Methods of Capital Budgeting (Part -1), Accountancy and Financial Management | Accountancy and Financial Management - B Com PDF Download
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:
- It is easy to calculate and simple to understand.
- Pay-back method provides further improvement over the accounting rate return.
- Pay-back method reduces the possibility of loss on account of obsolescence.
Demerits
- It ignores the time value of money.
- It ignores all cash inflows after the pay-back period.
- 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.
Example 1
Project cost is Rs. 30,000 and the cash inflows are Rs. 10,000, the life of the project is 5 years. Calculate the pay-back period.
Solution
= Rs. 30,000/Rs. 10,000 = 3 Years
The annual cash inflow is calculated by considering the amount of net income on the amount of depreciation project (Asset) before taxation but after taxation. The income precision earned is expressed as a percentage of initial investment, is called unadjusted rate of return. The above problem will be calculated as below:
Unadjusted rate of return = Annual Return/Investment x 100
= 33.33%
Example 2
A project costs Rs. 20,00,000 and yields annually a profit of Rs. 3,00,000 after depreciation @ 12½% but before tax at 50%. Calculate the pay-back period.
Profit after depreciation | 3,00,000 |
Tax @ 50% | 1,50,000 |
Add depreciation 20,00,000 @ 12½% | 2,50,000 |
| Cash in flow | 4,00,000 |
Solution
Pay-back period = Investment/Cash flow
= 20,00,000/4,00,000 = 5 years
Uneven Cash Inflows
Normally the projects are not having uniform cash inflows. In those cases the pay-back period is calculated, cumulative cash inflows will be calculated and then interpreted.
Example 3
Certain projects require an initial cash outflow of Rs. 25,000. The cash inflows for 6 years are Rs. 5,000, Rs. 8,000, Rs. 10,000, Rs. 12,000, Rs. 7,000 and Rs. 3,000.
Solution
| Year | Cash Inflows (Rs.) | Cumulative Cash Inflows (Rs.) |
| 1 | 5,000 | 5,000 |
| 2 | 8,000 | 13,000 |
| 3 | 10,000 | 23,000 |
| 4 | 12,000 | 35,000 |
| 5 | 7,000 | 42,000 |
| 6 | 3,000 | 45,000 |
The above calculation shows that in 3 years Rs. 23,000 has been recovered Rs. 2,000, is balance out of cash outflow. In the 4th year the cash inflow is Rs. 12,000. It means the payback period is three to four years, calculated as follows
Pay-back period = 3 years+2000/12000 x 12 months
= 3 years 2 months.
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.
Example 4
From the following particulars, compute:
1. Payback period.
2. Post pay-back profitability and post pay-back profitability index.
(a)
Cash outflow - Rs. 1,00,000
Annual cash inflow (After tax before depreciation) - Rs. 25,000
Estimate Life - 6 years
(b)
Cash outflow Annual cash inflow (After tax depreciation) - Rs. 1,00,000
First five years - Rs. 20,000
Next five years - Rs. 8,000
Estimated life - 10 Years
Salvage value - Rs. 16,000
Solution
(a) (i) Pay-back period
(ii) Post pay-back profitability
=Cash inflow (Estimated life – Pay-back period)
=25,000 (6 – 4)
=Rs. 50,000
(iii) Post pay-back profitability index
(b) Cash inflows are equal, therefore pay back period is calculated as follows:
(i)
| Year | Cash Inflows (Rs.) | Cumulative Cash Inflows (Rs.) |
| 1 | 20,000 | 20,000 |
| 2 | 20,000 | 40,000 |
| 3 | 20,000 | 60,000 |
| 4 | 20,000 | 80,000 |
| 5 | 20,000 | 1,00,000 |
| 6 | 8,000 | 1,08,000 |
| 7 | 8,000 | 1,16,000 |
| 8 | 8,000 | 1,24,000 |
| 9 | 8,000 | 1,32,000 |
| 10 | 8,000 | 1,40,000 |
(ii) Post pay-back profitability
= Cash inflow (estimated life – pay-back period)
= 8,000 (10–5)
= 8000 x 5 = 40,000
(iii) Post pay-back profitability index
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
- It is easy to calculate and simple to understand.
- It is based on the accounting information rather than cash inflow.
- It is not based on the time value of money.
- It considers the total benefits associated with the project.
Demerits
- It ignores the time value of money.
- It ignores the reinvestment potential of a project.
- 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.
Example 5
A company has two alternative proposals. The details are as follows:
| Proposal I | Proposal II | |
| Automatic Machine | Ordinary Machine | |
| Cost of the machine | Rs. 2,20,000 | Rs. 60,000 |
| Estimated life | 5½ years | 8 years |
| Estimated sales p.a | Rs. 1,50,000 | Rs. 1,50,000 |
| Costs : Material | 50,000 | 50,000 |
| Labour | 12,000 | 60,000 |
| Variable Overheads | 24,000 | 20,000 |
Compute the profitability of the proposals under the return on investment method.
