methods of capital budgeting

Methods of capital budgeting

Traditional method
I. Pay back period method ;-

Under this method a project is evaluated on the basis of pay back period of the project .
The pay back period is the period during which the capital outlay cost of investment is covered from the expected profitability of the project to determine the pay back period
The following steps are to be taken :-
Take initial capital outlay of project
Take the estimated profitability of the project
The profits should be before depreciation but after tax
The pay back period will be calculated as
If the annual cash inflows are equal

= cost of project / annual cash inflows (before dep. And after tax )

ii If the annual cash inflow are not equal

Add the annual cash inflows till the cost of project is recovered


II Rate of return per unit of investment method:-
In This method the rate of return is calculated on the basis of total expected profit after dep. And tax and net investment of project

= Total profit ( After depreciation and tax ) / net investment X 100
III Rate of return on investment
Under this method the rate of return is calculated on the basis of total expected profit from the project and average cost of investment
= total profit ( after depreciation and tax ) /average investment X100
Average investment =total investment /2
Discounted cash flow technique or time adjusted technique

I Net present value method of cash inflows
Calculate net present value as NPV= present value of cash inflows – present value of cash outflows

If this is only one project then if it is positive of net present value then the project will be accepted and if it is negative the project will be rejected
If there are many projects then only higher net present value’s project will be accepted
Profitability index method

The profitability index is the relationship of present value of cash inflows and outflows . In facts it is a comparison of benefits and cost of projects that is why this method is known as benefit cost method and the profitability index calculate the profitability of a project the following steps are to be taken
take the initial capital outlay or cost of investment
Take the annual cash inflows expected profitability before depreciation and after tax
Calculate present value with the determine discount rate and pvf and total cash inflows
Net present profitability index (P.I.)
= present value of cash inflows / present value of cash outflows

Or
= net present value/ present value of cash outflows
Internal rate of return method

Internal rate of return is calculation of interest or discount rate or cut off rate which the investment is expected . It is rate which equates the present value of cash inflows and present value of cash outflows
Other words , it is rate where the net present value is zero or near the zero . It is calculated by following way
when the annual cash inflows are equal in such case take cost of project and expect annual profit before depreciation and after tax . The cost of project is divided by the annual profitability and then calculate number
in other it is pay back period trace the value calculated on the present value table on life of project .The rate under which this value falls is the internal rate of return
when a case to calculate the internal rate of return the following steps to be taken

i) Take the cost of project
ii) Take the expect annual cash inflows before dep and after tax
iii) Assume any discount rate and calculate the present values of cash inflows and cash outflows and calculated net present value
iv) If the npv is in positive then assume a higher rate go on assuming higher rates till the npv becomes negative .
v) To determine the internal rate of return apply following formula
vi) IRR = lower rate + [NPV of lower rate / PV of lower rate – PV of higher rate ] X ( higher rate – lower rate )
vii) To accept the project if calculated internal rate of return is more than the standard rate then project will be accepted . but if project are mutually exclusive then project with higher internal rate of return will be accepted