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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:

Year12345
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:

YearCash flowsDiscount factor at 10%Discounted Cash flowDiscounted cash flow
1                  10,0000.9091                                     9,091                                9,091
2                  20,000                   0.8264                                   16,528                              25,619
3                  30,0000.7513                                   22,539                              48,158
4                  40,000                              0.6830                                   27,320                              75,478
5                  50,0000.6209                                   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:

Year012345
Cash flows             -3,00,000                              50,000                                   50,000                              50,000                                   50,000                              50,000

If the discount rate is 10%. Compute NPV.

Solution:

YearCash flowAF at 10%Discounted cash flow
0             -3,00,0001.0000                             -3,00,000
1 to 5                  50,0003.7907                               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:

Year012345
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:

Year012345
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:

YearCash flowDiscount factor @ 10%Discounted cash flowDiscount factor at 5%Discounted cash flow
0-400000                              1.0000                       -4,00,000.001.0000                       -4,00,000.00
1100000                              0.9091                             90,909.090.9524                             95,238.10
2100000                              0.8264                             82,644.630.9070                             90,702.95
3100000                              0.7513                             75,131.480.8638                             86,383.76
4100000                              0.6830                             68,301.350.8227                             82,270.25
5100000                              0.6209                             62,092.130.7835                             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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