Question 12. Describe various methods of capital budgeting?

Ans:
Introduction:-
The investment decision of a firm are know as capital budgeting
or capital expenditure decision. a capital budgeting decision may be
defined as the farms decision to invest its current fund in long term assets
to get the benefit over the year
Capital budgeting means planning for capital assets. It is to be
decided whether money should be invested in long term project like setting
up a new factory or installing machine etc. there may be various proposals
regarding capital expenditure. we are require to choose the best out of
various alternative.
In any business investment of fund in land, building equipment
or stock must be made carefully. Once the decision to acquire a fixed
assets is taken, it is very difficult to reserve that decision.

Various capital budgeting method are:

1.Pay back period method
2.Average rate of retune
3.Net present value method
4.Internal rate of retune
5.Discount rate of retune.
 (1) Pay Back Period Method
The pay back is one of the most popular traditional method of
evaluation investment proposal. It is defined as number of year required
to recover the original cost outlay invested in a project. If the project
generates constant annual cash inflow the payback period can be
computed by dividing cash outlay by the annual cash flow

Payback period = initial investment

Annual cash inflow
Suppose a project costs Rs 2000000 and yield annually a
profit of Rs 300000 after a depreciation 12.5% (straight
line method) but before tax 50% the frist step would be
calculate cash in flow of project the cash inflow is 400000
calculate as follow-
Profit before tax 300000
Less tax 50% 150 000
Profit after tax 150000
Add depreciation off 250000
Total amount 400000

This pay back period in this cash is 5 year in.200000/400000

(2) Average rate of retune

 The accounting rate of retune (ARR) also know as the retune on
investment (ROI). It is used to measured the profitability of an
investment. The accounting rate of retune is found out by dividing the
average after tax profit by the average investment.
The accounting rate of retune is an average rate that can be
determined by the following equation:

ARR = Average income

Average investment

Rate of retune means the average annual yield on the project.

Under this method profit after tax and depreciation as
percentage of total investment is considered. Suppose a
project requiring an investment of Rs 1000000 yield profit
after tax and depreciation as following:

Year profit after tax &depreciation

1. 50000
2. 75000
3. 125000
 4. 130000
5. 80000
Total __________________
460000

_suppose at the end of 5 year the plant and machine of the

project can be sold for 80000. In this case the rate of
retune can be calculate as follow:

Total profit X 100

Net investment in the project X No of year profit

460000
= 920000 X 5

= 10000\100

= 10%
This rate is compare with the rate expected on other
project if the same funds are invested alternative in this
project.
Sometime management compare this rate with cut off rate. For
example management may decide that they will not undertake any
project. Which has an average annual retune of less than 15% any
capital expenditure. Which has annual average retune of less than
15% will be automatically rejected.

(3) Net present value method

The best method for evaluation of investment proposal is

the net present value method or discount cash flow technique. This
method taken into account the time value of money. Under this method
the first thing to determine is the cash outflow. Each project will involve
certain investment and commitment of cash at certain point of time.
These are cash outflow each project will involve certain point of time.
This are cash outflow. This a project which required an initial
investment of Rs 1000000 has cash outflow of Rs 100000 immediately.
The second thing to determine is the cash inflow. this
can be calculate by adding depreciation to profit after tax and
depreciation

Year end cash inflow

1. 230000
2. 228000
3. 278000
4. 283000
 5. 273000
6. 80000
Total cost 1372000
_______________________________________________

The concept of present value is easy to understand. We have already seen

that a rupee received this is not equal to be deposited in a bank say at
10% and become Rs.1.10 next year. Therefore if somebody after to give
us Rs1.10 next or 1 rupee received next year.

(4) Internal Rate Of Retune

The internal rate of retune method is a discounted cash flow technique
which takes into account the magnitude and timing of cash flow. The
concept of IRR is very easy to understand in the cash of one period
project.
Assume that you deposit Rs 10000 with a bank. You would
get back Rs 10800 after one year. The true rate of retune on
your investment would be:

Rate of retune =10800-10000

10000

=10800- 1
 10000
= 1.08 or 8%

We can now develop a formula for the rate of retune (r) on

an investment(I) that generate a single cash flow one
period © as followings:

R= C -i
I

R= C - 1
I

C = 1+r
I

C= I
(1+r)
The internal rate of retune can be defined as that rate.

(5) Discount Pay Back Period

 One of serious object to the back method is that it does not
discount the cash flow for calculating the pay back period. Therefore
some people calculate the payback period. The number of year require
to cover invested on the present value basis is called discount pay back
period’
Let us take an example

Year Cash Machine Year Cash Machine

end inflow A end inflow B
_______________________________________________
(1) - - (1) 10 10
(2) 5 5 (2) 14 24
(3) 20 25 (3) 16 40
(4) 14 39 (4) 17 57
(5) 14 53 (5) 15 72
_______________________________________________
Investment: Rs 25 lakhs Investment Rs 40 lakhs
Payback Period :3 year Payback Period :3 year
_______________________________________________