CAPITAL BUDGETING

Introduction
✔ The investment decisions of a firm are generally known as the capital budgeting,
or capital expenditure decisions.
✔ A capital budgeting decision may be defined as the firm’s decision to invest its
current funds most efficiently in the long-term assets in anticipation of an
expected flow of benefits over a series of years.
✔ The long-term assets are those that affect the firm’s operations beyond the one-
year period.
✔ The firm’s investment decisions would generally include expansion, acquisition,
modernization and replacement of the long-term assets. Sale of a division or
business (divestment) is also as an investment decision.
 Introduction
Decisions like the change in the methods of sales distribution, or an advertisement
campaign or a research and development programme have long-term implications
for the firm’s expenditures and benefits, and therefore, they should also be
evaluated as investment decisions. Investment in fixed and current assets is one
single activity.
The following are the features of investment decisions:
✔ The exchange of current funds for future benefits
✔ The funds are invested in long-term assets
✔It The future benefits
is significant will occur
to emphasize to the
that firm over aand
expenditures series of years
benefits of an investment should
be measured in cash.
 Introduction
✔ In the investment analysis, it is cash flow, which is important, and not the
accounting profit.
✔ Investment decisions affect the firm’s value. The firm’s value will increase if
investments are profitable and add to the shareholders’ wealth.
✔ Thus, investments should be evaluated on the basis of a criterion, which is
compatible with the objective of the Shareholder Wealth Maximization.
✔ An investment will add to the shareholders’ wealth if it yields benefits in excess
of the minimum benefits, as per the opportunity cost of capital.
✔ Assuming: the investment project’s opportunity cost of capital is known, the
expenditures and benefits of the investment are known with certainty.
 Importance of Investment Decisions

Investment decisions require special attention because of the following reasons:

✔ They influence the firm’s growth in the long run
✔ They affect the risk of the firm
✔ They involve commitment of large amount of funds
✔ They are irreversible, or reversible at substantial loss
✔ They are among the most difficult decisions to make
 Importance of Investment Decisions
Growth
✔ The effects of investment decisions extend into the future and have to be endured
for a longer period than the consequences of the current operating expenditure.
✔ A firm’s decision to invest in long-term assets has a decisive influence on the rate
and direction of its growth.
✔ wrong decision can prove disastrous for the continued survival of the firm;
unwanted or unprofitable expansion of assets will result in heavy operating costs
to the firm.
✔ On the other hand, inadequate investment in assets would make it difficult for the
firm to compete successfully and maintain its market share.
 Importance of Investment Decisions
✔ Risk A long-term commitment of funds may also change the risk complexity of
the firm. If the adoption of an investment increases average gain but causes
frequent fluctuations in its earnings, the firm will become more risky. Thus,
investment decisions shape the basic character of a firm.

✔ Funding Investment decisions generally involve large amount of funds, which

make it imperative for the firm to plan its investment programs very carefully
and make an advance arrangement for procuring finances internally or
externally.
 Importance of Investment Decisions
✔ Irreversibility Most investment decisions are irreversible. It is difficult to find a
market for such capital items once they have been acquired. The firm will incur
heavy losses if such assets are scrapped.

✔ Complexity Investment decisions are among the firm’s most difficult decisions.
They are an assessment of future events, which are difficult to predict. It is really a
complex problem to correctly estimate the future cash flows of an investment.
Economic, political, social and technological forces cause the uncertainty in cash
flow estimation.
 TYPES OF INVESTMENT DECISIONS
There are many ways to classify investments. One classification is as follows:
✔ Expansion of existing business or expansion of new business
✔ Replacement and modernization

A company may add capacity to its existing product lines to expand existing
operations. For example, the Gujarat State Fertilizer Company (GSFC) may
increase its plant capacity to manufacture more urea. It is an example of related
diversification.
 Expansion and Diversification
✔ A firm may expand its activities in a new business. Expansion of a new business
requires investment in new products and a new kind of production activity within the
firm.
✔ If a packaging manufacturing company invests in a new plant and machinery to
produce ball bearings, which the firm has not manufactured before, this represents
expansion of new business or unrelated diversification.
✔ Sometimes a company acquires existing firms to expand its business. In either case,
the firm makes investment in the expectation of additional revenue. Investments in
existing or new products may also be called as revenue expansion investments.
 Replacement and Modernization
✔ The main objective of modernization and replacement is to improve operating
efficiency and reduce costs.
✔ Cost savings will reflect in the increased profits, but the firm’s revenue may remain
unchanged. Assets become outdated and obsolete with technological changes.
✔ The firm must decide to replace those assets with new assets that operate more
economically.
✔ If a cement company changes from semi-automatic drying equipment to fully
automatic drying equipment, it is an example of modernization and replacement.
 Replacement and Modernization

