International financial and management accounting lesson 12

12.4.1 Pay Back Period Method12.4.2 Accounting or Average Rate of Return ARR 12.5 Discounted Cash Flows Method 12.5.1 Net Present Value NPV Method 12.5.2 Present Value Index 12.5.3 Inter

UNIT V

12.4.1 Pay Back Period Method

12.4.2 Accounting or Average Rate of Return (ARR)

12.5 Discounted Cash Flows Method

12.5.1 Net Present Value (NPV) Method

12.5.2 Present Value Index

12.5.3 Internal Rate of Return (IRR) Method

12.0 AIMS AND OBJECTIVES

After studying this lesson you will be able to:

 Decide why capital budgeting is the most important decision of the financialmanagement

 Describe various objectives and methods of capital budgeting

 Distinguish between divisible and indivisible projects

12.1 INTRODUCTION

The capital budgeting is one of the important decisions of the financial management ofthe enterprise The decisions pertaining to the financial management of the firm are shown

in Figure 12.1:

International Financial and

Management Accounting Decisions of Financial Management

Financing Investment Dividend Liquidity

Long Term Investment Short Term Investment

Capital Budgeting Working Capital Management

Figure 12.1: Decisions of Financial Management

The capital budgeting is the decision of long term investments, which mainly focuses theacquisition or improvement on fixed assets The importance of the capital budgeting isonly due to the benefits of the long term assets stretched to many number of years in thefuture It is a tool of analysis which mainly focuses on the quality of earning pattern ofthe fixed assets

The capital budgeting decision is a decision of capital expenditure or long term investment

or long term commitment of funds on the fixed assets

Charles T Horngreen “A long-term planning for making and financing proposed capitaloutlays”

12.2 SIGNIFICANCE OF CAPITAL BUDGETING

To make rational investment: The study of capital budgeting on capital expenditures

evades not only over capitalization but also under capitalization The long-term investmentnormally demands heavy volume of investment which is met out by the firm either throughexternal or internal source of financing Hence, the amount of capital raised by the firmshould neither greater nor lesser than the investment

Locking up of capital: The amount invested is requiring longer gestation to recover.

The longer gestation is connected with future horizon in getting back the investment.The future is uncertain unlike the present If the longer is the gestation in the future leads

to greater risk involved

Effect on the profitability of the enterprise: The profitability of the enterprise is mainly

depending on the proper planning of the capital expenditure

Nature of Irreversibility: The improper/unwise capital expenditure decision cannot be

immediately corrected as soon as it was found Once it is invested is invested whichcannot be reversed The poor investment decision will require the firm either to keep it

as an idle in the form of investment or to unnecessarily meet out fixed commitmentcharge of the capital which excessively raised more than the requirement

12.3 TECHNIQUES OF EVALUATION

The methods are the nothing but the instruments of the capital budgeting to study thequality of the investments/fixed assets The investments are studied by the firms in thefollowing angles:

 Based on the number of years taken for getting back the investment – Pay BackPeriod Method

219 Capital Budgeting:

An Overview

 Based on the profits accrued out of the investment – Accounting Rate of Return/

Average Rate of Return

 Based on the timing of benefits – Present value of future benefits of the investment–

Discounted cash flow methods

 Based on the comparison in between the cash outlay and receipts discounted

with the help of minimum rate of return - Net present value method

 Based on the identification of maximum rate of return, in between the initial

cash outlay and discounted expected future receipts - Internal Rate of return

method

 Based on the ration in between the present values of cash inflows and

outflows–Present value index method

The classification of methods are generally in two categories:

 Traditional methods

 Pay Back Period method

 Accounting Rate of Return

 Discounted cash flow methods

 Net present value method

 Internal Rate of Return method

 Present value index method

 Discounted pay back period method

12.4 TRADITIONAL METHOD

12.4.1 Pay Back Period Method

What is pay back period?

The pay back period is the period taken by the firm to get back the investment The pay

back period is nothing but number of years/months/days required by the firm to get back

its investment invested in the project

To find out the pay back period, the following are two important covenants required:

 Initial outlay / Initial investment/ Original investment

 Cash inflows

How the pay back period is calculated?

The pay back period is calculated by way of establishing the relationship between the

volume of investment and the annual earnings

While calculating the pay back period, the nature of annual earnings should be identified

The nature of the annual earnings can be classified into two categories:

 Cash flows are equivalent or constant

 Cash flows are not equivalent or constant

If the cash flows are equivalent, How the pay back period is to be calculated?

