Investment Decisions- 2 | Financial Management & Economics Finance: CA Intermediate (Old Scheme) PDF Download

 Page 1


7.17 
INVESTMENT DECISIONS 
SECTION 2 
 7.7 CAPITAL BUDGETING TECHNIQUES  
In order to maximise the return to the shareholders of a company, it is important 
that the best or most profitable investment projects are selected. Results of making 
a bad long-term investment decision can be devastating in both financial and 
strategic terms. Care required for investment project selection and evaluation. 
There are a number of techniques available for appraisal of investment proposals 
and can be classified as presented below: 
 
Organizations may use any one or more of capital investment evaluation techniques; 
some organizations use different methods for different types of projects while others 
may use multiple methods for evaluating each project. These techniques have been  
discussed below – net present value, profitability index, internal rate of return, modified 
internal rate of return, payback period, and accounting (book) rate of return.  
 
 
Capital Budgeting 
Techniques
Traditional  or Non 
Discounting
Payback Period
Accounting  Rate of Return 
(ARR)
Time adjusted or 
Discounted Cash Flows
Net Present Value (NPV)
Profitability Index (PI)
Internal Rate of Return (IRR)
Modified Internal Rate of 
Return (MIRR)
Discounted Payback 
Page 2


7.17 
INVESTMENT DECISIONS 
SECTION 2 
 7.7 CAPITAL BUDGETING TECHNIQUES  
In order to maximise the return to the shareholders of a company, it is important 
that the best or most profitable investment projects are selected. Results of making 
a bad long-term investment decision can be devastating in both financial and 
strategic terms. Care required for investment project selection and evaluation. 
There are a number of techniques available for appraisal of investment proposals 
and can be classified as presented below: 
 
Organizations may use any one or more of capital investment evaluation techniques; 
some organizations use different methods for different types of projects while others 
may use multiple methods for evaluating each project. These techniques have been  
discussed below – net present value, profitability index, internal rate of return, modified 
internal rate of return, payback period, and accounting (book) rate of return.  
 
 
Capital Budgeting 
Techniques
Traditional  or Non 
Discounting
Payback Period
Accounting  Rate of Return 
(ARR)
Time adjusted or 
Discounted Cash Flows
Net Present Value (NPV)
Profitability Index (PI)
Internal Rate of Return (IRR)
Modified Internal Rate of 
Return (MIRR)
Discounted Payback 
 
 
7.18 FINANCIAL MANAGEMENT  
 7.8 TRADITIONAL OR NON-DISCOUNTING 
TECHNIQUES  
These techniques of capital Budgeting does not discount the future cash flows. 
There are two such techniques namely Payback Period and Accounting Rate of 
Return  
7.8.1 Payback Period 
Time required to recover the initial cash-outflow is called pay-back period. The 
payback period of an investment is the length of time required for the cumulative 
total net cash flows from the investment to equal the total initial cash outlays.  At 
that point in time, the investor has recovered the money invested in the project.   
Steps in Payback period technique: - 
(a) The first steps in calculating the payback period is determining the total initial 
capital investment (cash outflow) and  
(b) The second step is calculating/estimating the annual expected after-tax cash 
flows over the useful life of the investment.   
1. When the cash inflows are uniform over the useful life of the project, the number 
of years in the payback period can be calculated using the following equation: 
Total initial capital investment
Payback period = 
Annual expected after - tax net cash flow
 
Example- 4 
Suppose a project costs ` 20,00,000 and yields annually a profit of `  3,00,000 after 
depreciation @ 12½% (straight line method) but before tax 50%. The first step 
would be to calculate the cash inflow from this project. The cash inflow is `  4,00,000 
calculated as follows:  
Particulars 
(`)
Profit before tax 3,00,000 
Less: Tax @ 50% (1,50,000) 
Profit after tax 1,50,000 
Add: Depreciation written off 2,50,000
Total cash inflow 4,00,000 
Page 3


7.17 
INVESTMENT DECISIONS 
SECTION 2 
 7.7 CAPITAL BUDGETING TECHNIQUES  
In order to maximise the return to the shareholders of a company, it is important 
that the best or most profitable investment projects are selected. Results of making 
a bad long-term investment decision can be devastating in both financial and 
strategic terms. Care required for investment project selection and evaluation. 
There are a number of techniques available for appraisal of investment proposals 
and can be classified as presented below: 
 
Organizations may use any one or more of capital investment evaluation techniques; 
some organizations use different methods for different types of projects while others 
may use multiple methods for evaluating each project. These techniques have been  
discussed below – net present value, profitability index, internal rate of return, modified 
internal rate of return, payback period, and accounting (book) rate of return.  
 
