What is the method of capital budgeting in discounted – payback period?
The capital budgeting procedure is known as discounted payback. The profitability of a project is determined through it. A period called the discounted payback period is given by undertaking the initial expenditure by discounting future cash flows and recognizing the time value of the money.
A method in which the time value of the money becomes an upgraded version of the simple payback period method is called the discounted payback method. This method is used by the companies to assess the benefit of undertaking a particular project of the business.
Below mentioned are some of the different methods used in the capital budgeting:
- The traditional method or Non-Discount method- It includes the payback period method and accounting rate of return method.
- Discounted cash flow method- It includes the NPV method, Profitability method and IRR method.
Payback period method
It is a period in which the proposal helps to generate cash to recover the investment made initially. It mainly focuses on the cash inflows, the economic life of the project, the investment made in the project and no consideration is given to the time value of the money.
Payback period= cash outlay ( investment)/ Annual cash inflow
Accounting rate of return method or ARR method
The disadvantages in the payback period method are corrected by this method. The rate of return usually expresses the percentage of the earning of the investments in a particular project. It is based on the condition that that is any project having ARR higher the minimum rate established by the manager will be considered, and those below the predetermined price are rejected.
ARR= Average income/Average investment
Discounted cash inflow method
The cash inflows and outflows through the life on an asset are calculated by this method.
Net present value method
The method which is used to evaluate the capital investment proposal is known as the net present value. The cash inflow that is expected at the various periods of the era and is discounted at a special rate. The original investment value is compared to the present amount of cash inflow. If the difference between them is positive (+), then accept it, if the difference is negative (-), rejected it.
NPV= PVB- PVC
The meaning of PVB is the present value of the benefit
The meaning of PVC present value of cost
Internal rate of return or IRR method
This method is defined as the rate at which the net present value of the investment is zero.
The discounted cash inflow=discounted cash outflow
Profitability index method
At the required rate of return, the ratio of the present value cash benefit to the initial cash outflow of the investment.
PI= Present value of cash inflow/initial cash outlay
PI= NPV (benefits)/NPV (cost)