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# List of techniques used in Capital budgeting Decision

## List of techniques used in Capital budgeting Decision

Techniques used in Capital budgeting Decision ; Some of the major techniques used in capital budgeting decision are:

1. Discounted Payback period.
2. Net present value (also known as NPV)
3. Internal Rate of Return (also known as IRR)
4. Profitability Index (also known as PI)

### 1. Discounted Payback period:

The discounted pay back period  is a capital budgeting decision, which is used to determine the profitability of a project. A discounted pay back period gives the number of years it takes to break even from undertaking the intial investment, by discounting the future cash flow and recognizing the time value of money.

The major disadvantage of this method is that it ignores the cash inflows from the project after the payback period.

Example 1:

 Year 1 2 3 4 5 Cash flows 10,000 20,000 30,000 40,000 50,000

if the intial investment is Rs 50,000 and discount rate is 10%. Calculate Discounted Pay back period.

Solution:

 Year Cash flows Discount factor at 10% Discounted Cash flow Discounted cash flow 1 10,000 0.9091 9,091 9,091 2 20,000 0.8264 16,528 25,619 3 30,000 0.7513 22,539 48,158 4 40,000 0.6830 27,320 75,478 5 50,000 0.6209 31,045 1,06,523

Discounted Payback period =3+ {[50,000-48,158]/[75,478-48,158]}

= 3.06 years.

### 2. Net Present Value

Net present value (also known as NPV) is one of the capital budgeting decision. It is the difference between the present value of cash inflows and present value of cash outflows.

Example 2:

 Year 0 1 2 3 4 5 Cash flows -3,00,000 50,000 50,000 50,000 50,000 50,000

If the discount rate is 10%. Compute NPV.

Solution:

 Year Cash flow AF at 10% Discounted cash flow 0 -3,00,000 1.0000 -3,00,000 1 to 5 50,000 3.7907 1,89,535 NPV -1,10,465

### 3. Profitability Index

Profitability Index (also known as benefit cost ratio), measures the value of every single rupee invested. It is calculated by dividing the present value of future cash flow of a project by the investment of a project.

Example 3:

 Year 0 1 2 3 4 5 Cash flows -150,000 50,000 50,000 50,000 50,000 50,000

Compute Profitability Index, if the discount rate is 10%.

Solution:

Profitability Index= P V of cash inflows/ Initial Investment

= 50,000* AF @ 10% for 5 years/ 150,000

= 1.26

### 4. Internal Rate of Return

Internal rate of return is a metric used in capital budgeting measuring the profitability of potential investments. IRR is a discount rate at which the NPV of all cash flows from a particular project will be equal to 0. It is also defined as the rate at which the intial investment is recovered.

Example 4:

 Year 0 1 2 3 4 5 Cash flows 6,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000

If the discount rate is 10%. Compute IRR.

Solution:

 Year Cash flow Discount factor @ 10% Discounted cash flow Discount factor at 5% Discounted cash flow 0 -400000 1.0000 -4,00,000.00 1.0000 -4,00,000.00 1 100000 0.9091 90,909.09 0.9524 95,238.10 2 100000 0.8264 82,644.63 0.9070 90,702.95 3 100000 0.7513 75,131.48 0.8638 86,383.76 4 100000 0.6830 68,301.35 0.8227 82,270.25 5 100000 0.6209 62,092.13 0.7835 78,352.62 NPV -20,921.32 32,947.67

IRR= {[20921.32*5]+[32947.67*10]}/[20921.32+32947.67]

= 8.05%  (approximately).

### Techniques used in Capital budgeting Decision

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