 
Capital Budgeting 
Techniques
Traditional  or Non 
Discounting
Payback Period
Accounting  Rate of Return 
(ARR)
Time adjusted or 
Discounted Cash Flows
Net Present Value (NPV)
Profitability Index (PI)
Internal Rate of Return (IRR)
Modified Internal Rate of 
Return (MIRR)
Discounted Payback 
 
 
7.18 FINANCIAL MANAGEMENT  
 7.8 TRADITIONAL OR NON-DISCOUNTING 
TECHNIQUES  
These techniques of capital Budgeting does not discount the future cash flows. 
There are two such techniques namely Payback Period and Accounting Rate of 
Return  
7.8.1 Payback Period 
Time required to recover the initial cash-outflow is called pay-back period. The 
payback period of an investment is the length of time required for the cumulative 
total net cash flows from the investment to equal the total initial cash outlays.  At 
that point in time, the investor has recovered the money invested in the project.   
Steps in Payback period technique: - 
(a) The first steps in calculating the payback period is determining the total initial 
capital investment (cash outflow) and  
(b) The second step is calculating/estimating the annual expected after-tax cash 
flows over the useful life of the investment.   
1. When the cash inflows are uniform over the useful life of the project, the number 
of years in the payback period can be calculated using the following equation: 
Total initial capital investment
Payback period = 
Annual expected after - tax net cash flow
 
Example- 4 
Suppose a project costs ` 20,00,000 and yields annually a profit of `  3,00,000 after 
depreciation @ 12½% (straight line method) but before tax 50%. The first step 
would be to calculate the cash inflow from this project. The cash inflow is `  4,00,000 
calculated as follows:  
Particulars 
(`)
Profit before tax 3,00,000 
Less: Tax @ 50% (1,50,000) 
Profit after tax 1,50,000 
Add: Depreciation written off 2,50,000
Total cash inflow 4,00,000 
 
 
7.19 
 
INVESTMENT DECISIONS 
While calculating cash inflow, depreciation is added back to profit after tax since it 
does not result in cash outflow. The cash generated from a project therefore is 
equal to profit after tax plus depreciation. The payback period of the project shall 
be: 
 Payback period = 
` 20,00,000
4,00,000
= 5 Years 
Some Accountants calculate payback period after discounting the cash flows by a 
predetermined rate and the payback period so calculated is called, ‘Discounted 
payback period’ (discussed later on). 
2. When the annual cash inflows are not uniform, the cumulative cash inflow 
from operations must be calculated for each year. The payback period shall be 
corresponding period when total of cumulative cash inflows is equal to the initial 
capital investment. However, if exact sum does not match then the period in which 
it lies should be identified. After that we need to compute the fraction of the year. 
This method can be understood with the help of an example 
Example- 5 
Suppose XYZ Ltd. is analyzing a project requiring an initial cash outlay of `  2,00,000 
and expected to generate cash inflows as follows: 
Year Annual Cash Inflows (`) 
1 80,000 
2 60,000 
3 60,000 
4 20,000 
It’s payback period shall be computed by using cumulative cash flows as follows: 
Year Annual Cash Inflows 
(`) 
Cumulative Cash Inflows 
(`) 
 
1 80,000 80,000  
2 60,000 1,40,000  
3 60,000 2,00,000 ? 
4 20,000 2,20,000  
In 3 years total cash inflows equal to initial cash outlay. Hence, payback period is 3 
years. 
Page 4


7.17 
INVESTMENT DECISIONS 
SECTION 2 
 7.7 CAPITAL BUDGETING TECHNIQUES  
In order to maximise the return to the shareholders of a company, it is important 
that the best or most profitable investment projects are selected. Results of making 
a bad long-term investment decision can be devastating in both financial and 
strategic terms. Care required for investment project selection and evaluation. 
There are a number of techniques available for appraisal of investment proposals 
and can be classified as presented below: 
 
Organizations may use any one or more of capital investment evaluation techniques; 
some organizations use different methods for different types of projects while others 
may use multiple methods for evaluating each project. These techniques have been  
discussed below – net present value, profitability index, internal rate of return, modified 
internal rate of return, payback period, and accounting (book) rate of return.  
 
