Advantages and Disadvantages of Capital Budgeting Techniques

This document discusses the advantages and disadvantages of capital budgeting techniques such as net present value, payback period, accounting rate of return, and internal rate of return. It explains how these techniques are used to analyze the profitability and risk of investment projects. The document also highlights the benefits and limitations of each technique.

FINANCIAL MANAGEMENT

Introduction......................................................................................................................................2
(a) Calculation.............................................................................................................................2
(b) Evaluating the advantages and the disadvantages of the capital budgeting techniques.........3
REFERENCES................................................................................................................................6
Books and journals......................................................................................................................6

Introduction
Question 3
(a) Calculation
Year Annual cash
inflow
Annual cash
outflow
Less:
depreciation
EBIT/EBT/EAT Add:
depreciation
Cash
inflow
1 105000 15500 64000 25500 64000 89500
2 105000 15500 51200 38300 51200 89500

3 105000 15500 40960 48540 40960 89500
4 105000 15500 32768 56732 32768 89500
5 105000 15500 26214.4 63285.6 26214.4 89500
6 105000 15500 20971.52 68528.48 20971.52 89500
i. Payback period-
Year Cash inflow
1 89500 89500
2 89500 179000
3 89500 268500
4 89500 358000
5 89500 447500
6 173386.08 620886.08
3
51500
0.6
Payback period 3.6 years
ii. Accounting rate of return-
iii. Net present value-
Year Cash inflow PV factor @ 12%
1 89500 0.893 79910.71429
2 89500 0.797 71348.85204
3 89500 0.712 63704.33218
4 89500 0.636 56878.86802
5 89500 0.567 50784.70359
6 173386 0.507 87842.78411
Sum of discounted cash
flows
410470
Less: initial investment 320000
NPV 90470
iv. Internal rate of return-
Year Cash inflow
0 -320000
1 89500
2 89500
3 89500
4 89500
5 89500

6 173386.08
21%
(b) Evaluating the advantages and the disadvantages of the capital budgeting techniques.
Net present value- It refers to the difference in between the present value of the cash
inflows and outflows. It is been used in the capital budgeting for analyzing the profitability in
respect of the investment project (Alkaraan, 2017). Positive net present value describes that the
project is profitable and the negative net present value associated with the investment results in
unprofitable outcomes. NPV is computed by subtracting the cash outflows from the cash inflows.
Benefits Limitations
 Net present value provides more
importance to time value of the money
factor.
 At the time of making the calculation
under NPV, both the cash flow values
are considered that is before and after
over the time period of project.
 Under this technique, High priority is
been given to the profitability and the
risk of the proposal.
 It helps in enhancing the value of the
firm in the overall market as it indicates
the profitability that will be generated
from the project in which the company
has made investments.
 Net present value is a difficult and time
consuming method because it requires
assessment of all the cash inflows and
outflows of the project.
 It does not facilitate accurate results if
the investment amount of the mutually
exclusive proposal is not been equal.
 While assessing the net present value
for the project, it creates difficulty in
calculating the discount rate
appropriately.
 At the time when the project is of an
unequal life, net present value does not
provide the correct decision making.
Payback period- It means the length of the time that is required for recovering the cost of
the investment. It is stated as the time taken by the investment for reaching to the break-even
point. The desirability of the particular investment is been directly relates to the payback period.
The lesser the time of the payback reflects that the investment made is more attractive
(Mahmoud and Neale, 2016). The concept of payback is been generally used within the financial
and the capital budgeting. It is also used for determining cost savings from the technology that is
energy efficient.
Benefits Limitations
 This method is easy to use and simple
to understand as it needs few inputs for
the calculation in comparison to the
other investment appraisal technique.
 It helps the managers in making quicker
 Payback period ignores time value of
money which is been considered as the
most important concept for the
business.
 It considers the cash flow till the

decisions as they could be able to
calculate the payback period quickly.
recovery of the initial investment and
fails to consider cash flow in the
subsequent years.
 It ignores the analysis of the
profitability as shorter payback does
not depict that the project will generate
profits (Sangster, 1993). This results
the project to unviable condition after
the ending of the payback period.
Accounting rate of return- It refers to the percentage return rate that is expected to
receive on an investment or the asset in comparison with the cost of initial investment.
Accounting rate of return divides the average revenue from the asset by enterprise initial
investments in order to derive the ratio or the return that is expected over life of the asset
(Ashford, Dyson and Hodges, 1988). It does not consider time value of the money which is an
integral part for maintaining the business.
Benefits Limitations
 Accounting rate of return is based on
the accounting information and thus it
does need any other special reports for
determining the rate of return.
 It is easiest to compute and very simple
in understanding.
 This technique is based on the
accounting profit and hence helps in
measuring profitability from the
investment.
 It ignores time value of money concept
which is essential for knowing the
accurate estimations in the future.
 It also ignores the cash flow generated
from the investment.
 Accounting rate of return method do
not consider the terminal value of
project.
Internal rate of return- It is the metric that is used in the capital budgeting for estimating
profitability of the potential investments. It is rate of discount which makes net present value for
all the cash flows from the specific project that equates to zero (Ballantine and Stray, 1998). For
assessing the future growth and the expansion, internal rate of return is been computed.
Benefits Limitations
 The foremost and the important benefit
of this technique is that it considers the
tie value of the money at the time
evaluating the project.
 It is very easy to interpret this method
after the calculation of the IRR. If the
cost of capital is less than the IRR, then
the project will be accepted.
 Economies of the scale is the major
component for every business which is
been ignored by this method.
 The assumption regarding the
reinvestment rate is impractical as this
method assumes the positive value of
the future cash flows for the remaining
time period.
 It indulges the finance manager for

compulsorily investing into the other
dependent and the contingent projects.

REFERENCES
Books and journals
Alkaraan, F., 2017. Strategic investment appraisal: multidisciplinary perspectives. In Advances
in Mergers and Acquisitions (pp. 67-82). Emerald Publishing Limited.
Ashford, R. W., Dyson, R. G. and Hodges, S. D., 1988. The capital-investment appraisal of new
technology: problems, misconceptions and research directions. Journal of the Operational
Research Society. 39(7). pp.637-642.
Ballantine, J. and Stray, S., 1998. Financial appraisal and the IS/IT investment decision making
process. Journal of Information Technology. 13(1). pp.3-14.
Mahmoud, O. and Neale, B., 2016. Managerial judgment factors and the real options approach in
the investment appraisal process: evidence from UK automotive firms. International Journal of
Business and Social Science. 7(5). pp.71-84.
Sangster, A., 1993. Capital investment appraisal techniques: a survey of current usage. Journal
of Business Finance & Accounting. 20(3). pp.307-332.