Capital budgeting decision

NON DISCOUNTED CASH-FLOWS METHODS

1. Payback period

This determines the period it takes for an investment to generate sufficient incremental cash to realize its capital outlay. Determination of payback period depends on the nature of cash flows which may either be:

a. uniform or even

b. varying or uneven over the useful life of the investment.

For a uniform cash-flow pattern the payback period is calculated as follows

Initial outlay

PBP=

Annual cash flow

Acceptance criteria

Under this technique the PBP determined for the investment should be shorter than the useful life of the investment or at least equal to the PBP desired by the firm for that category of investment. When evaluating different projects, the most viable is the one with the shortest PBP.

EXAMPLE 2

Constant cash flow

An investment of initially out lay of Tshs400m/= generates uniform cash inflows of Tshs100m/= per year and the useful life of this investment is 6years. Evaluate the project using PBP.

SOLUTION

PBP= 400,000,000 = 4 years

100,000,000

The project is viable because the PBP is shorter than the useful life of the project.

Unequal cash flows

In case of unequal cash inflows, the payback period can be found out by accumulating the cash inflows until the total is equal to the initial cash outlay.

ADVANTAGES OF PBP

• It uses cash-flows information which is relevant information for the objective of the firm
• It is a simple technique to understand.
• It costs less than other methods in terms of time and cost.

DISADVANTAGES OF PBP

• It ignores inflation i.e. time value of money.
• It does not consider all cash flows. The technique ignores cash-flows after the PBP.
• 3. Uniformity of conditions is unrealistic

ACCOUNTING RATE OF RETURN [ARR]