Prachi gupta 02415101718 bba4sem

MANAGEMENT EDUCATION AND RESEARCH
INSTITUTE
Financial MANAGEMENT
BBA(204)
Submitted By: Prachi gupta
(02415101718)
BBA 4th semester
Submitted To: KOMPAL MA’AM

Capital budgeting is the process in which a business determines and
evaluates potential large expenses or investments. These expenditures and
investments include projects such as building a new plant or investing in a
long-term venture. Often, a company assesses a prospective project’s
lifetime cash inflows and outflows to determine whether the potential returns
generated meet a sufficient target benchmark, also known as “investment
appraisal.”
The main features of capital budgeting are-
a) potentially large anticipated benefits .
b) a relatively high degree of risk.
c) relatively long time period between the initial outlay and the anticipated
return.

The traditional methods comprise of the following
evaluation techniques:-
• Payback Period Method
• Average Rate of Return or Accounting Rate of Return
Method

Pay back period method:-
This method means the period in which the total investment in the
permanent assets pays back itself. This method is based upon the
concept that every capital expenditure pays itself back within a certain
period of time. Thus, this method measures the period of time means
the time taken where the cost of project is recovered from the earning
of the project itself.
Decision rule: the investment with a shorter pay back period is
accepted and the one which has a longer pay back period is rejected.
Pay back period= cost of project
Annual Cash Flow

Disadvantages of Pay back period method:
 it does not take into account salvage value of asset.
 Does not recognize importance of time value of money,
 Does not consider profitability of economic life of project,
 Does not reflect all the relevant dimensions of profitability.
Advantages of Pay back period method:
 it is easy to calculate, simple to understand.
 it saves cost.
 a firm having less funds can select the shorter time period for pay back

EVALUATION OF PAYBACK PERIOD:-
Calculation Of Cash Flow After Tax:-
Particulars Amount
Earnings Before Int., tax and dep. XXX
(-) Interest (on loan) (XXX)
(-) Depreciation (XXX)
Profit before tax / Earnings before tax / Operating profit XXX
(-) Tax (XXX)
Profit after tax / Earnings after tax XXX
(+) Non-cash expenses XXX
Cash Flow After Tax XXX

Case 1 :- When Equal Cash Flow are given
Example:-
Company C is planning to undertake a project requiring initial investment of $105
million. The project is expected to generate $25 million per year in net cash flows
for 7 years. Calculate the payback period of the project.
Solution:-
Payback Period
= Initial Investment ÷ Annual Cash Flow
= $105M ÷ $25M
= 4.2 years

Example:-
Company C is planning to undertake another project requiring initial investment of $50 million and is expected
to generate $10 million net cash flow in Year 1, $13 million in Year 2, $16 million in year 3, $19 million in Year
4 and $22 million in Year 5. Calculate the payback value of the project.
Year
Annual
Cash Flow
Cumulative
Cash Flow
0 (50) (50)
1 10 (40)
2 13 (27)
3 16 (11)
4 19 8
5 22 30
Case 2 :- When Unequal Cash Flow are given
Payback Period = 3 + 11/19
= 3 + 0.58
= 3.58 ≈ 3.6 years
Solution:-
Step 1:- Calculate cumulative cash flow Step 2:- calculate pay back period by interpolation
formula
Lowest Discount + PV @ lower -- aimed * change in r%
Rate d/s rate value
higher -- lower
value value

Rules for Pay back period:-
 If PBP is less than the pre-determined rate or mgnt expected cutoff rate, then company
accept the proposal,
PBP < Pre-determined rate.
 If PBP is greater than the pre-determined rate or mgnt expected cutoff rate, then company
reject the proposal ,
PBP > Pre-determined rate.
 If PBP is equal to the pre-determined rate or mgnt expected cutoff rate, then it is a point of
indifference or nuclear point,
PBP = Pre-determined rate.
“ Lower The Pay Back
Period The Better it
is…….”