 
Capital Budgeting 
Techniques
Traditional  or Non 
Discounting
Payback Period
Accounting  Rate of Return 
(ARR)
Time adjusted or 
Discounted Cash Flows
Net Present Value (NPV)
Profitability Index (PI)
Internal Rate of Return (IRR)
Modified Internal Rate of 
Return (MIRR)
Discounted Payback 
 
 
7.18 FINANCIAL MANAGEMENT  
 7.8 TRADITIONAL OR NON-DISCOUNTING 
TECHNIQUES  
These techniques of capital Budgeting does not discount the future cash flows. 
There are two such techniques namely Payback Period and Accounting Rate of 
Return  
7.8.1 Payback Period 
Time required to recover the initial cash-outflow is called pay-back period. The 
payback period of an investment is the length of time required for the cumulative 
total net cash flows from the investment to equal the total initial cash outlays.  At 
that point in time, the investor has recovered the money invested in the project.   
Steps in Payback period technique: - 
(a) The first steps in calculating the payback period is determining the total initial 
capital investment (cash outflow) and  
(b) The second step is calculating/estimating the annual expected after-tax cash 
flows over the useful life of the investment.   
1. When the cash inflows are uniform over the useful life of the project, the number 
of years in the payback period can be calculated using the following equation: 
Total initial capital investment
Payback period = 
Annual expected after - tax net cash flow
 
Example- 4 
Suppose a project costs ` 20,00,000 and yields annually a profit of `  3,00,000 after 
depreciation @ 12½% (straight line method) but before tax 50%. The first step 
would be to calculate the cash inflow from this project. The cash inflow is `  4,00,000 
calculated as follows:  
Particulars 
(`)
Profit before tax 3,00,000 
Less: Tax @ 50% (1,50,000) 
Profit after tax 1,50,000 
Add: Depreciation written off 2,50,000
Total cash inflow 4,00,000 
 
 
7.19 
 
INVESTMENT DECISIONS 
While calculating cash inflow, depreciation is added back to profit after tax since it 
does not result in cash outflow. The cash generated from a project therefore is 
equal to profit after tax plus depreciation. The payback period of the project shall 
be: 
 Payback period = 
` 20,00,000
4,00,000
= 5 Years 
Some Accountants calculate payback period after discounting the cash flows by a 
predetermined rate and the payback period so calculated is called, ‘Discounted 
payback period’ (discussed later on). 
2. When the annual cash inflows are not uniform, the cumulative cash inflow 
from operations must be calculated for each year. The payback period shall be 
corresponding period when total of cumulative cash inflows is equal to the initial 
capital investment. However, if exact sum does not match then the period in which 
it lies should be identified. After that we need to compute the fraction of the year. 
This method can be understood with the help of an example 
Example- 5 
Suppose XYZ Ltd. is analyzing a project requiring an initial cash outlay of `  2,00,000 
and expected to generate cash inflows as follows: 
Year Annual Cash Inflows (`) 
1 80,000 
2 60,000 
3 60,000 
4 20,000 
It’s payback period shall be computed by using cumulative cash flows as follows: 
Year Annual Cash Inflows 
(`) 
Cumulative Cash Inflows 
(`) 
 
1 80,000 80,000  
2 60,000 1,40,000  
3 60,000 2,00,000 ? 
4 20,000 2,20,000  
In 3 years total cash inflows equal to initial cash outlay. Hence, payback period is 3 
years. 
  