✔ Replacement decisions help to introduce more efficient and economical assets

and therefore, are also called cost-reduction investments.
✔ However, replacement decisions that involve substantial modernization and
technological improvements expand revenues as well as reduce costs.
✔ Another useful ways to classify investments is as follows:
▪ Mutually exclusive investments
▪ Independent investments
▪ Contingent investments
Mutually Exclusive Investments
Mutually exclusive investments serve the same purpose and compete with each
other. If one investment is undertaken, others will have to be excluded. A company
may, for example, either use a more labour- intensive, semiautomatic machine, or
employ a more capital-intensive, highly automatic machine for production.
Choosing the semi-automatic machine precludes the acceptance of the highly
automatic machine.
Independent Investments
Independent investments serve different purposes and do not compete with
each other. For example, a heavy engineering company may be considering
expansion of its plant capacity to manufacture additional excavators and
addition of new production facilities to manufacture a new product—light
commercial vehicles. Depending on their profitability and availability of funds,
the company can undertake both investments.
Contingent Investments
Contingent investments are dependent projects; the choice of one
investment necessitates undertaking one or more other investments. For
example, if a company decides to build a factory in a remote, backward area,
it may have to invest in houses, roads, hospitals, schools, etc., for the
employees to attract the work force. Thus, building of factory also requires
investment in facilities
for employees. The total expenditure will be treated as one single investment.
 INVESTMENT EVALUATION CRITERIA
Three steps are involved in the evaluation of an investment:
✔ Estimation of cash flows
✔ Estimation of the required rate of return (the opportunity cost of capital)
✔ Application of a decision rule for making the choice

Investment Decision Rule

The investment decision rules may be referred to as capital budgeting techniques, or
investment criteria. A sound appraisal technique should be used to measure the
economic worth of an investment project. The essential property of a sound
technique is that it should maximize the shareholders’ wealth.
 The following other characteristics should also be possessed by a sound investment
evaluation criterion:
✔ It should consider all cash flows to determine the true profitability of the project.
✔ It should provide for an objective and unambiguous way of separating good projects
from bad projects.
✔ It should help ranking of projects according to their true profitability.
✔ It should recognize the fact that bigger cash flows are preferable to smaller ones and
early cash flows are preferable to later ones.
✔ It should help to choose among mutually exclusive projects that project which
maximizes the shareholders’ wealth.
✔ It should be a criterion which is applicable to any conceivable investment project,
independent of others.
 Evaluation Criteria
Several investment criteria (or capital budgeting techniques) are in use in practice.
They may be grouped in the following two categories:
1. Discounted Cash Flow (DCF) Criteria
✔ Net present value (NPV)
✔ Internal rate of return (IRR)
✔ Profitability index (PI)
2. Non-discounted Cash Flow Criteria
✔ Payback (PB)
✔ Discounted payback
✔ Accounting rate of return (ARR).
 NET PRESENT VALUE
The net present value (NPV) method is the classic economic method of
evaluating the investment proposals.
It is a Discounted Cash Flow DCF technique that explicitly recognizes the time
value of money. It correctly postulates that cash flows arising at different time
periods differ in value and are comparable only when their equivalents—present
values—are found out.
 The following steps are involved in the calculation of NPV:
✔ Cash flows of the investment project should be forecasted based on realistic
assumptions.
✔ Appropriate discount rate should be identified to discount the forecasted cash flows.
The appropriate discount rate is the project’s opportunity cost of capital, which is equal
to the required rate of return expected by investors on investments of equivalent risk.
✔ Present value of cash flows should be calculated using the opportunity cost of capital as
the discount rate.
✔ Net present value should be found out by subtracting present value of cash outflows
from present value of cash inflows. The project should be accepted if NPV is positive (i.
e., NPV > 0).
ILLUSTRATION 8.1: Calculating Net Present Value
Assume that Project X costs `2,500 now and is expected to generate year-end cash
inflows of `900, `800, `700, `600 and `500 in years 1 through 5. The opportunity cost of
the capital may be assumed to be 10 per cent. The net present value for Project X can
be calculated by referring to the present value table. The calculations are shown
below:
 Project X’s present value of cash inflows (`2,725) is greater than that of cash
outflow (`2,500). Thus, it generates a positive net present value (NPV = +`225).
Project X adds to the wealth of owners; therefore, it should be accepted. The
formula for the net present value can be written as follows:

where C1, C2... represent net cash inflows in year 1, 2..., k is the opportunity cost of capital,
C0 is the initial cost of the investment and n is the expected life of the investment. It
should be noted that the cost of capital, k, is assumed to be known and is constant
 Why is NPV Important?

Why should a financial manager invest `2,500 in Project X? Project X should be

undertaken if it is best for the company’s shareholders; they would like their shares to be
as valuable as possible.
Let us assume that the total market value of a hypothetical company is `10,000, which
includes `2,500 cash that can be invested in Project X. Thus the value of the company’s
other assets must be `7,500. The company has to decide whether it should spend cash
and accept Project X or to keep the cash and reject Project X. Clearly Project X is desirable
since its PV (`2,725) is greater than the `2,500 cash. If Project X is accepted, the total
market value of the firm will be: `7,500 + PV of Project X = `7,500 + `2,725 = `10,225; that
is, an increase by `225. The company’s total market value would remain only `10,000 if
Project X was rejected.
 Acceptance Rule
The NPV acceptance rules are:
✔ Accept the project when NPV is positive: NPV > 0
✔ Reject the project when NPV is negative: NPV < 0
✔ May accept the project when NPV is zero: NPV = 0

✔ The NPV method can be used to select between mutually exclusive projects;
the one with the higher NPV should be selected.
✔ Using the NPV method, projects would be ranked in order of net present values;
that is, first rank will be given to the project with highest positive net present
value and so on.
 Evaluation of the NPV Method

NPV is the true measure of an investment’s profitability. It provides the most

acceptable investment rule for the following reasons:
✔ Time value It recognizes the time value of money—a rupee received today is
worth more than a rupee received tomorrow.
✔ Measure of true profitability It uses all cash flows occurring over the entire life
of the project in calculating its worth. Hence, it is a measure of the project’s
true profitability. The NPV method relies on estimated cash flows and the
discount rate rather than any arbitrary assumptions, or subjective
considerations.
✔ Value-additivity The discounting process facilitates measuring cash flows in terms of
present values; that is, in terms of equivalent, current rupees. Therefore, the NPVs of
projects can be added. For example, NPV (A + B) = NPV (A) + NPV (B). This is called the
value-additivity principle.
✔ It implies that if we know the NPVs of individual projects, the value of the firm will
increase by the sum of their NPVs. We can also say that if we know values of individual
assets, the firm’s value can simply be found by adding their values. The value-additivity
is an important property of an investment criterion because it means that each project
can be evaluated, independent of others, on its own merit.
✔ Shareholder value The NPV method is always consistent with the objective of the
shareholder value maximization. This is the greatest virtue of the method.
 In practice, NPV may pose some computational problems.
✔ Cash flow estimation The NPV method is easy to use if forecasted cash flows are
known. In practice, it is quite difficult to obtain the estimates of cash flows due
to uncertainty.
✔ Discount rate It is also difficult in practice to precisely measure the discount rate.
✔ Mutually exclusive projects Further, caution needs to be applied in using the
NPV method when alternative (mutually exclusive) projects with unequal lives,
or under funds constraint are evaluated. The NPV rule may not give
unambiguous results in these situations.
✔ Ranking of projects, It should be noted that the ranking of investment projects
as per the NPV rule is not independent of the discount rates.
It can be seen that the project ranking is reversed when the discount rate is
changed from 5 per cent to 10 per cent. The reason lies in the cash flow patterns.
The impact of the discounting becomes more severe for the cash flow occurring
later in the life of the project; the higher is the discount rate, the higher would be
the discounting impact. In the case of Project B, the larger cash flows come later
in the life. Their present value will decline as the discount rate increases.
 INTERNAL RATE OF RETURN
The internal rate of return (IRR) method is another discounted cash flow technique,
which takes account of the magnitude and timing of cash flows. Other terms used to
describe the IRR method are yield on an investment, marginal efficiency of capital,
rate of return over cost, time adjusted rate of internal return.
The concept of internal rate of return is quite simple to understand in the case of a
one-period project. Assume that you deposit `10,000 with a bank and would get back
`10,800 after one year. The true rate of return on your investment would be:
 IRR can be determined by solving the following equation for r:

