Techniques of

Capital Budgeting
1.Non-Discounted Techniques
2. Discounted Techniques
A: Non-discounted Technique
1. Payback Period (PBP)
2. Average Rate of Return (ARR)

B: Discounted Technique
3. Discounted Pay Back Period (D-PBP)
4. Net Present Value (NPV)
5. Internal Rate of Return (IRR)
6. Profitability Index /Analysis (PI)
1. Payback Period
The pay backs one of the most popular and widely used
traditional method of evaluating investment proposal. The
payback period is the number of years to recoup the cash
investment. It is the simplest and perhaps the most widely
employed quantitative method for appraising capital
expenditures. This method answers the questions: how many
years will it take for the cash benefit to pay the original cost
of an investment, normally, disregarding salvage value? Cash
benefit here represents cash flow after tax (CFAT), ignoring
interest payment, thus, payback period measures the
number of years required for the CFAT to pay back the
original outlay required in an investment.
Advantages
• It is very easy to understand and compute.
• It gives more important on liquidity for making decision about
the investment proposal.
• Cash flow is subjective than profitability.

 Disadvantages
• It ignores the time value of money.
• It ignores the cash flows occurring after the payback period.
• It is not consistent with the objectives of maximizing the
market value of the firm's shares.
• The payback period is calculated by two ways:
i) When the annual CFAT is uniform or equal 
Payback period (PBP)= Initial Cost
Annual Cash flow After Tax
ii) When the annual CFAT is not uniform or equal
b) Payback period = Minimum year of amount to be covered +
amount to be covered
cash flow for next year
Decision Rules:
• Lower pay back period is accepted.
• Higher payback period is rejected. 
2. Accounting Rate of Return: The accounting rate of return also
known as the return on investment method uses accounting
information, as revealed by financial statements. It is used to
measure the profitability of an investment. The accounting
rate of return is determined by dividing the average net profit
after tax by the average investment. The average investment
would equal to half of the original investment if it is
depreciated constantly.
Accounting rate of return =
Average net income x 100%
Average Investment

Where , average investment= investment+scrap value

2
Advantages
• It is very simple to understand and use.
• The accounting rate of return can be determined from
accounting data; unlike the NPV & IRR rules, no adjustments are
required to arrive at the cash flow of project.
• It incorporates the entire stream of income in calculating the
project's profitability.
 Disadvantages
• It ignores the time value of money,
• It uses accounting profit, not cash flows, in appraising the
projects.
• It gives more weight age to futures receipts.
Decision Rules:
• Higher accounting rate of return is accepted.
• Lower accounting rate of return is rejected
• Net Present Value Method:

The net present value method is the classic economic

value of evaluating the investment proposals. It is one
of the discounted cash flow techniques explicitly
recognizing the time value of money. Net present
value is the true measure of an investment’s
profitability. The net present value method is a
process of calculating the present value of the
project's cash flows, using the opportunity cost of
capital as discounted rate, and finding out the net
present value by subtracting the initial investment
from the present value of cash flows.
Under the net present value method the investment project
is accepted if its net present value is positives (NPV > 0).
The market value of the firm's share is expected to
increase by the project's positives Net present value.
Between the mutually exclusive projects, the one with
the highest net present value will be chosen.
 Advantages
• It considers the time value of money.
• It includes all the cash flow over the period.
• It helps to in maximizing the value of firm.
• It is useful for the selection of mutually exclusive projects.
 
Disadvantages
• It is difficult to calculate and to use.
• It is difficult to calculate the appropriate discount
rate.
• It may give incorrect decision when the projects are
unequal life. 
 
 NPV- Calculation Step
1. Find discounted CFAT using given rate of rerun(cost
of capital)
2. Add all CFAT to find out total present value (TPV)
3. Deduct initial investment (NCO) from TPV to find
out NPV
Formula:
I. when CFAT is uneven

II. When CFAT is even

Net Present Value = Total Present Value – Net Cash
outlay

Decision Rules:
Independent Project
• If the net present value is positive, the project is
accepted.
• If the net present value is negative, the project is
rejected.
Mutually exclusive project
• Higher net present value is accepted.
Profitability Index (PI)

The third discounted method of evaluating the

investment proposals is the profitability index. It is
also known as cost-benefit ratio. It is the ratio of the
present value of cash inflows at the required rate of
return, to the initial cash outflow of investments.

Profitability index=Total Present Value

NCO
• Advantages
It considers s the time value of money.
It considers the all cash flow over the period.
It makes the right in the case of different amount of net
cash outlay of different project.
 
• Disadvantages
It is difficult to determine interest or discount rate.
It is difficult to calculate profitability index if two project
having different useful lives.
 
 
Decision Rules
Independent Project
• If the profitability index is greater than one, the
project is accepted.
• If the profitability index is less than one, the project is
rejected..
Mutually exclusive project
• Higher profitability index is accepted.
• Lower profitability index is rejected.
• Internal Rate of Return (IRR)
The internal Rate of return method is another
discounted cash flow method which takes account of
the magnitude and timing of cash flows. The internal
rate of return can be defined as that rate which
equates the present value of cash inflows with the
present value of cash outflows of investments. In
other words, it is the rate at which the net present if
the investment is zero. There is no satisfactory way of
defining true rate of return to a long -term assets.
• Advantages:
It considers the time value of money.
It includes all cash flow of the project.
• Disadvantages
It does not holds the value-additively principle.
It fails to indicate correct between mutually exclusive
projects.
Steps to calculate IRR
• Find out the factor value
• Select the two interest rate or discount rate from the
annuity table
• Calculate the present value at the two selected
interest rate
• use formula:
Internal Rate of Return =
Decision Rules
Independent Project
• If the internal rate of return is greater than cost of
capital , the project is accepted.
• If the internal rate of return is less than cost of
capital , the project is rejected.
Mutually exclusive project
• Higher internal rate of return is accepted.
• Lower internal rate of return is rejected.