The cost of the project is Rs.1,00,000 The annual earnings of the project is Rs.20,000

Calculate the pay back period

Years520,000 Rs

1,00,000Rs

EarningsAnnual

Average

InvestmentInitial

periodback

Pay

=

=

=

International Financial and

Management Accounting

It is obviously understood that, Rs.20,000 of annual earnings (cash inflows) requires

5 years time period to get back the original volume of the investment

If the cash flows are not equivalent, How the pay back period is to be calculated?The cost of the project is Rs.1,00,000 The annual earnings of the project are as follows

Net Income Amount Rs

40,000 30,000 20,000 20,000 20,000

The ultimate aim of determining the cumulative cash inflows to find out how manynumber of years taken by the firm to recover the initial investment

The next step under this method is to determine the cumulative cash flows

The uncollected portion of the investment is Rs,10,000 This Rs.10,000 is collected fromthe 4th year Net income/cash inflows of the enterprise During the 4th year the totalearnings amounted Rs.20,000 but the amount required to recover is only Rs.10,000 Forearning Rs.20,000 one full year is required but the amount required to collect it back isamounted Rs.10,000 How many months the firm may require to collect Rs.10,000 out

of the entire earnings Rs.20,000?

Pay back period consists of two different components

 Pay back period for the major portion of the investment collection in full course E.g.: 3 years

- Pay back period for the left /uncollected portion of the investment

For the second category 0.5years

20,000 Rs

10,000

Rs =

=

Total pay back period= 3 Years +.5 year = 3.5 years

Criterion for selection: If two or more projects are given for appraisal, considered to be

mutually exclusive to each other for selection, the pay back period of the projects shouldtabulated in accordance with the ascending order The project which has lesser payback period only to be selected over the other projects given for scrutiny

Why lesser pay back has to be chosen?

The reason behind is that the project which has lesser pay back period got faster recovery

of the initial investment through cash inflows/Net income

221 Capital Budgeting:

An Overview

Solution:

First step is identify the nature of the annual cash inflows

In this problem, the annual cash inflows are equivalent throughout life period of the

project

Annual Cash Inflows= Rs 40,000 =

Illustration 2

Calculate the pay back period for a project which requires a cash outlay of Rs.20,000

and generates cash inflows of Rs 4,000 Rs.8,000 Rs 6,000 and Rs 4,000 in the first,

second, third, and fourth year respectively

Solution:

First step is to identify the nature of the cash inflows

The cash inflows are not equivalent/constant

Year Cash Inflows Cumulative

Cost of the project is to be recovered Rs.20,000 The project takes 3 full years time

period to recover the major portion of the initial investment which amounted Rs.18,000

out of Rs.20,000

The remaining amount of the initial investment is recovered only during the fourth year

The left portion Rs.2,000 has to be recovered only from the fourth year cash inflows of

Rs.4,000

Pay Back Period = Pay Back period of the major portion + Pay Back period of the

remaining portion

Pay Back period of the major portion = 3 years

Pay Back period of the remaining portio: For the entire earnings of Rs.4,000, the

firm consumed one full year/12 months time period How many number of months

required to recover Rs.2,000?

months6

months12

5.04,000.Rs

2,000

Total pay back period = 3 years + 6 months = 3 years 6 months

Illustration 3

A project cost of Rs.10,00,000 and yields annually a profit of Rs.1,60,000 after depreciation

and depreciation at 12% per annum but before tax 50% Calculate pay back period

Solution:

Pay Back Period

inflowCash Annual

InvestmentInitial

=

In this problem, the initial investment is given which amounted Rs.5,00,000

International Financial and

Management Accounting

The annual cash inflow is not given directly; to determine the cash inflow; what is meant

by the cash inflow?

Cash inflow = Profit after tax + DepreciationProfit Before taxation = Rs.1,60,000(-)Taxation = Rs 80,000Profit after taxation = Rs 80,000

(+)Depreciation 12% on = Rs 10,00,000

= Rs 1,20,000Annual Cash Inflow = Rs 2,00,000Pay Back Period = Rs.10,00,000 = 5 years = Rs.2,00,000

Illustration 4

A company proposing to expand its production can go in either for an automatic machinecosting Rs.2,24,000 with an estimated life of 5 ½ years or an ordinary machine costingRs.60,000 having an estimated life of 8 years The annual sales and costs are estimated

Compute the comparative profitability of the proposals under the pay back period method

Solution:

The first step is to find out the Annual profits of the two different machines

The next step is to find out the pay back period of the two different machines respectively

Profitability Statement Automatic Machine (Rs) Ordinary Machine (Rs)

The pay back period method highlights that the ordinary machine is more ideal than theautomatic machine due to lesser pay back period i.e., 3 years It means that the ordinarymachine is bearing the faster rate in getting back the investment invested than theautomatic machine

223 Capital Budgeting:

An Overview

The another method to discuss is post pay back impact of the two different machines

Post pay back profit is the profit of the two different machines after the recovery of the

initial investment The machine which has greater post pay back profit construe

Post Pay Back Profit Particulars Automatic Machine (Rs) Ordinary Machine (Rs)