The rate of return, r, depends on the project’s cash flows, rather than any outside factor.
Therefore, it is referred to as the internal rate of return. The internal rate of return (IRR) is
the rate that equates the investment outlay with the present value of cash inflow received,
after one period. This also implies that the rate of return is the discount rate which makes
NPV = 0. There is no satisfactory way of defining the true rate of return of a long-term asset.
IRR is the best available concept.
 Uneven Cash Flows: Calculating IRR by Trial and Error

In the NPV method, the required rate of return, k, is known and the net present
value is found, while in the IRR method the value of r has to be determined at
which the net present value becomes zero.
The value of r in Equation can be found out by trial and error. The approach is to
select any discount rate to compute the present value of cash inflows. If the
calculated present value of the expected cash inflow is lower than the present
value of cash outflows, a lower rate should be tried. On the other hand, a higher
value should be tried if the present value of inflows is higher than the present value
of outflows. This process will be repeated unless the net present value becomes
zero.
ILLUSTRATION 8.2: Trial and Error Method for Calculating IRR
A project costs `16,000 and is expected to generate cash inflows of `8,000, `7,000 and
`6,000 at the end of each year for next 3 years. IRR is the rate at which project will have
a zero NPV. As a first step, try (arbitrarily) a 20 per cent discount rate. The project’s NPV
at 20 per cent is:

A negative NPV of `1,004 at 20 per cent indicates that the project’s true rate of
return is lower than 20 per cent.
 Let us try 16 per cent as the
discount rate. At 16 per cent,
the project’s NPV is:

Since the project’s NPV is still negative at 16 per cent, a rate lower than 16 per cent
should be tried. When we select 15 per cent as the trial rate, we find that the project’s
NPV is `200:
 Trial and Error Method for Calculating IRR

Step1: Determine NPV of 2 closest ratio of return

NPV for 15% = 200
NPV for 16% = - 57
Step 2: Add absolute value of NPV
200+57= 257
Step 3: Calculate :NPV of lesser percentage/Total NPV for two percentages
200/257 = 0.8
Step 4: Add result of step 3 to smaller discount rate
15+0.8=15.8
Note :To be more precise :15+(16-15)X 0.8=15.8
 Level Cash Flows
An easy procedure can be followed to calculate the IRR for a project that produces level or equal
cash flows each period. To illustrate, let us assume that an investment would cost `20,000 and
provide annual cash inflow of `5,430 for 6 years. If the opportunity cost of capital is 10 per cent,
what is the investment’s NPV? The `5,430 is an annuity for 6 years. The NPV can be found as
follows:
The rate, which gives a PVFA of 3.683 for 6 years, is the project’s internal rate of
return. Thus, 16 per cent is the project’s IRR that equates the present value of the
initial cash outlay (`20,000) with the constant annual cash inflows (`5,430 per
year) for 6 years.
 Acceptance Rule
The accept-or-reject rule, using the IRR method, is to accept the project if its internal
rate of return is higher than the opportunity cost of capital (r > k). Note that k is also
known as the required rate of return, or the cut-off, or hurdle rate. The project shall
be rejected if its internal rate of return is lower than the opportunity cost of capital (r
< k). The decision maker may remain indifferent if the internal rate of return is equal
to the opportunity cost of capital.
Thus the IRR acceptance rules are:
✔ Accept the project when r > k
✔ Reject the project when r < k
✔ May accept the project when r = k
 Evaluation of IRR Method
IRR method is like the NPV method. It is a popular investment criterion since it measures
profitability as a percentage and can be easily compared with the opportunity cost of
capital. IRR method has following merits:
✔ Time value The IRR method recognizes the time value of money.
✔ Profitability measure It considers all cash flows occurring over the entire life of the
project to calculate its rate of return.
✔ Acceptance rule It generally gives the same acceptance rule as the NPV method.
✔ Shareholder value It is consistent with the Shareholder Wealth Maximization
objective.
Whenever a project’s IRR is greater than the opportunity cost of capital, the
shareholders’ wealth will be enhanced.
 The problems that IRR method may suffer from:
✔ Multiple rates A project may have multiple rates, or it may not have a unique rate
of return. These problems arise because of the mathematics of IRR computation.
✔ Mutually exclusive projects It may also fail to indicate a correct choice between
mutually exclusive projects under certain situations.
✔ Value additivity Unlike in the case of the NPV method, the value additivity
principle does not hold when the IRR method is used—IRRs of projects do not add.
Thus, for Projects A and B, IRR(A) + IRR(B) need not be equal to IRR (A + B).
The NPV and IRR of Projects A and B are given below:
The source of conflict between the two techniques lies in their different implicit
reinvestment rates. The IRR method is assumed to imply that the cash flows generated
by the project can be reinvested at its internal rate of return, the NPV method is
thought to assume that the cash flows are reinvested at the opportunity cost of capital.