 
7.20 FINANCIAL MANAGEMENT  
Suppose if in above example the initial outlay is `  2,05,000 then payback period 
shall be computed as follows: 
Year Annual Cash Inflows 
(`) 
Cumulative Cash 
Inflows (`)  
 
1 80,000 80,000  
2 60,000 1,40,000  
3 60,000 2,00,000  
4 20,000 2,20,000 ? 
Payback period shall lie between 3 to 4 years. Since up to 3 years a sum of  
`  2,00,000 shall be recovered balance of `  5,000 shall be recovered in the part 
(fraction) of 4
th
 year, computation is as follows: 
 year
4
1
20,000
5,000
= 
Thus, total cash outlay of `  205,000 shall be recovered in 3¼ years’ time. 
Advantages of Payback period 
? It is easy to compute. 
? It is easy to understand as it provides a quick estimate of the time needed for 
the organization to recoup the cash invested.   
? The length of the payback period can also serve as an estimate of a project’s 
risk; the longer the payback period, the riskier the project as long-term 
predictions are less reliable.  In some industries with high obsolescence risk like 
software industry or in situations where an organization is short on cash, short 
payback periods often become the determining factor for investments. 
Limitations of Payback period 
? It ignores the time value of money.  As long as the payback periods for two 
projects are the same, the payback period technique considers them equal as 
investments, even if one project generates most of its net cash inflows in the 
early years of the project while the other project generates most of its net cash 
inflows in the latter years of the payback period.   
? A second limitation of this technique is its failure to consider an investment’s 
total profitability; it only considers cash inflows up-to the period in which initial 
investment is fully recovered and ignores cash flows after the payback period.   
Page 5


7.17 
INVESTMENT DECISIONS 
SECTION 2 
 7.7 CAPITAL BUDGETING TECHNIQUES  
In order to maximise the return to the shareholders of a company, it is important 
that the best or most profitable investment projects are selected. Results of making 
a bad long-term investment decision can be devastating in both financial and 
strategic terms. Care required for investment project selection and evaluation. 
There are a number of techniques available for appraisal of investment proposals 
and can be classified as presented below: 
 
Organizations may use any one or more of capital investment evaluation techniques; 
some organizations use different methods for different types of projects while others 
may use multiple methods for evaluating each project. These techniques have been  
discussed below – net present value, profitability index, internal rate of return, modified 
internal rate of return, payback period, and accounting (book) rate of return.  
 
 
Capital Budgeting 
Techniques
Traditional  or Non 
Discounting
Payback Period
Accounting  Rate of Return 
(ARR)
Time adjusted or 
Discounted Cash Flows
Net Present Value (NPV)
Profitability Index (PI)
Internal Rate of Return (IRR)
Modified Internal Rate of 
Return (MIRR)
Discounted Payback 
 
 
7.18 FINANCIAL MANAGEMENT  
 7.8 TRADITIONAL OR NON-DISCOUNTING 
TECHNIQUES  
These techniques of capital Budgeting does not discount the future cash flows. 
There are two such techniques namely Payback Period and Accounting Rate of 
Return  
7.8.1 Payback Period 
Time required to recover the initial cash-outflow is called pay-back period. The 
payback period of an investment is the length of time required for the cumulative 
total net cash flows from the investment to equal the total initial cash outlays.  At 
that point in time, the investor has recovered the money invested in the project.   
Steps in Payback period technique: - 
(a) The first steps in calculating the payback period is determining the total initial 
capital investment (cash outflow) and  
(b) The second step is calculating/estimating the annual expected after-tax cash 
flows over the useful life of the investment.   
1. When the cash inflows are uniform over the useful life of the project, the number 
of years in the payback period can be calculated using the following equation: 
Total initial capital investment
Payback period = 
Annual expected after - tax net cash flow
 
Example- 4 
Suppose a project costs ` 20,00,000 and yields annually a profit of `  3,00,000 after 
depreciation @ 12½% (straight line method) but before tax 50%. The first step 
would be to calculate the cash inflow from this project. The cash inflow is `  4,00,000 
calculated as follows:  
Particulars 
(`)
Profit before tax 3,00,000 
Less: Tax @ 50% (1,50,000) 
Profit after tax 1,50,000 
Add: Depreciation written off 2,50,000
Total cash inflow 4,00,000 
 