Annual Profit R.No.1 64,000 20,000

Estimated Life R.No.2 5½ years 8 years

Pay Back Period R.No.3 3½ years 3 years

Post Pay Back Period

R.No 4=R.No.2-R.No.3 2 years 5 years

Post pay back profit of the Automatic machine is higher than the Ordinary machine;

which amounted Rs.1,28,000 It means that the profit of the automatic machine after

the recovery of the initial investment is greater than that of the ordinary machine

Illustration 5

A company has to choose one of the following two mutually exclusive projects Investment

required for each project is Rs 30,000 Both the projects have to be depreciated on

straight line basis The tax rate is 50%

Year Profit Before Depreciation

First step is to find out the depreciation under the straight line method

The next step is to determine the pay back period of the both projects A and B respectively

The next step is to compare both pay back periods of two different projects

The depreciation under the straight line method is as follows

For Project A

000,6.Rsyears5

30,000 RsProject theofLife

InvestmentInitial

=

=

For Project B

000,6.Rsyears5

30,000 RsProject theofLife

InvestmentInitial

=

=

The second half of the equation is that pay back period for the remaining i.e., Rs.5000 ofinitial investment which is to be recovered during the fourth year out of Rs.10,000

If Rs.10,000 earned throughout the year /12 months, how many months taken by thefirm in recovering Rs.5,000 out of Rs10,000

months6

months12

5.000,10.Rs

5,000

300 Rs

= 4 years +.02 × 365 days = 4 years + 8 days = 4 years and 8 days

Pay back period of the project B is greater than that of the earlier Project A It meansthat the Project A is bearing the faster rate in getting back the investment invested

225 Capital Budgeting:

An Overview

Merits

 It is a simple method to calculate and understand

 It is a method in terms of years for easier appraisal

Demerits

 It is a method rigid

 It has completely discarded the principle of time value of money

 It has not given any due weight age to cash inflows after the pay back period

 It has sidelined the profitability of the project

12.4.2 Accounting or Average Rate of Return (ARR)

Under this method, the profits are extracted from the book of accounts to denominate

the rate of return The profits which are extracted are nothing but after depreciation and

taxation and not cash inflows

Selection criterion of the projects:

Highest rate of return of the project only is given appropriate weightage

The Accounting rate of return can be computed as follows

Accounting Rate of Return (ARR)= 100

InvestmentOriginal

ReturnAnnual

×

Accounting Rate of Return (ARR)= AverageInvestment 100

ReturnAnnualAverage

×

Average annual return= Average profit after depreciation and taxation of the entire life

of project i.e for many number of years

Average Investment = Opening Investment + Closing Investment

2

=

2

Scrap–InvestmentOpening

Illustration 6

Calculate the average rate of return for Projects X and Y from the following

Projected net income ( after interest, depreciation and taxes)

Project

t the throughouincome

Total

Average Annual Income (Project X) = Rs 3,000

years4

12,000 Rs

=

Average Annual Income (Project Y) = Rs 4,000

years5

20,000 Rs

=

The next step is to find out the Average rate of return :

Average rate of return (Project X) = 100 7.5%

000,40.Rs

3,000 Rs

=

×

Average rate of return (Project Y) = 100 8.33%

60,000 Rs

000,5

Consumable stores per annum 6,000 7,500Other charges per annum 8,000 9,000

227 Capital Budgeting:

An Overview

Steps involved in the computation of the accounting rate of return

The first is to compute the total number of units expected to produce

Total number of units of production = Total machine hours per annum × Units per hour

For old machine = 2,000 Hrs× 24= 48,000 units

For new machine = 2,000 Hrs × 36= 72,000 units

The second step is to determine the volume of annual sale of units:

Total volume of sales = Total number of units × Selling price per unit

For old machine = 48,000 units × Rs 1.25= Rs.60,000

For new machine = 72,000 units× Rs.1.25= Rs.90,000

According to the second assumption, the volume of sales is known as unaffected

throughout the life period of the projects

The next step is to find out the volume of the wages

Total wages = wages per hour × Machine running hours

For old machine = Rs.3×2000 Hrs= Rs.6,000

For new machine = Rs5.25×2000 Hrs=Rs.10,500

The next step is to find out the total material cost

Total material cost per unit = Total number of units × Material cost per unit

For old machine = 48,000×.5= Rs.24,000

For new machine = 72,000×.5=Rs.36,000

The last step is to find out the depreciation

Depreciation under straight line method = EconomicInitiallifeinvestmentperiodof theasset

For old machine = Rs.8,000

For new machine = Rs.12,000

The next step is to draft the profitability statement of the enterprise under the head of

two different machine viz old and new To find out the annual income of the enterprise

under two different machines

Profitability Statement

The Average rate of return

100InvestmentAverage

ReturnAnnualAverage

100Investment

Original

ReturnAnnualAverage

Tax at 50% 3,000 5,250

Profit after tax 3,000 5,250