Non Discounted Capital Budgeting Techniques

NON-DISCOUNTED
CAPITAL BUDGETING
TECHNIQUES
MANAGEMENT ACCOUNTING 2
NON-DISCOUNTED CASH
FLOW (UNADJUSTED
APPROACH)
PAYBACK PERIOD
◦ Payback period is the length of time required for a project’s
cumulative net cash inflows to equal its net investment.
◦ It measures the time required for a project to break-even.
◦ If the expected annual net cash inflows are equal (annuity form)
the payback is computed by dividing the net investment by the
annual net cash inflows.
𝑵𝒆𝒕 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
◦ 𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝑷𝒆𝒓𝒊𝒐𝒅 𝒘𝒊𝒕𝒉 𝑬𝒒𝒖𝒂𝒍 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘𝒔 =
𝑨𝒏𝒏𝒖𝒂𝒍 𝑵𝒆𝒕 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘𝒔
PAYBACK PERIOD
◦ If the expected cash inflows are unequal, the payback is
calculated by determining the length of time required for
cumulative net cash inflows to equal the net investment.
𝑈𝑛𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑒𝑑 𝑐𝑜𝑠𝑡 𝑎𝑡 𝑠𝑡𝑎𝑟𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟

◦ 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 𝑝𝑟𝑖𝑜𝑟 𝑡𝑜 𝑓𝑢𝑙𝑙 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 + 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑑𝑢𝑟𝑖𝑛𝑔 𝑓𝑢𝑙𝑙 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑒𝑑
PAYBACK PERIOD
◦ Decision Rule:
◦ The desirability of the project is determined by comparing the project’s

payback period against the maximum acceptable payback period as
predetermined by management. The project with shorter payback period
than the maximum will be accepted. In short:
◦ If: PB period ≤ Maximum allowed PB period; Accept

◦ If: PB period> Maximum allowed PB period; Reject
Advantages of Payback Period
Method:
1. It is easy to compute and understand.
2. It is used to measure the degree of risk associated with a project.
3. Generally, the longer the payback period, the higher the risk.
4. It is used to select projects which provide a quick return of invested funds.
Disadvantages of the Payback Period
Method:
1. It does not recognized the time value of money.
2. It ignores the impact of cash inflows after the payback period.
3. It does not distinguish between alternatives having different economic lives.
4. The conventional payback computation fails to consider salvage value, if
any.
5. It does not measure profitability – only the relative liquidity of the investment.
6. There is no necessary relationship between a given payback and investor
wealth maximization so an investor would not know what an acceptable
payback is.
Payback Period with Even Cash Flows
Illustration:
◦ The information provided below pertains to Project A of the Maharlika
Corporation. The Maximum payback period set be the firm if three years.
Project A
Net investment P120,000
Annual net cash inflows P50,000
Estimated life 5 years
Payback Period with uneven Cash
Flows Illustration:
◦ Makinang Corporation is evaluating two projects with the following cash flows.
The maximum payback period set by the firm is 3 years.
Cash Flows
Year Project X Project Y
0 (P100,000) (P100,000)
1 20,000 50,000
2 30,000 40,000
3 40,000 10,000
4 50,000
5 70,000
Bail-out Period
◦ An approach which incorporates the salvage value in payback
computations.
◦ This is reached when the cumulative cash earnings plus the
salvage value at the end of a particular year equals the original
investment.
Determination of Bail-out Period
illustration:
◦ An investment of P150,000 is expected to produce annual cash
earnings of P50,000 for 5 years. Its estimated salvage value is
P70,000 during the first year and this is expected to decrease by
P15,000 annually.
◦ What is the bail-out payback period?

Payback Reciprocal
◦ Payback reciprocal measures the rate of recovery of investment
during the payback period.
◦ For projects with even cash flows, the payback reciprocal is
computed as follows:
1
◦ 𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝑹𝒆𝒄𝒊𝒑𝒓𝒐𝒄𝒂𝒍 =
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑
◦ For projects with uneven cash flows, the payback reciprocal can be
computed on an annual basis by dividing the Cash inflows for the year by
the net investment.
Payback Reciprocal
◦ An alternative way of expressing the payback period is as the “payback
period reciprocal” which is expressed as:
𝟏
◦ 𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝑷𝒆𝒓𝒊𝒐𝒅 𝑹𝒆𝒄𝒊𝒑𝒓𝒐𝒄𝒂𝒍 = 𝐱 𝟏𝟎𝟎
𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝒑𝒆𝒓𝒊𝒐𝒅
◦ The higher the payback period reciprocal, (and hence the lower
the payback period) the worthwhile the project becomes.
Accounting rate of Return
◦ Accounting rate of return or simple rate of return is a measure of
a project’s profitability from a conventional accounting
standpoint by relating the required investment to the future
annual net income.
◦ Average annual net income is determined by summing the
expected net income over the project’s life and dividing by the
total number of periods in the life of the project.
◦ Average net investment is assumed to be one-half of the net
investment.
◦ ARR is computed as follows:
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑨𝒏𝒏𝒖𝒂𝒍 𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆
◦ 𝑨𝑹𝑹 =
𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝒐𝒓 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
◦ Or, if a cost reduction project is involved, the formula becomes:

𝑪𝒐𝒔𝒕 𝑺𝒂𝒗𝒊𝒏𝒈𝒔−𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 𝒐𝒏 𝒏𝒆𝒘 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
◦ 𝑨𝑹𝑹 =
𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝒐𝒓 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
◦ Decision rule:
◦ Under the ARR method, choose the project with the highest rate
if return. Accept the project if the ARR is greater than the cost of
capital.
◦ Thus:
◦ If: ARR ≥ Required rate of return; Accept
◦ If: ARR < Required rate of return: Reject
Advantages using the ARR
1. It is easily understood by investors acquainted with financial
statements.
2. It is used as a rough preliminary screening device of investment
proposals.
Disadvantages of using the ARR
1. It ignores the time value of money by failing to discount the
future cash inflows and outflows.
2. It does not consider the timing component of cash inflows.
3. Different averaging techniques may yield inaccurate answers.
4. It utilizes the concepts of capital and income primarily designed
for the purposes of financial statements preparation and which
may not be relevant to the evaluation of investment proposals.
Determination of Accounting Rate of
Return illustration:
◦ Consider the following information about a proposed project:
Initial investment required P65,000
Annual cash inflows P10,000
Salvage value of the asset at the P0
end of 20 years
Straight-line method of
depreciation will be used.
◦ Compute the Accounting Rate of Return
◦ Based on initial investment
◦ Based on average investment
Determination of Accounting Rate of
Return illustration:
◦ Toronto Corporation is considering an investment in Project A based on the following
information.
Project A
Net investment P120,000
Annual net income P20,000
Target ARR 25%
◦ The average annual net income is P20,000 (P100,000 / 5 years) and the average net
investment is P60,000 (P120,000 / 2). The accounting rate of return is:
Reference:
◦ Ma. Elenita Balatbat Cabrera (2012), Financial Management: Principles and
Applications Comprehensive Volume 2012 – 2013 edition, GIC Enterprises & Co., Inc.

Non Discounted Capital Budgeting Techniques

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NON-DISCOUNTED

𝑈𝑛𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑒𝑑 𝑐𝑜𝑠𝑡 𝑎𝑡 𝑠𝑡𝑎𝑟𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟

◦ The desirability of the project is determined by comparing the project’s

◦ If: PB period ≤ Maximum allowed PB period; Accept

◦ What is the bail-out payback period?

◦ Or, if a cost reduction project is involved, the formula becomes:

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