internal Rate of Return (IRR):

6. Profitability Index (PI):

PI = PV cash inflows/ Initial cash outlay A 1

PI = NPV (Benefits)/ NPV (Costs)

NB: All projects with PI > 1.0 is accepted.

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