Capital Budgeting

Decisions_ Payback
Period
DR. JAMES MATHEW
 The investment decisions of a firm are generally
known as capital budgeting or capital expenditure
Long term decisions.
Investment Capital budgeting decision may be defined as the
Decisions firm’s decision to invest its funds in the long term
(Capital assets in anticipation of an expected flow of
benefits over a number of years.
Budgeting
It involves a current outlay or series of outlays of
Decisions) cash resources in return for an anticipated flow of
future benefits.
Features

Exchange of current funds for future benefits

Funds are invested in long term assets
Future benefits will accrue over a series of years
There is relatively high degree of risk
There is relatively long period between the initial outlay and the anticipated return
Importance of Capital budgeting Decisions

Capital budgeting decisions are important because of the following reasons:

They influence the growth of the firm
Substantial Expenditures
Long term periods: The effects of the decision will be felt over a long period of time. They have
long term consequences influencing the rate and growth of a firm.
High Risk
Irreversibility
Complexity
Types of Investment Decisions

Different ways to classify investment decisions.

◦ Expansions
◦ Diversification
◦ Replacement and Modernization
◦ Research and Development

Another Classification
◦ Mutually exclusive investments
◦ Independent investments
◦ Contingent of Dependent investments
Capital Budgeting Process

Identification of investment proposals

Screening the proposals
Estimation of cash flows
Evaluation of proposals
Fixing priorities
Final approval and preparation of capital expenditure budget
Implementing proposal
Performance review
Methods of Traditional Methods
Capital Time Adjusted Methods or
Budgeting Discounted Methods
Traditional Payback period method
Methods Rate of return method
 Time Adjusted Net present value method
Methods or Internal rate of return method
Discounted Methods Profitability index method
Payback Period Method

The number of years required to recover the original cash outlay invested in a project.
Payback period = Initial investment/ Constant annual cash inflow
Incase of unequal cash inflows, payback period is found out by cumulating cash inflows until the
cash inflows equal the initial cash outlay.
Acceptance Rule
◦ The shorter the payback period, the more desirable is the project.
◦ Firms generally specify the maximum acceptable payback period.
Advantages

Simple to understand and easy to calculate

Costs less than other methods
It is a rough and ready method for dealing with risk.
It reduces the risk of loss through possible obsolescence
Suitable for firms having shortage of cash or liquidity problems.
Limitations

It fails to consider the time value of money

It ignores cash flows beyond the payback
Does not consider cost of capital which is an important factor in making sound investment
decisions
Determining a minimum acceptable payback period is a subjective decision.
It is a measure of a project’s capital recovery, not profitability.
Popularity of Payback Method

Popular because of the following reasons:

Simplicity
A company can have more favourable short run effects on EPS by accepting projects with
shorter payback period
The riskiness of the project can be tackled by having a shorter payback period.
The emphasis in payback is on the early recovery of investment thereby giving an insight into
the liquidity of the project.