Accounting Rate of Return Method:-
Average return on average = average accounting profit after tax * 100
investment average investment
Accounting rate of return (also known as simple rate of return) is the ratio of estimated
accounting profit of a project to the average investment made in the project. ARR is used in
investment appraisal.. Average accounting profit is the arithmetic mean of accounting income
expected to be earned during each year of the project's life time. Average investment may be
calculated as the sum of the beginning and ending book value of the project divided by 2.
Another variation of ARR formula uses initial investment instead of average investment.
Average profit = Sum of all profits
no. of years
Average investment = 1 initial cost of __ salvage + net working + salvage
2 project value capital value

Merits of Average Rate of Return (ARR)
 Simple : It is very simple and easy to understand and to use
 Considers Profitability : It gives due weightage to the profitability of the project. Under
this method projects having higher rate of return will be accepted. These are
comparable with returns on similar investment derived by other firms.
 Appropriate Method : This method takes into account savings over the entire
economic life of the project.
Demerits of Average Rate of Return
 Ignores Time Factor : It ignores the time value of money. A project having low initial
inflows and high future inflows would have the same average return as a project
having the inflows in the reverse order.
 Use of Accounting Profit : It uses accounting profits and not the cash inflows in
appraising the investment projects.
 Ignores Re-investment of Profits : This method ignores the fact that profits can be
reinvested and profits can be earned on such reinvestment, which in turn will affect
the rate of return.

Evaluation of average rate of return
Case 1:- when straight line method of depreciation is used:-
Example :- A project costs Rs. 1,50,000 and has a scrap value of Rs. 30,000. Its streams of income before
depreciation and taxes during first five years is Rs. 30,000; Rs. 36,000; Rs. 42,000; Rs. 48,000 and Rs. 60,000.
Assuming tax rate at 50% and depreciation on straight line basis. Calculate the average rate of return (ARR) for
the project.
Solution:-
(i) Computation of Average Net Income after tax
Average Net Income before Depreciation and Tax Rs.
Rs. 30,000 + 36,000 + 42,000 + 48,000 + 60,000 = 43,200
5
Less: Depreciation (Annual)
Rs. 1,50,000 - Rs. 30,000 = 24,000
5
Average Net Income before tax = 19,200
Less : Income tax 50% = 9,600
Average Net Income after tax = 9,600
(ii) Computation of Average Investment :
Initial Investment + Scrap Value
2
= Rs. 1,50,000 + Rs. 30,000 = 90,000
2
(iii) ARR = Average Net Income after Tax * 100
Average Investment
= Rs. 9,600 x 100
Rs.90,000
= 10.67%

Case 2:- when written down method of depreciation is used:-
Example : filoflex ltd. is considering investing in a project that requires an initial investment of
Rs 20,00,000 for some machinery. The net inflows be as follows:
Year Profit After tax
1 60,000
2 70,000
3 58,000
4 67,000
5 75,000
Finally, deprecation rate is 10% which to be calculated by WDV method. There is no
salvage value. Calculate average rate of return.

Solution :
Average profit after tax = Rs 3,30,000 = Rs 66,000
5
Average Investment :-
Year Opening Value (-) Depreciation = 10% Closing Value Average Investment
1 20,00,000 (2,00,000) 18,00,000 19,00,000
2 18,00,000 (1,80,000) 16,20,000 17,10,000
3 16,20,000 (1,62,000) 14,58,000 15,39,000
4 14,58,000 (1,45,800) 13,12,200 13,85,100
5 13,12,200 (1,31,200) 11,81,000 12,46,600
TOTAL 77,80,700
Average Investment
= 77,80,700 = Rs 15,56,140
5
Average Rate of Return = Average profit after tax x 100
Average investment
= Rs 66,000 x 100
Rs 15,56,140
= 4.24%

Rules for Accounting / Average Rate of Return :
 If ARR is more than cost of capital, then company accept the proposal,
ARR > Cost of capital.
 If ARR is greater than cost of capital, then company reject the proposal ,
ARR < Cost of capital.
 If ARR is equal to cost of capital, then it is a point of indifference or nuclear point,
ARR = Cost of capital.
“ Higher the Accounting /
average Rate of Return, the
better it is…...”

Prachi gupta 02415101718 bba4sem

Prachi gupta 02415101718 bba4sem

More Related Content

What's hot

Similar to Prachi gupta 02415101718 bba4sem

Recently uploaded

Prachi gupta 02415101718 bba4sem