METHODS OF CAPITAL BUDGETING | AFM IMPORTANT TOPIC JAIIB AFM 2024 EXAM
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INTRODUCTION
Capital budgeting is the process of selecting whether to invest in capital assets. Capital assets are often long-term investments like new equipment, structures, and software updates, even if they only represent a very small portion of a company’s total assets.
By incorporating strategically planned capital budgeting into their financial operations, businesses can more effectively determine and rank which projects, programs, and other investment assets may be the most financially advantageous in the long run.
When businesses are planning their next significant capital investment, it is essential that working finance professionals understand the five main capital budgeting techniques and how to use them to determine the best course of action. This is because these assets frequently only yield measurable returns over the long term.
| Here is an explanatory video https://youtu.be/VMajeIfHGsA for METHODS OF CAPITAL BUDGETING |
METHODS OF CAPITAL BUDGETING
A company has a limited amount of funds due to which they must select a preferable project. Following are the methods by which a company chooses to prefer a particular project.
| Methods of capital budgeting | |
| Non-discounted methods | Discounted methods |
| Doesn’t value time value of money | Considers time value of money |
- The idea of the time value of money is crucial to investments because it accounts for the decline in the actual worth of funds brought on by the effects of inflation.
The methods that are covered under the non-discounted method of capital budgeting pay-back period method and accounting rate of return. Let’s discuss this in detail about these methods.
PAYBACK PERIOD METHOD
It’s defined as the period needed to get back the initial investment for any particular project. It’s a computation of the number of years required for the recovery of the initial amount. This method doesn’t address which investment can be profitable. The advantageous side of this method is shorter paybacks can attract more investments and it’s easier to compute.
Let’s practice a question based on this method
NUMERICALS
A company purchases a machine for Rs 100000 and the annual cash inflow is 20000. Calculate the payback period.
| Cash flow is defined as the net amount of the cash and cash equivalents coming into and going out of a business. |
| Payback period: Initial investment/annual cash inflows 100000/20000 = 5
The answer is 5 years
|
Company A purchases a machine for 70000 and 1the cash inflow for 5 years is. Calculate the payback period.
| Year | Cash inflow | CCF |
| 1 | 10000 | 10000 |
| 2 | 30000 | 40000 |
| 3 | 20000 | 60000 |
| 4 | 30000 | 90000 |
| 5 | 40000 | 130000 |
The cash inflow is not annual as represented in the table.
6000 cash is recovered in the 3rd year and 90000 in the 4th year to get the exact payback period.
1000 (remaining amount) ÷ 3000 (extra amount received in the 4th year) = 0.33
3 years (close to receiving the complete initial investment) + 0.33 = 3.3 years
Accounting rate of return
This formula is used to make capital budgeting decisions by measuring the net profit or return, expected on investment compared to the initial cost. It’s useful in determining the annual percentage rate of return of a project and it’s calculated as the ratio of annual profit/initial investment. It’s generally used while considering multiple projects since it provides the expected rate of return from each project.
ARR’s inability to distinguish between investments that produce various cash flows over the course of a project is one of its setbacks that differs from the required rate of return, which is the minimum return an investor would take for an investment or project in exchange for taking on a specific amount of risk.
Accounting rate of return = Average profit after tax × 100
Net investment in the project
Let’s learn to solve a numerical based on it.
NUMERICAL
A company purchases a machine of 1000000 having a life of four years with 200000 scrap value and it’s expected that it will generate profit as follows: Calculate the average rate of return
| Year | Profit after tax |
| 1 | 30000 |
| 2 | 20000 |
| 3 | 10000 |
| 4 | 20000 |
Average profit = Total profit = 30000+20000+10000+20000= 20000
Given, the No. of years is equal to 4
Net investment = Initial investment – scrap value = 1000000 – 200000 = 800000
Average rate = Average profit/Net investment = 20000 × 100/800000 = 2.5%
DISCOUNTED CASH FLOW METHOD
- The discounted cash flow method can be used to calculate the present value of a series of future cash flows.
- The foundation for the use of present value information for investors is the notion that the value of an item today is greater than the value of the same thing that would only be accessible tomorrow.
- The discounted cash flow method can be used to determine the present values of numerous competing investments, and the investor will normally pick the one with the highest present value.
- If the investor feels that the highest present value investment is riskier than the other options, they may not choose it.
- The technique takes into count the interest factor and the return after the payback period.
Let’s cover a few methods under discounted cash flow
NET PRESENT VALUE METHOD
It’s the most used method for the estimation of capital investment proposals.
It considers the time value of the money.
In this method, cash inflow predicted at various periods of time is discounted at a certain price.
Present and original values are compared and if the difference between the value of these two turns out to be positive then it’s undertaken or spurned otherwise.
Let’s solve a numerical based on it.
NUMERICALS
| A company purchases a machine costing 20000 and will produce cash inflow of 4000, 5000, 5000 for next three years. What is the NPV if its discount rate is 12%?
Here we’ll have to multiply the discounting factor by the cash flow in order to get the present value of cash inflow.
Upon adding the Present value of cash inflow, we get 11110. Value of cash outflow (investment) = 2000 NET PRESET VALUE = cash Inflow – cash outflow (investment) = 11110 – 2000 |
| A company invests in an Infrastructure project and its net present value at 10% is 100000 and 12% (-) 25000. Calculate the IRR for the project
IRR = Ra + NPVa ( ra – rb)/NPVa – NPVb ra = Lower discount of rate chosen rb = Higher discount of rate chosen Na = NPV at ra Nb =NPV at rb : 10 + 100000 X 12% – 10% (100000 – 25000) : 10 + 100000 (2) 125000 : 10 + 0.8 (2) 10 + 1.6 = 11.6% |
INTERNAL RATE OF RETURN
It’s defined as the rate at which the net present value of the investment becomes zero and the discounted inflow cash is equal to the discounted cash outflow. Again, the time value of money is considered in this method.
IRR is used for the determination of the discount rate that will bring the present value of the total annual nominal cash inflows to the same amount as the original net cash outlay for the investment.
To comprehend and evaluate probable rates of annual return over time for capital budgeting projects, IRR is the best tool available.
IRR can help investors calculate the investment return of various assets, in addition to being utilized by businesses to choose which capital projects to deploy.
| Here is the link to the video lecture: https://youtu.be/Qj4eMgNyrvQ |
PROFITABILITY INDEX METHOD
The profitability index is used to determine how appealing a project or investment is (PI).
By dividing the project’s initial investment by the present value of anticipated future cash flows, the PI is calculated.
Higher values correspond to initiatives with greater appeal, and a PI value greater than 1.0 is regarded as a sound investment.
Due to capital limitations and rival businesses, only projects with the greatest PIs should be continued.
| Which of these is not a discounting method of capital budgeting? Net present value method
internal rate of return profitability index Payback period method Under the net present value of the project method of project appraisal The future cash flow is compared with the initial investment made in the project A comparison of the net present value with the initial investment is made in the project The present value of cash flow is compared with the initial investment made in the project A comparison of the present value with the initial investment is made in the project If the net present value of a project is negative then the project can be selected by the company The statement is true The statement is false Here is the link to the video lecture: https://youtu.be/Qj4eMgNyrvQ |
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| COVER FOLLOWING TOPIC COST OF CAPITAL: https://youtu.be/22BTgQY1R-s
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