Capital Budgeting Techniques:: Relative Income Generating Capacity and Rank Them in Order of Their Desirability

Capital budgeting Techniques:
The capital budgeting appraisal methods are techniques of

evaluation of investment proposal will help the company to
decide upon the desirability of an investment proposal
depending upon their;
relative income generating capacity and
 rank them in order of their desirability.
These methods provide the company a set of norms on the basis
of which either it has to accept or reject the investment proposal.
The most widely accepted techniques used in estimating the cost-
returns of investment projects can be grouped under two
categories.
,
1. Traditional methods
2. Discounted Cash flow methods
Traditional methods
 These methods are based on the principles to
determine the desirability of an investment
project on the basis of its useful life and
expected returns.
 These methods depend upon the accounting
information available from the books of
accounts of the company.
 These will not take into account the concept of
‘time value of money’, which is a significant
factor to determine the desirability of a
project in terms of present value.
Pay-back period method: - even cash flow
It is the most popular and widely recognized traditional method of
evaluating the investment proposals.
It can be defined, as ‘the number of years required to recover the
original cash out lay invested in a project’.
The pay back period is also called payout or payoff period.
This period is calculated by dividing the cost of the project by the
annual earnings after tax but before depreciation.
Under this method the projects are ranked on the basis of the
length of the payback period.
A project with the shortest payback period will be given the
highest rank and taken as the best investment.
The shorter the payback period, the less risky the investment is
the formula for payback period is
The payback period is expressed in years and fractions of years.

Merits:
1. It is one of the earliest methods of evaluating the investment
projects.
2. It is simple to understand and to compute.
3. It dose not involve any cost for computation of the payback period.
4. It is one of the widely used methods in small scale industry sector .
5. It can be computed on the basis of accounting information available
from the books.
Demerits:
1.This method fails to take into account the cash flows received by the
company after the pay back period.
2.It doesn’t take into account the interest factor involved in an
investment outlay.
3.It is not consistent with the objective of maximizing the market value
of the company’s share.
4. It fails to consider the pattern of cash inflows
i. e., the magnitude and timing of cash in flows.
Example 1:
The Delta company is planning to purchase a machine known as
machine X. Machine X would cost $25,000 and would have a useful life
of 10 years with zero salvage value. The expected annual cash inflow of
the machine is $10,000.
According to payback period analysis, the purchase of

machine X is desirable because its payback period is
2.5 years which is shorter than the maximum
payback period of the company.
Example 2:
The management of Rani Beverage Company is considering to purchase
a new equipment to increase the production and revenues, due to
increased demand . The useful life of the equipment is 10 years and the
company’s maximum desired payback period is 4 years. The inflow
and outflow of cash associated with the new equipment is given below:
Initial cost of equipment: $37,500
Annual cash inflows: Sales: $75,000
Annual cash Outflows: Cost of ingredients: $45,000
Salaries expenses: $13,500
Maintenance expenses: $1,500
Non cash expenses: Depreciation expense: $5,000
Computation of net annual cash inflow: =
$75,000–($45,000+$13,500+$1,500) = $15,000
Payback period of the equipment. = $37,500/$15,000 =2.5 years
Depreciation is a non-cash expense and has therefore been ignored
while calculating the payback period of the project. 2.5 years which is
shorter than the maximum desired payback period of 4 years.
Example 3:
The management of Health Supplement Inc. wants to reduce its labor
cost by installing a new machine. Two types of machines are available in
the market – machine X and machine Y. Machine X would cost $18,000
where as machine Y would cost $15,000. Both the machines can reduce
annual labor cost by $3,000.
Which is the best machine to purchase according to payback method?
Payback period of machine X: $18,000/$3,000 = 6 years
Payback period of machine y: $15,000/$3,000 = 5 years
According to payback method, machine Y is more desirable than

machine X because it has a shorter payback period than machine X.
Accounting (or) Average rate of return method (ARR):
 In the above examples we have assumed that the projects generate
even cash inflow but many projects usually generate uneven cash
flow.
 When projects generate inconsistent or uneven cash inflow
(different cash inflow in different periods), the simple formula given
above cannot be used to compute payback period.
 In such situations, we need to compute the cumulative cash inflow
and then apply the following formula:
Example 1:
Julie Miller is evaluating a new project for her firm, Basket Wonders
(BW). She has determined that the after-tax cash flows for the project
will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively,
for each of the Years 1 through 5. The initial cash outlay will be
$40,000.
Example 2: Company B wants to invest in a new project, and
managements maximum desired payback period is 3 years. The project
requires an initial investment of £550 000, and is expected to generate
the following cash inflows:
Year 1 = £75 000, Year 2 = £140 000, Year 3 = £250 000,
Year 4 = £120 000,Year 5 = £60 000
Calculation:
Year 0 = - £550 000
Year 1 = (£75 000 - £550 000) = - £475 000
Year 2 = (£140 000 - £475 000) = - £335 000
Year 3 = (£250 000 (- £335 000) = - £85 000
Year 4 = (£120 000 (- £85 000) = £35 000
Year 5 = (£60 000 + £35 000)= £95 000
Payback Period = A + (B/C)
Payback Period = Year 3 + (£85 000/£120 000) = 3.7
Therefore, the payback period for this project is 3.7 years.
This means the payback period (3.7 years) is more than managements
maximum desired payback period (3 years), so they should reject the
project.
Example 3:
An investment of $200,000 is expected to generate the following cash inflows in six
years: Year 1: $70,000, Year 2: $60,000,Year 3: $55,000,Year 4: $40,000,Year
5: $30,000, Year 6: $25,000. Compute payback period of the investment. Should the
investment be made if management wants to recover the initial investment in 3
years or less?
Solution:
Because the cash inflow is uneven, the payback period formula cannot be used to
compute the payback period. We can compute the payback period by computing the
cumulative net cash flow as follows:
Payback period = 3 + (15,000*/40,000)
= 3 + 0.375
= 3.375 Years
*Unrecovered investment at start of 4th year:
= Initial cost – Cumulative cash inflow at the end of 3rd year
= ($200,000 – $185,000)
= $15,000
The payback period for this project is 3.375 years which is longer than the maximum
desired payback period of the management (3 years). The investment in this
project is therefore not desirable.
Thank you

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Capital budgeting Techniques:

The capital budgeting appraisal methods are techniques of

The payback period is expressed in years and fractions of years.

According to payback period analysis, the purchase of

Payback period of machine X: $18,000/$3,000 = 6 years

Payback period of machine y: $15,000/$3,000 = 5 years

According to payback method, machine Y is more desirable than

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