Page 132 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 6: Capital Budgeting

Merits Notes
1. This method is quite simple and easy to understand; it has the advantage of making it clear
that there is no profit of any project unless the payback is over. When funds are limited it
is always better to select projects having shorter payback periods. This method is suitable
to industries where the risks of obsolescence are very high.
2. The payback period can be compared to a break-even point, the point at which costs are
fully recovered, but profits are yet to commence.
3. The risk associated with a project arises due to uncertainty associated with the cash inflows.
A shorter payback period means less uncertainty towards risk.

Limitations

1. The method does not give any considerations to time value of money. Cash flows occurring
at all points of time are simply added.
2. This method becomes a very inadequate measure of evaluating two projects where cash
inflows are uneven.
3. It stresses capital recovery rather than profitability. It does not take into account the
returns from a project after its payback period. Therefore, this method may not be a good
measure to evaluate where the comparison is between two projects one involving a long
gestation period and other yielding quick results only for a short period.

Payback Reciprocal

A simple method of calculating the internal rate of return is the payback reciprocal which is 1
divided by the payback period.

Example: A project has an initial cash outlay of 2,00,000 followed by 10 years of annual
cash savings of , 50,000. The payback period is 2,00,000/ 50,000 = 4 years and the payback
reciprocal is
1 1
  25%
Payback period 4

A major drawback of the payback reciprocal that it does not indicate any cutoff period for the
purpose of investment decision. It is, however, argued that the reciprocal of the payback would
be a close approximation of the internal rate of return if the life of the project is at least twice the
payback period and the project generates equal amount of the annual, cash inflows.

Accounting Rate of Return (ARR)

The Accounting Rate of Return (ARR) method of evaluating capital budgeting projects is so
named because it parallels traditional accounting concepts of income and investment. A project
is evaluated by computing a rate of return on the investment, using accounting measures of net
income. The formula for the accounting rate of return is:
Annual revenue from project  Annual exp. of project
ARR =  100
Project investment
This rate is compared with the rate expected on other projects, had the same funds been invested
alternatively in those projects. Sometimes, the management compares this rate with the minimum
rate (called cut of rate) they may have in mind.

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