To overcome shortcomings of the regular IRR, Modified IRR is introduced. The

Modified internal rate of return (MIRR) is the compound average annual rate that is
calculated with a reinvestment rate different than the project’s IRR.
 Modified internal rate of return (MIRR)
The procedure for calculating MIRR is as follows:
Step 1: Calculate the present value of the costs (PVC) associated with the project,
using the cost of capital (r) as the discount rate:

Step 2: Calculate the terminal value (TV) of the cash inflows expected from the project:

Step 3: Obtain MIRR by solving the following equation:

 Modified internal rate of return (MIRR)
To illustrate the calculation of MIRR let us consider an example. Pentagon Limited is
evaluating a project that has the following cash flow stream associated with it:
The time line diagram for this problem is
given below.
 PROFITABILITY INDEX
Time-adjusted method of evaluating the investment proposals is the benefit – cost
(B/C) ratio or profitability index (PI).
Profitability index is the ratio of the present value of cash inflows, at the required
rate of return, to the initial cash outflow of the investment. The formula for
calculating benefit-cost ratio or profitability index is as follows:
ILLUSTRATION 8.3: PI of Uneven Cash Flows
The initial cash outlay of a project is `100,000 and it can generate cash inflow of `40,000,
`30,000, `50,000 and `20,000 in year 1 through 4. Assume a 10 per cent rate of discount.
The PV of cash inflows at 10 per cent discount rate is:
 Acceptance Rule
The following are the PI acceptance rules:
✔ Accept the project when PI is greater than one PI > 1
✔ Reject the project when PI is less than one PI < 1
✔ May accept the project when PI is equal to one PI = 1
✔ The project with positive NPV will have PI greater than one. PI less than one
means that the project’s NPV is negative.
 Evaluation of PI Method
Like the NPV and IRR rules, PI is a conceptually sound method of appraising investment
projects. It is a variation of the NPV method and requires the same computations as the
NPV method.
✔ Time value It recognizes the time value of money.
✔ Value maximization It is consistent with the shareholder value maximization
principle. A project with PI greater than one will have positive NPV and if accepted, it
will increase share-holders’ wealth.
✔ Relative profitability In the PI method, since the present value of cash inflows is
divided by the initial cash outflow, it is a relative measure of a project’s profitability.
 PAYBACK
The payback (PB) is one of the most popular and widely recognized traditional methods
of evaluating investment proposals. Payback is the number of years required to recover
the original cash outlay invested in a project. If the project generates constant annual
cash inflows, the payback period can be computed by dividing cash outlay by the annual
cash inflow. That is:

ILLUSTRATION 8.4: Payback (Constant Cash Flows)

Assume that a project requires an outlay of `50,000 and yields annual cash inflow of
`12,500 for 7 years. The payback period for the project is:
Unequal cash flows In case of unequal cash inflows, the payback period can be found out
by adding up the cash inflows until the total is equal to the initial cash outlay. Consider
the following example.

