Various methods of evaluation of capital budgeting proposals
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These guesses will probably be wrong, at least to some extent, as it is extremely difficult to forecast the rate of inflation accurately. The discount factor r can be calculated using: Examples: N. We expect it to have a life of five years and to have a scrap value of Rs. Quite simply, the payback period is a calculation of how long it takes to get your original investment back. In case of capital rationing situations, a company is compelled to invest in projects having shortest payback period. Illustration 2 : If a choice has to be made between Project A and Project B because they are operationally mutually exclusive, the project chosen will depend upon the appraisal method used, because conflicting ranking will occur.

The attractiveness of a capital investment should consider the time value of money, the future cash flows expected from the investment, the uncertainty related to those cash flows and the performance metric used to select a project. Divide cash flows and tax savings into risky and less risky groups. This preference for current money as against future money is captured by the concept of time value of money. This technique takes into account the interest factor and the return after the payback period. This method incorporates the time value of money in the investment calculation. In general terms, a project is acceptable if its profitability index value is greater than 1. The cashflow estimates of the project are first discounted at the cost of equity, and a base-case present value is arrived at as if the project is all-equity financed.

It considers the cash flow stream in its entirety. Thus, where the project generates constant cash inflows. Present Value of Money: The present value of future money is the present worth of that money. It uses the entire stream of incomes in calculating the accounting rate. Methods that ignore present values are normally used for the evaluation of capital investment proposals that have relatively short useful lives. Normally, the project with shorter economic life is preferred, if other things are equal. They all have their flaws for making an intelligent analysis, when evaluating the worth of several projects.

It is more practicable concept of decision making. Mutually exclusive projects, however, are different. Should Keymer Farm go ahead with the project? The future value of Rs. This method incorporates the assumption about how the cash inflows are reinvested once they are received and thus avoids any influence of the cost of capital on cash inflows. We have estimated that it will generate additional profits over its life as follows: These estimates are of profits before depreciation.

With simple calculations, selection or rejection of the project can be done, with results that will help gauge the risks involved. Investment decision techniques based on discounted cash flows replace accounting income with cash flows. The project which gives a shorter discounted pay-back period is accepted. In Keymer Farm's case, the cash flows are expressed in terms of the actual dollars that will be received or paid at the relevant dates. However, the major problem of this method lies in projecting the future rates of interest at which the cash inflows will be reinvested.

Here the main feature is that the rate of return is based on the figures for income and investment which are determined according to conventional accounting concepts. Once a change in method of depreciation takes place, the method will not be easy to use and will not work practically. It is difficult to predict the effect of higher selling prices on demand. The subject matter is difficult to grasp by nature of the topic covered and also because of the mathematical content involved. In case of capital rationing, a company is compelled to invest in projects having shortest payback period. This is calculated on the basis of the funds utilised from time to time as opposed to the investment made at the beginning.

The shorter the payback period, the less risky is the project. It is biased against short-term projects in the same way that payback is biased against longer-term ones. Which project should he choose? Note that initial outlay I o is the same. Taking a rate of 10% the following will be the result. Competing investment proposals with the same accounting rate of return may require different amounts of investment.

Internal Rate of Return Method: This method is also called Time Adjusted Return on Investment or Discounted Rate of Return. Limitations: The limitations of profitability index method are as follows: 1. Discounted Cash Flow Methods 1. As inflation rate increases, so will the minimum return required by an investor. There are two ways to it; either increase the revenues or reduce the costs. Solution: If a choice has to be made between Project A and Project B because they are operationally mutually exclusive, the project chosen will depend upon the appraisal method used, because conflicting ranking will occur.