## 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**:

- Discounted Payback period.
- Net present value (also known as NPV)
- Internal Rate of Return (also known as IRR)
- 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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