ILLUSTRATION 8.5: Payback (Uneven Cash Flows)

Suppose that a project requires a cash outlay of `20,000, and generates cash inflows of
`8,000; `7,000; `4,000; and `3,000 during the next 4 years. What is the project’s payback?
When we add up the cash inflows, we find that in the first three years `19,000 of the
original outlay is recovered. In the fourth year cash inflow generated is `3,000 and only
`1,000 of the original outlay remains to be recovered. Assuming that the cash inflows occur
evenly during the year, the time required to recover `1,000 will be (`1,000/`3,000) × 12
months = 4 months. Thus, the payback period is 3 years and 4 months.
Acceptance Rule
Many firms use the payback period as an investment evaluation criterion and a
method of ranking projects. They compare the project’s payback with a
predetermined, standard payback. The project would be accepted if its payback period
is less than the maximum or standard payback period set by management. As a
ranking method, it gives highest ranking to the project, which has the shortest
payback period and lowest ranking to the project with highest payback period. Thus, if
the firm has to choose between two mutually exclusive projects, the project with
shorter payback period will be selected.
 Evaluation of Payback
Payback is a popular investment criterion in practice.
✔ Simplicity The most significant merit of payback is that it is simple to understand
and easy to calculate. The business executives consider the simplicity of method
as a virtue. This is evident from their heavy reliance on it for appraising
investment proposals in practice.
✔ Cost effective Payback method costs less than most of the sophisticated
techniques that require a lot of the analysts’ time and the use of computers.
✔ Short-term effects A company can have more favorable short-run effects on
earnings per share by setting up a shorter standard payback period. It should,
however, be remembered that this may not be a wise long-term policy as the
company may have to sacrifice its future growth for current earnings.
✔ Risk shield The risk of the project can be tackled by having a shorter standard
payback period as it may ensure guarantee against loss. A company has to invest
in many projects where the cash inflows and life expectancies are highly uncertain.
Under such circumstances, payback may become important, not so much as a
measure of profitability but as a means of establishing an upper bound on the
acceptable degree of risk.
✔ Liquidity The emphasis in payback is on the early recovery of the investment.
Thus, it gives an insight into the liquidity of the project. The funds so released can
be put to other uses.
Cash flows after payback: Payback fails to take account of the cash inflows earned
after the payback period. For example, consider the following projects X and Y:

As per the payback rule, both the projects are equally desirable since both return the
investment outlay in two years. If we assume an opportunity cost of 10 per cent,
Project X yields a positive net present value of `806 and Project Y yields a negative net
present value of `530. As per the NPV rule, Project X should be accepted and Project Y
rejected. The payback rule gave wrong results because it failed to consider `2,000 cash
flow in the third year for Project X.
Cash flows ignored Payback is not an appropriate method of measuring the profitability of an
investment project as it does not consider all cash inflows yielded by the project. Considering
Project X again, payback rule did not take into account its entire series of cash flows.
Cash flow patterns Payback fails to consider the pattern of cash inflows, i.e., magnitude and
timing of cash inflows. In other words, it gives equal weights to returns of equal amounts
even though they occur in different time periods. For example, compare the following
projects C and D where they involve equal cash outlay and yield equal total cash inflows over
equal time periods:
Using payback period, both projects are equally desirable. But Project C should be
preferable as larger cash inflows will come earlier in its life. This is indicated by the NPV
rule; Project C has higher NPV (`881) than Project D (`798) at 10 per cent opportunity
cost. It should be thus clear that payback is not a measure of profitability.
As such, it is dangerous to use it as a decision criterion.
Administrative difficulties A firm may face difficulties in determining the maximum,
acceptable payback period. There is no rational basis for setting a maximum payback
period. It is generally a subjective decision.
Inconsistent with shareholder value Payback is not consistent with the objective of
maximizing the market value of the firm’s shares. Share values do not depend on
payback periods of investment projects.
 The reciprocal of payback will be a close approximation of the internal rate of return
if the following two conditions are satisfied:
✔ The life of the project is large or at least twice the payback period
✔ The project generates equal annual cash inflows The payback reciprocal is a useful
technique to quickly estimate the true rate of return. But its major limitation is
that every investment project does not satisfy the conditions on which this
method is based. When the useful life of the project is not at least twice the
payback period, the payback reciprocal will always exceed the rate of return.
Similarly, it cannot be used as an approximation of the rate of return if the project
yields uneven cash inflows.
 DISCOUNTED PAYBACK
One of the serious objections to the payback method is that it does not discount the
cash flows for calculating the payback period.
We can discount cash flows and then calculate the payback.
The discounted payback period is the number of periods taken in recovering the
investment outlay on the present value basis.
The discounted payback period still fails to consider the cash flows occurring after the
payback period.
Let us consider an example. Projects P and Q involve the same outlay of `4,000 each.
The opportunity cost of capital may be assumed as 10 per cent. The cash flows of the
projects and their discounted payback periods are shown in Table 8.3.

