IGNOU : M.COM : MCO 7 : UNIT 6 : Q - 3. What are the requirements of a good method of capital budgeting decision making? Give an overview of different methods.

Ans. Requirements of a good method

The previous section has shown us various methods, which may be used for investment decision making. In fact, each method has its own advantages as well as shortcomings. Given below are the requirements of a good method of investment decision making.

1. It should be based on cash-flows rather than on profits or expenditure.

2. Cash flows to be covered over the entire expected life of the asset rather than few years only.

3. It should give the absolute value of gain or loss.

4. It should consider time value of money.

5. It should indicate relative profitability between different alternatives so that a ranking can be made between different proposals.

6. It should indicate the degree of risk and the chances of getting profit or loss in a given situation.

There is probably no method which will posses all the above attributes but different methods do posses some of them. As we get introduced to different methods in this and the next unit, we will be able to assess the suitability of a method /methods for different situations.

 

METHODS OF CAPITAL BUDGETING

ACCOUNTING RATE OF RETURN

The Accounting Rate of Return also called the Average Rate of Return (ARR) is the average of the rate of return for different years for the whole life of an asset. It is a ratio between the Net Profit After Tax and the amount of initial investment made in the project.

ARR= Average PAT / Initial Investment

Another view about ARR is that since we take average of the PAT for calculating ARR we should also use average level of investment for the project. In such a situation the equation for calculating ARR should be modified as follows.

ARR= Average Profit After Tax / Average Investment

 

PAYBACK PERIOD

The Payback- period is the time duration required to recover the initial cash outflows. This method is based on cash flows and not on accounting data like the ARR. Ordinary people not well versed in appraisal techniques, often use very simple technique to judge the profitability of any investment proposal. They think in terms of initial expenditure (outflow) and the time duration in which this amount can be recovered. Suppose somebody spent Rs.50,000 on any project and expects that within 3 year he can get back this amount, then the payback period is 3 years. Payback period of any proposal can be calculated as follows;

 If the cash inflows are uniform then

Payback period = Initial cash outflow / Annual cash inflows

If the cash inflows are not uniform then

Payback period = time period in which the cumulative cash flows are equal to initial inflows.