 
7.19 
 
INVESTMENT DECISIONS 
While calculating cash inflow, depreciation is added back to profit after tax since it 
does not result in cash outflow. The cash generated from a project therefore is 
equal to profit after tax plus depreciation. The payback period of the project shall 
be: 
 Payback period = 
` 20,00,000
4,00,000
= 5 Years 
Some Accountants calculate payback period after discounting the cash flows by a 
predetermined rate and the payback period so calculated is called, ‘Discounted 
payback period’ (discussed later on). 
2. When the annual cash inflows are not uniform, the cumulative cash inflow 
from operations must be calculated for each year. The payback period shall be 
corresponding period when total of cumulative cash inflows is equal to the initial 
capital investment. However, if exact sum does not match then the period in which 
it lies should be identified. After that we need to compute the fraction of the year. 
This method can be understood with the help of an example 
Example- 5 
Suppose XYZ Ltd. is analyzing a project requiring an initial cash outlay of `  2,00,000 
and expected to generate cash inflows as follows: 
Year Annual Cash Inflows (`) 
1 80,000 
2 60,000 
3 60,000 
4 20,000 
It’s payback period shall be computed by using cumulative cash flows as follows: 
Year Annual Cash Inflows 
(`) 
Cumulative Cash Inflows 
(`) 
 
1 80,000 80,000  
2 60,000 1,40,000  
3 60,000 2,00,000 ? 
4 20,000 2,20,000  
In 3 years total cash inflows equal to initial cash outlay. Hence, payback period is 3 
years. 
  
 
7.20 FINANCIAL MANAGEMENT  
Suppose if in above example the initial outlay is `  2,05,000 then payback period 
shall be computed as follows: 
Year Annual Cash Inflows 
(`) 
Cumulative Cash 
Inflows (`)  
 
1 80,000 80,000  
2 60,000 1,40,000  
3 60,000 2,00,000  
4 20,000 2,20,000 ? 
Payback period shall lie between 3 to 4 years. Since up to 3 years a sum of  
`  2,00,000 shall be recovered balance of `  5,000 shall be recovered in the part 
(fraction) of 4
th
 year, computation is as follows: 
 year
4
1
20,000
5,000
= 
Thus, total cash outlay of `  205,000 shall be recovered in 3¼ years’ time. 
Advantages of Payback period 
? It is easy to compute. 
? It is easy to understand as it provides a quick estimate of the time needed for 
the organization to recoup the cash invested.   
? The length of the payback period can also serve as an estimate of a project’s 
risk; the longer the payback period, the riskier the project as long-term 
predictions are less reliable.  In some industries with high obsolescence risk like 
software industry or in situations where an organization is short on cash, short 
payback periods often become the determining factor for investments. 
Limitations of Payback period 
? It ignores the time value of money.  As long as the payback periods for two 
projects are the same, the payback period technique considers them equal as 
investments, even if one project generates most of its net cash inflows in the 
early years of the project while the other project generates most of its net cash 
inflows in the latter years of the payback period.   
? A second limitation of this technique is its failure to consider an investment’s 
total profitability; it only considers cash inflows up-to the period in which initial 
investment is fully recovered and ignores cash flows after the payback period.   
 
 
7.21 
 
INVESTMENT DECISIONS 
? Payback technique places much emphasis on short payback periods thereby 
ignoring long-term projects. 
7.8.1.1 Payback Reciprocal 
As the name indicates it is the reciprocal of payback period. A major drawback of 
the payback period method of capital budgeting is that it does not indicate any cut 
off period for the purpose of investment decision. It is, however, argued that the 
reciprocal of the payback would be a close approximation of the Internal Rate of 
Return (later discussed in detail) if the life of the project is at least twice the payback 
period and the project generates equal amount of the annual cash inflows. In 
practice, the payback reciprocal is a helpful tool for quick estimation of rate of 
return of a project provided its life is at least twice the payback period.  
The payback reciprocal can be calculated as follows: 
Payback Reciprocal =
Average annual cash in flow 
Initial investment
 
Example- 6 
Suppose a project requires an initial investment of `  20,000 and it would give 
annual cash inflow of `  4,000. The useful life of the project is estimated to be 5 
years. In this example payback reciprocal will be: 
`
` 
 4,000×100
20,000
=20% 
The above payback reciprocal provides a reasonable approximation of the internal 
rate of return, i.e. 19%. 
7.8.2 Accounting (Book) Rate of Return (ARR) or Average Rate of Return 
(ARR) 
The accounting rate of return of an investment measures the average annual net 
income of the project (incremental income) as a percentage of the investment. 
Accounting rate of return =
Average annual  net income
Investment
 
The numerator is the average annual net income generated by the project over its 
useful life.  The denominator can be either the initial investment (including 
installation cost) or the average investment over the useful life of the project. 
Average investment means the average amount of fund remained blocked during