CAPITAL BUDGETING

# CAPITAL BUDGETING - Management Science-II Prof. R.Madumathi...

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Management Science-II Prof. R.Madumathi Indian Institute of Technology Madras MODULE 2 Capital Budgeting Capital Budgeting is a project selection exercise performed by the business enterprise. Capital budgeting uses the concept of present value to select the projects. Capital budgeting uses tools such as pay back period, net present value, internal rate of return, profitability index to select projects. Capital Budgeting Tools Payback Period Accounting Rate of Return Net Present Value Internal Rate of Return Profitability Index Payback Period Payback period is the time duration required to recoup the investment committed to a project. Business enterprises following payback period use "stipulated payback period", which acts as a standard for screening the project.

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Management Science-II Prof. R.Madumathi Indian Institute of Technology Madras Computation Of Payback Period When the cash inflows are uniform the formula for payback period is cash outflow divided by annual cash inflow Computation Of Payback Period When the cash inflows are uneven, the cumulative cash inflows are to be arrived at and then the payback period has to be calculated through interpolation. Here payback period is the time when cumulative cash inflows are equal to the outflows. i.e., Payback Reciprocal Rate The payback period is stated in terms of years. This can be stated in terms of percentage also. This is the payback reciprocal rate. Reciprocal of payback period = [1/payback period] x 100
Management Science-II Prof. R.Madumathi Indian Institute of Technology Madras Decision Rules A. Capital Rationing Situation Select the projects which have payback periods lower than or equivalent to the stipulated payback period. Arrange these selected projects in increasing order of their respective payback periods. Select those projects from the top of the list till the capital Budget is exhausted. Decision Rules C. Mutually Exclusive Projects In the case of two mutually exclusive projects, the one with a lower payback period is accepted, when the respective payback periods are less than or equivalent to the stipulated payback period. Determination Of Stipulated Payback Period Stipulated payback period, broadly, depends on the nature of the business/industry with respect to the product, technology used and speed at which technological changes occur, rate of product obsolescence etc. Stipulated payback period is, thus, determined by the management's capacity to evaluate the environment vis-a-vis the enterprise's products, markets and distribution channels and identify the ideal- business design and specify the time target.

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Management Science-II Prof. R.Madumathi Indian Institute of Technology Madras Advantages Of Payback Period It is easy to understand and apply. The concept of recovery is familiar to every decision-maker. Business enterprises facing uncertainty - both of product and
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## This note was uploaded on 03/04/2011 for the course HR 303 taught by Professor Sanghamitra during the Fall '05 term at Indian Institute of Technology, Chennai.

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CAPITAL BUDGETING - Management Science-II Prof. R.Madumathi...

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