• Capital Budgeting is a project selection exercise performed by the
business enterprise.
• Capital budgeting uses the concept of present value to select the
projects.
• Capital budgeting uses tools such as pay back period, net present
value, internal rate of return, profitability index to select projects.
Capital Budgeting Tools
• Payback Period
• Accounting Rate of Return
• Net Present Value
Payback Period :
Payback period is the time duration required to recoup the investment committed to a project. Business enterprises following payback period use "stipulated payback period", which acts as a standard for screening the project.
Advantages Of Payback Period
• It is easy to understand and apply. The concept of recovery is familiar to every decision-maker.
• Business enterprises facing uncertainty - both of product and
technology - will benefit by the use of payback period method since the stress in this technique is on early recovery of investment. So
enterprises facing technological obsolescence and product
obsolescence - as in electronics/computer industry - prefer payback
period method.
• Liquidity requirement requires earlier cash flows. Hence, enterprises having high liquidity requirement prefer this tool since it involves minimal waiting time for recovery of cash outflows as the emphasis is on early recoupment of investment.
Disadvantages Of Payback Period
• The time value of money is ignored. For example, in the case of project
• A Rs.500 received at the end of 2nd and 3rd years are given same
weightage. Broadly a rupee received in the first year and during any
other year within the payback period is given same weight. But it is
common knowledge that a rupee received today has higher value than a rupee to be received in future.
• But this drawback can be set right by using the discounted payback period method. The discounted payback period method looks at recovery of initial investment after considering the time value of inflows.
Accounting Rate Of Return
Accounting rate of return is the rate arrived at by expressing the average annual net profit (after tax) as given in the income statement as a percentage of the total investment or average investment. The accounting rate of return is based on accounting profits. Accounting profits are different from the cash flows from a project and hence, in many instances, accounting rate of return might not be used as a project evaluation decision. Accounting rate of return does find a place in business decision making when the returns expected are accounting profits and not merely the cash flows.
Advantages
• It Is Easy To Calculate.
• The Percentage Return Is More Familiar To The Executives.
• The definition of cash inflows is erroneous; it takes into account profit after tax only. It, therefore, fails to present the true return.
• Definition of investment is ambiguous and fluctuating. The decision could be biased towards a specific project, could use average investment to double the rate of return and thereby multiply the chances of its acceptances.
business enterprise.
• Capital budgeting uses the concept of present value to select the
projects.
• Capital budgeting uses tools such as pay back period, net present
value, internal rate of return, profitability index to select projects.
Capital Budgeting Tools
• Payback Period
• Accounting Rate of Return
• Net Present Value
Payback Period :
Payback period is the time duration required to recoup the investment committed to a project. Business enterprises following payback period use "stipulated payback period", which acts as a standard for screening the project.
• It is easy to understand and apply. The concept of recovery is familiar to every decision-maker.
• Business enterprises facing uncertainty - both of product and
technology - will benefit by the use of payback period method since the stress in this technique is on early recovery of investment. So
enterprises facing technological obsolescence and product
obsolescence - as in electronics/computer industry - prefer payback
period method.
• Liquidity requirement requires earlier cash flows. Hence, enterprises having high liquidity requirement prefer this tool since it involves minimal waiting time for recovery of cash outflows as the emphasis is on early recoupment of investment.
Disadvantages Of Payback Period
• The time value of money is ignored. For example, in the case of project
• A Rs.500 received at the end of 2nd and 3rd years are given same
weightage. Broadly a rupee received in the first year and during any
other year within the payback period is given same weight. But it is
common knowledge that a rupee received today has higher value than a rupee to be received in future.
• But this drawback can be set right by using the discounted payback period method. The discounted payback period method looks at recovery of initial investment after considering the time value of inflows.
Accounting Rate Of Return
Accounting rate of return is the rate arrived at by expressing the average annual net profit (after tax) as given in the income statement as a percentage of the total investment or average investment. The accounting rate of return is based on accounting profits. Accounting profits are different from the cash flows from a project and hence, in many instances, accounting rate of return might not be used as a project evaluation decision. Accounting rate of return does find a place in business decision making when the returns expected are accounting profits and not merely the cash flows.
Advantages
• It Is Easy To Calculate.
• The Percentage Return Is More Familiar To The Executives.
Disadvantages
• The definition of cash inflows is erroneous; it takes into account profit after tax only. It, therefore, fails to present the true return.
• Definition of investment is ambiguous and fluctuating. The decision could be biased towards a specific project, could use average investment to double the rate of return and thereby multiply the chances of its acceptances.
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