Name:

Ahmed Ali

Class:

MBA(B)

Roll no:

08

Quiz:

Capital Budgeting

Submitted to:

Maam Qundeel Nawaz

Q. Explain the decision criteria for payback period, net present value,
Internal rate of return. In your own words explain the pros and cons of all
techniques?

Capital Budgeting:
Capital budgeting, or investment appraisal, is the planning process of identify , analysis of selected
project to determine profitability .

Project should not be delayed.

Expenditure should not be greater than authorized amount .

Investment Appraisal Techniques

1-Payback period
2-Internal rate of return
3-Net present value

1-Payback Period:

Payback period is the time in which the initial cash outflow of an investment is expected to be recovered
from the cash inflows generated by the investment. It is one of the simplest investment appraisal
techniques.

Decision Rule :

Accept the project with lowest payback period.

Reject other projects whose payback period high.

Example: Evaluation of project based on the payback method of ABC corporation for 4 years or
less.
Year

Cash
Flow

-10000

5000

2000

4000

1000

1000

The cost of the project is $10000.the payback period is the number of years it takes for projects
cash flow to payback the cost of the project.
After One year the project have paid back the $5000 of the $10000 cost.
After 2nd year the project have paid back $7000 of the $10000 cost.
After 3rd year the project have paid a total of $11000.
The project payback period lies between 2 to 3 years.to payback the $10000 we only need 3000
of 4000 that the project is expected to generate in year 3.
The project should be accepted since its payback period is less than the maximum acceptable
payback period.

Pros:

Cons:

It is easy to calculate and understand.

Cash flow based technique.
Reduce risk of project.

Ignore variability of cash flow.

Ignore the time value of money.
If two project have same payback period then no decision.
It does not consider the cash flows occurring after the payback period.

2-Net Present Value:

Net present value is the present value of net cash inflows generated by a project including
salvage value, if any, less the initial investment on the project. It is one of the most reliable
measures used in capital budgeting because it accounts for time value of money by using
discounted cash inflows.

Decision Rule:
Accept the project only if its NPV is positive or zero. Reject the project having negative NPV.
While comparing two or more exclusive projects having positive NPVs, accept the one with
highest NPV.

Example:
Calculate the net present value of a project which requires an initial investment of $243,000 and
it is expected to generate a cash inflow of $50,000 each month for 12 months. Assume that the
salvage value of the project is zero. The target rate of return is 12% per annum.

Solution:
Net Present Value
= $50,000 (1 (1 + 1%)^-12) 1% $243,000
= $50,000 (1 1.01^-12) 0.01 $243,000
$50,000 (1 0.887449) 0.01 $243,000
$50,000 0.112551 0.01 $243,000
$50,000 11.2551 $243,000

 $562,754 $243,000
$319,754

Pros:

Net present value accounts for time value of money.

It is more reliable than other investment appraisal techniques which do not discount
future cash flows such payback period and accounting rate of return.

Cons:

It is based on estimated future cash flows of the project and estimates may be far from
actual results.

Net Present Value is a dollar return but present return are easier to communicate and
understand internal rate of return.

3-Internal rate of return:

Internal rate of return is the interest rate at which the net present value of all the cash flows
(both positive and negative) from a project equal zero.
Internal rate of return is used to evaluate the attractiveness of a project or investment. If the IRR
of a new project exceeds a companys required rate of return, that project is desirable. If IRR
falls below the required rate of return, the project should be rejected.

Decision Rule:
A project should only be accepted if its IRR is NOT less than the target internal rate of return. Otherwise
reject the project.

Pros:

Cons:

Consider time value of money.

The IRR method shows the return on the original money invested.

Internal rate of return is present rate of return that is easier to understand.

Internal rate of return will be wrong if the cash flow estimates are incorrect.
Reinvestment rate assumptions.