2. CAPITAL BUDGETING

METHODS OF CAPITAL BUDGETING OF EVALUATION
By matching the available resources and projects it can be invested. The funds available are always living funds. There are many considerations taken for investment decision process such as environment and economic conditions. The methods of evaluations are classified as follows:
 (A) Traditional methods (or Non-discount methods)
(i) Pay-back Period Methods
(ii) Post Pay-back Methods
(iii) Accounts Rate of Return
(B) Modern methods (or Discount methods)
(i) Net Present Value Method
(ii) Internal Rate of Return Method
(iii) Profitability Index Method

Pay-back Period 

Pay-back period is the time required to recover the initial investment in a project.

(It is one of the non-discounted cash flow methods of capital budgeting).

    Pay-back period = Initial investment/  Annual cash inflows 

Merits of Pay-back method 

The following are the important merits of the pay-back method: 

1. It is easy to calculate and simple to understand. 

2. Pay-back method provides further improvement over the accounting rate return. 

3. Pay-back method reduces the possibility of loss on account of obsolescence.

Demerits 

1. It ignores the time value of money. 

2. It ignores all cash inflows after the pay-back period. 

3. It is one of the misleading evaluations of capital budgeting.

Accept/Reject criteria 

If the actual pay-back period is less than the predetermined pay-back period, the project would be accepted. If not, it would be rejected. 

Post Pay-back Profitability Method 

One of the major limitations of pay-back period method is that it does not consider the cash inflows earned after pay-back period and if the real profitability of the project cannot be assessed.  To improve over this method, it can be made by considering the receivable after the pay-back period.  These returns are called post pay-back profits.

Accounting Rate of Return or Average Rate of Return 

Average rate of return means the average rate of return or profit taken for considering the project evaluation. This method is one of the traditional methods for evaluating the project proposals:

Merits 

1. It is easy to calculate and simple to understand. 

2. It is based on the accounting information rather than cash inflow. 

3. It is not based on the time value of money. 

4. It considers the total benefits associated with the project. 

Demerits 

1. It ignores the time value of money. 

2. It ignores the reinvestment potential of a project. 

3. Different methods are used for accounting profit. So, it leads to some difficulties in the calculation of the project.

Accept/Reject criteria If the actual accounting rate of return is more than the predetermined required rate of return, the project would be accepted. If not it would be rejected. 

Net Present Value 

Net present value method is one of the modern methods for evaluating the project proposals. In this method cash inflows are considered with the time value of the money. Net present value describes as the summation of the present value of cash inflow and present value of cash outflow. Net present value is the difference between the total present value of future cash inflows and the total present value of future cash outflows.

Merits 

1. It recognizes the time value of money. 

2. It considers the total benefits arising out of the proposal. 

3. It is the best method for the selection of mutually exclusive projects. 

4. It helps to achieve the maximization of shareholders’ wealth. 

Demerits 

1. It is difficult to understand and calculate. 

2. It needs the discount factors for calculation of present values. 

3. It is not suitable for the projects having different effective lives.

Accept/Reject criteria If the present value of cash inflows is more than the present value of cash outflows, it would be accepted. If not, it would be rejected.