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CAPITAL BUDGETING:CAPITAL BUDGETING:

INVESMENTINVESMENT

APPRAISALAPPRAISAL

ARR, PAYBACK, NPV,

IRR

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NATURE OF INVESTMENT

DECISIONSOut lay precedes economic benefits hence concept

of Time Value of money

Large size of outlay/resources

Difficult to bail out of investment

HOW TO EVALUATE INVESTMENTOPPERTUNITIES?

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ACCOUNTING RATE OF RETURN

(ARR)

It is defined as % of the average investment

translated as accounting profit over the

life of project

ARR = Average Annual Profit

_______________________________ x 100%

Average investment to earn that profit

Average Investment = Cost of machine + Disposal Value

2

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MERITS

1. Widely in Practice

2. It is a measure ofprofit hence liked by

many as evaluation

criteria of

investment

3. % results are easy to

comprehend by

managers

DEMERITS

1. Accounting profit is

of less value ascompared to

accounting profits

2. Can not be useful for

evaluating options

3. It ignores time value

of money

4. It is useful for shortterm reporting

instead of whole

project

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PAYBACK PERIOD (PP)

It is length of time during which initial

investment/out flow is recovered from

cash inflows of the project.

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NET PRESENT VALUE (NPV)

It is the present value of future cash flows of the

project worked out after considering all costs

and benefits of investment.

It is assumed that present value of future cash

flows should be >investment being made.

Following ingredients of Time Factor are

incorporated

Interest Loss, Risk and Inflation

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Logical investor desires that proposed

investment should yield a return that is

greater than Risk free rate of return after

giving allowances for risk and inflation

Discount

RateInterest foregoneInflation

Risk Premium

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PV of cash flows of year n

= Actual cash flow of year n

( 1+ r )n

As the time in which cash flow is to be

received increases its present value of it

would diminish proportionately.

Using discount tables

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MERITS

1. Time value of themoney

2. All cash flows arerecorded

3. Maximization ofshareholders wealth isascertained

4. Additivity is possible

5. Useful both forevaluating mutuallyexclusive projects or

otherwise.6. It takes in to account

investment size

DEMERITS

1. Managers are not

familiar with thishence do not like it

2. It is not a measure of

profitability

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INTERNAL RATE OF RETURN (IRR)

It is the discount rate that when applied to

future cash flows of the project, will

produce an NPV of Zero.

Simply when present value of future cash

flows is equal to the cash outflow

Trial and the error is the approach that mustusually be adapted

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Formula

= A +

(NPVA

)x B A

NPVBWhere A and B are the two discount rates.

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MERITS

1. Provides the

minimum

requirement

2. Can choose from

options. One withhighest IRR

DEMERITS

1. It does not address scaleof investment hencemay lead to a wrongdecision

2. It is represented in %hence easily

understandable3. Additivity is not

possible.

4. It is useful whenprojects are not mutually

exclusive. Projects withyield than opportunitycost are accepted.