The projects indicated are of same desirability by the simple payback period.
When cash flows are discounted to calculate the discounted payback period, Project P
recovers the investment outlay faster than Project Q, and therefore, it would be
preferred over Project Q. Discounted payback period for a project will be always
higher than simple payback period because its calculation is based on the discounted
cash flows.
Discounted payback rule is better as it discounts the cash flows until the outlay is
recovered. But it does not help much. It does not take into consideration the entire
series of cash flows. It can be seen in our example that if we use the NPV rule, Project
Q (with the higher discounted payback period) is better.
 ACCOUNTING RATE OF RETURN
The accounting rate of return (ARR), also known as the return on investment (ROI),
uses accounting information, as revealed by financial statements, to measure the
profitability of an investment. The accounting rate of return is the ratio of the average
after tax profit divided by the average investment. The average investment would be
equal to half of the original investment if it were depreciated constantly. Alternatively,
it can be found out by dividing the total of the investment’s book values after
depreciation by the life of the project. The accounting rate of return, thus, is an
average rate and can be determined by the following equation:
In Equation , average income should be defined in terms of earnings after taxes
without an adjustment for interest, viz., EBIT (1 – T) or net operating profit after tax.
Thus:

where EBIT is earnings before interest and taxes, T tax rate, I0 book value of
investment in the beginning, In book value of investment at the end of n
number of years.
ILLUSTRATION 8.6: Accounting Rate of Return
A project will cost `40,000. Its stream of earnings before depreciation, interest and taxes
(EBDIT) during first year through five years is expected to be `10,000, `12,000, `14,000,
`16,000 and `20,000. Assume a 50 per cent tax rate and depreciation on straight-line
basis. Project’s ARR is computed in Table 8.4.
A variation of the ARR method is to divide average earnings after taxes by the original
cost of the project instead of the average cost. Thus, using this version, the ARR in
Illustration 8.6 would be: `3,200 ÷ `40,000 × 100 = 8 per cent.

Acceptance Rule
As an accept-or-reject criterion, this method will accept all those projects whose ARR is
higher than the minimum rate established by the management and reject those
projects which have ARR less than the minimum rate.
This method will rank a project as number one if it has highest ARR and lowest rank
would be assigned to the project with lowest ARR.
 Evaluation of ARR Method
The ARR method may claim some merits:
✔ Simplicity The ARR method is simple to understand and use. It does not involve
complicated computations.
✔ Accounting data The ARR can be readily calculated from the accounting data; unlike
in the NPV and IRR methods, no adjustments are required to arrive at cash flows of
the project.
✔ Accounting profitability The ARR rule incorporates the entire stream of income in
calculating the project’s profitability.
✔ The ARR is a method commonly understood by accountants, and frequently used as
a performance measure.
 Evaluation of ARR Method
As a decision criterion, however, it has serious shortcomings.
✔ Cash flows ignored The ARR method uses accounting profits, not cash flows, in
appraising the projects. Accounting profits are based on arbitrary assumptions
and choices and also include non-cash items. It is, therefore, inappropriate to
rely on them for measuring the acceptability of the investment projects.
✔ Time value ignored The averaging of income ignores the time value of money.
In fact, this procedure gives more weightage to the distant receipts.
✔ Arbitrary cut-off The firm employing the ARR rule uses an arbitrary cut-off
yardstick. Generally, the yardstick is the firm’s current return on its assets (book-
value).
 Evaluation of ARR Method

Because of this, the growth companies earning very high rates on their
existing assets may reject profitable projects (i.e., with positive NPVs) and the
less profitable companies may accept bad projects (i.e., with negative NPVs).
The ARR method continues to be used as a performance evaluation and
control measure in practice. But its use as an investment criterion is certainly
undesirable. It may lead to unprofitable allocation of capital.