Page 122 - DMGT409Basic Financial Management

Unit 7: Capital Budgeting

7.3.1 Traditional Techniques or Non-discounted Cash Flow Techniques Notes

The traditional techniques are further subdivided into two, such as:

1. Pay back period, and
2. Accounting Rate of Return or Average Rate of Return (ARR).

Pay Back Period

Pay back period is one of the most popular and widely recognized technique of evaluating
investment proposals. Pay back period may be defined as that period required, to recover the

original cash outflow invested in a project. In other words it is the minimum required number of

years to recover the original cash outlay invested in a project. The cash flow after taxes is used to
compute pay back period.
Pay back period can be calculated in two ways, (i) Using formula (ii) Using Cumulative cash

flow method. The first method can be applied when the cash flows stream of each year is equal/

annuity in all the years’ or projects life, i.e., uniform cash flows for all the years. In this situation

the following formula is used to calculate pay back period.
Pay Back Period = Original Investment ÷ Constant Annual Cash Flows After Taxes
or
Initial investment (cash outlay)
Initial investment (cash outlay)
Pay back period =
Annual cash inflow
!
Caution The Second method is applied when, the cash flows after taxes are unequal or

not uniform over the projects’ life period. In this situation, pay back period is calculated
through the process of cumulative cash flows, cumulative process goes up to the period

where cumulative cash flows equals to the actual cash outflows. Put it simple:

PBP = Year before full recovery+(Unrecovered Amount of Investment ‚ Cash fl ows during
the year)
Accept-Reject Rule

Acceptance or rejection of the project is based on the comparison of calculated PBP with the
maximum or standard pay back period. Put it simple
Accept: Cal PBP < Standard PBP

Reject: Cal PBP > Standard PBP
Considered: Cal PBP = Standard PBP

Accept-reject role for mutually exclusive projects
These kinds of Proposals are those proposals which represent alternative methods of doing
the same job. In case one proposal is accepted, the need to accept the other is ruled out. For
Example, there are 5 pieces of equipment available in the market to carry out a job. If the
management chooses one piece of the equipment, others will not be required because they
are mutually exclusive projects.

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