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Capital Budgeting Essay

3214 words - 13 pages

Management Science-II

Prof. R.Madumathi

MODULE 2 Capital Budgeting
• Capital Budgeting is a project selection exercise performed by the business enterprise. •

Capital budgeting uses the concept of present value to select the projects.

Capital budgeting uses tools such as pay back period, net present value, internal rate of return, profitability index to select projects.

Capital Budgeting Tools
• • • • • Payback Period Accounting Rate of Return Net Present Value Internal Rate of Return Profitability Index

Payback Period
Payback period is the time duration required to recoup the investment committed to a project. Business enterprises following payback period use ...view middle of the document...

Decision Rules
C. Mutually Exclusive Projects
In the case of two mutually exclusive projects, the one with a lower payback period is accepted, when the respective payback periods are less than or equivalent to the stipulated payback period.

Determination Of Stipulated Payback Period
• Stipulated payback period, broadly, depends on the nature of the business/industry with respect to the product, technology used and speed at which technological changes occur, rate of product obsolescence etc. Stipulated payback period is, thus, determined by the management's capacity to evaluate the environment vis-a-vis the enterprise's products, markets and distribution channels and identify the idealbusiness design and specify the time target.

Indian Institute of Technology Madras

Management Science-II

Prof. R.Madumathi

Advantages Of Payback Period
• • It is easy to understand and apply. The concept of recovery is familiar to every decision-maker. Business enterprises facing uncertainty - both of product and technology - will benefit by the use of payback period method since the stress in this technique is on early recovery of investment. So enterprises facing technological obsolescence and product obsolescence - as in electronics/computer industry - prefer payback period method. Liquidity requirement requires earlier cash flows. Hence, enterprises having high liquidity requirement prefer this tool since it involves minimal waiting time for recovery of cash outflows as the emphasis is on early recoupment of investment.

Disadvantages Of Payback Period
• • The time value of money is ignored. For example, in the case of project

A Rs.500 received at the end of 2nd and 3rd years are given same weightage. Broadly a rupee received in the first year and during any other year within the payback period is given same weight. But it is common knowledge that a rupee received today has higher value than a rupee to be received in future.

But this drawback can be set right by using the discounted payback period method. The discounted payback period method looks at recovery of initial investment after considering the time value of inflows.

Indian Institute of Technology Madras

Management Science-II

Prof. R.Madumathi

Another important drawback of the payback period method is that it ignores the cash inflows received beyond the payback period. In its emphasis on early recovery, it often rejects projects offering higher total cash inflow.

Disadvantages Of Payback Period(Cont..)
• Investment decision is essentially concerned with a comparison of rate of return promised by a project with the cost of acquiring funds required by that project. Payback period is essentially a time concept; it does not consider the rate of return.

Example
There ARE TWO PROJECTS (Project A AND B) AVAILABLE FOR A COMPANY, WITH A LIFE OF 6 YEARS EACH AND REQUIRING A CAPITAL OUTLAY OF Rs.9,000/- EACH; AND ADDITIONAL WORKING CAPITAL OF...

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