Solution
Profitability Statement
| Automatic Machine | Ordinary Machine | |
Cost of the machine | Rs. 2,20,000 | Rs. 60,000 |
Life of the machine | 5 years 6 month | 8 years |
Estimated Sales | (A) 1,50,000 | 1,50,000 |
Less : Cost : Material | 50,000 | 50,000 |
Labour | 12,000 | 60,000 |
Variable overheads | 24,000 | 20,000 |
Depreciation (1) | 40,000 | 7,000 |
Total Cost | (B) 1,26,000 | 1,37,000 |
| Profit (A) – (B) | 24,000 | 12,500 |
Working:
(1) Depreciation = Cost / Life
Automatic machine = 2,20,000 / 5½ = 40,000
Ordinary machine = 60,000 / 8 = 7,500
Return on investment = Average profit/Original investment x 100
= 10.9%
= 20.8%
Automatic machine is more profitable than the ordinary machine.
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
- It recognizes the time value of money.
- It considers the total benefits arising out of the proposal.
- It is the best method for the selection of mutually exclusive projects.
- 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.
Example 6
From the following information, calculate the net present value of the two project and suggest which of the two projects should be accepted a discount rate of the two.
| Project X | Project Y | |
| Initial Investment | Rs. 20,000 | Rs. 30,000 |
| Estimated Life | 5 years | 5 years |
| Scrap Value | Rs. 1,000 | Rs. 2,000 |
The profits before depreciation and after taxation (cash flows) are as follows:
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Project x | 5,000 Rs | 10,000 Rs | 10,000 Rs | 3,000 Rs | 2,000 Rs |
| Project y | 20,000 Rs | 10,000 Rs | 5,000 Rs | 3,000 Rs | 2,000 Rs |
Note : The following are the present value factors @ 10% p.a.
| Year | 1 | 2 | 3 | 4 | 5 | 6 |
| Factor | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 | 0.564 |
Solution
| Cash Inflows |
| Present Value of Rs. 1 @ 10% | Present Value of Net Cash Inflow | |
Year | Project X Rs. | Project Y Rs. | Project X Rs. | Project Y Rs. | |
1 | 5,000 | 20,000 | 0.909 | 4,545 | 18,180 |
2 | 10,000 | 10,000 | 0.826 | 8,260 | 8,260 |
3 | 10,000 | 5,000 | 0.751 | 7,510 | 3,755 |
4 | 3,000 | 3,000 | 0.683 | 2,049 | 2,049 |
5 | 2,000 | 2,000 | 0.621 | 1,242 | 1,242 |
Scrap Value | 1,000 | 2,000 | 0.621 | 621 | 1,245 |
Total present valueInitial | 24,227 | 34,728 | |||
investments | 20,000 | 30,000 | |||
Net present value | 4,227 | 4,728 | |||
Project Y should be selected as net present value of project Y is higher.
Example 7
The following are the cash inflows and outflows of a certain project.
| Year | Outflows | Inflows |
| 0 | 1,75,000 | - |
| 1 | 5,50,000 | 35,000 |
| 2 | 45,000 | |
| 3 | 65,000 | |
| 4 | 85,000 | |
| 5 | 50,000 |
The salvage value at the end of 5 years is Rs. 50,000. Taking the cutoff rate as 10%, calculate net present value.
| Year | 1 | 2 | 3 | 4 | 5 |
| P.V. | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
Solution
| Year | Cash Inflows Rs. | Present Value Factor @ 10% | Present Value of Cash Inflows |
| 1 | 35,000 | 0.909 | 31,815 |
| 2 | 45,000 | 0.826 | 37,170 |
| 3 | 65000 | 0.751 | 48815 |
| 4 | 85000 | 0.683 | 58055 |
| 5 | 50000 | 0.621 | 31050 |
| 5(Salvage) | 50000 | 0.621 | 31050 |
| Total present value of cash inflows | 237955 |
Less : Total present value of outflows
Cash outflow at the beginning = 1,75,000
Cash outflow at the end of first Year 50000 x 0.909 = 45,450
Total value of outflows = 2,20,450
Net Present Value = 17,505
If the cash inflows are not given in that cases the calculation of cash inflows are Net profit after tax+Depreciation. In this type of situation first find out the Net profit after depreciation and deducting the tax and then add the deprecation. It gives the cash inflow.
Example 8 From the following information you can learn after tex and depreciation concept
| Initial Outlay | Rs. 1,00,000 |
| Estimated life | 5 Years |
| Scrap Value | Rs. 10,000 |
| Profit after tax : | |
| End of year 1 | Rs. 6,000 |
| 2 | Rs. 14,000 |
| 3 | Rs. 24,000 |
| 4 | 16,000 |
| 5 | Nil |
Solution Depreciation has been calculated under straight line method. The cost of capital may be taken at 10%. P.a. is given below.
| Year | 1 | 2 | 3 | 4 | 5 |
| PV factor @ 10% | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
Depreciation
Year | Profit after Tax | Depreciation | Cash Inflow |
1 | 6,000 | 18,000 | 24,000 |
2 | 14,000 | 18,000 | 32,000 |
3 | 24,000 | 18,000 | 42,000 |
4 | 16,000 | 18,000 | 34,000 |
5 | Nil | 18,000 | 18,000 |
Net Present Value
Year | Cash Inflow | Discount factor @ 10% | Present value (Rs.) |
1 | 24,000 | 0.909 | 21,816 |
2 | 32,000 | 0.826 | 26,432 |
3 | 42,000 | 0.751 | 31,542 |
4 | 34,000 | 0.683 | 23,222 |
5 | 18,000 | 0.621 | 11,178 |
Total present value of cash inflows = 1,14,190
Less : Initial cash investment = 1,00,000
Net present value = 1,41,90
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