PAY BACK METHOD:

Unlike net present value method and internal rate of return method, payback method does not

consider the present value of cash flows. Under this method, an investment project is accepted or
rejected on the basis of payback period. Payback period means the period of time that a project

requires to recover the money invested in it. The payback period of a project is expressed in years
and is computed using the following formula:
Formula of payback period:

According to this method, the project that promises a quick recovery of initial investment is

considered desirable. If the payback period of a project computed by the above formula is shorter
than or equal to the managements maximum desired payback period, the project is accepted

otherwise it is rejected. For example, if a company wants to recoup the cost of a machine within 5
years of purchase, the maximum desired payback period of the company would be 5 years. The
purchase of machine would be desirable if it promises a payback period of 5 years or less.
Consider the following example to understand the analysis of a project under this method:

Example 1:

Due to increased demand, the management of Rani Beverage Company is considering to

purchase a new equipment to increase the production and revenues. The useful life of the

equipment is 10 years and the companys maximum desired payback period is 4 years. The
inflow and outflow of cash associated with the new equipment is given below:
The initial cost of equipment
Annual cash inflow:
Sales
Annual cash outflow:
Cost of ingredients
Salaries expenses
Maintenance expenses
Non cash expenses:
Depreciation

$37,500
$75,000
$45,000
$13,500
$1,500
$5,000

Required: Should Rani Beverage Company purchase the new equipment? Use payback method
for your answer.

Solution:

Step 1: In order to compute the payback period of the equipment, we need to workout the net

annual cash inflow by deducting the total of cash outflow from the total of cash inflow associated
with the equipment.
Computation of net annual cash inflow:

$75,000 ($45,000 + $13,500 + $1,500)

= $15,000
Step 2: Now, the amount of investment required to purchase the equipment would be divided by
the amount of net annual cash inflow (computed in step 1) to find the payback period of the
equipment.

= $37,500/$15,000

=2.5 years
Depreciation is a non cash expense and therefore has been ignored.

According to payback method, the equipment should be purchased because the payback period
of the equipment is 2.5 years which is shorter than the maximum desired payback period of the
company.

Advantages and disadvantages of payback method:

Advantages:

An investment project with a short payback period promises the quick inflow of cash. It is
therefore, a useful capital budgeting method for cash poor firms.
A project with short payback period can improve the liquidity position of the business quickly.
The payback period is important for the firms for which liquidity is very important.
An investment with short payback period makes the funds available soon to invest in another
project.
A short payback period reduces the risk of loss caused by changing economic conditions and
other unavoidable reasons.
Payback period is very easy to compute.

Disadvantages:

The payback method does not take into account the time value of money.
It does not consider the useful life of the assets and inflow of cash after payback period. For
example, If two projects, project A and project B require an initial investment of $5,000. Project A
generates an annual cash inflow of $1,000 for 5 years whereas project B generates a cash inflow
of $1,000 for 7 years. It is clear that the project B is more profitable than project A. But according
to payback method, both the projects are equally desirable because both have a payback period
of 5 years ($5,000/$1,000).

NET PRESENT WORTH METHOD

Net present value method (also known as discounted cash flow method) is a popular capital

budgeting technique that takes into account the time value of money. It uses net present value of
the investment project as the base to accept or reject a proposed investment in projects like

purchase of new equipment, purchase of inventory, expansion or addition of existing plant assets
and the installation of new plants etc.

First, I would explain what is net present value and then how it is used to analyze investment
projects.

Net present value (NPV):

Net present value is the difference between the present value of cash inflows and the present
value of cash outflows that occur as a result of undertaking an investment project. It may be

positive, zero or negative. These three possibilities of net present value are briefly explained

below:

Positive NPV:

If present value of cash inflows is greater than the present value of the cash outflows, the net

present value is said to be positive and the investment proposal is considered to be acceptable.

Zero NPV:

If present value of cash inflow is equal to present value of cash outflow, the net present value is
said to be zero and the investment proposal is considered to be acceptable.

Negative NPV:

If present value of cash inflow is less than present value of cash outflow, the net present value is
said to be negative and the investment proposal is rejected.

Assumptions:

The net present value method is based on two assumptions. These are:
The cash generated by a project is immediately reinvested to generate a return at a rate that
is equal to the discount rate used in present value analysis.
The inflow and outflow of cash other than initial investment occur at the end of each period.

Advantages and Disadvantages:

The basic advantage of net present value method is that it considers the time value of money.
The disadvantage is that it is more complex than other methods that do not consider present

value of cash flows. Furthermore, it assumes immediate reinvestment of the cash generated by

investment projects. This assumption may not always be reasonable due to changing economic
conditions.

LIFE CYCLE COST ANALYSIS

Life-cycle cost analysis (LCCA) is a tool to determine the most cost-effective option

among different competing alternatives to purchase, own, operate, maintain and, finally,

dispose of an object or process, when each is equally appropriate to be implemented on

technical grounds. For example, for a highway pavement, in addition to the initial

construction cost, LCCA takes into account all the user costs, (e.g., reduced capacity at
work zones), and agency costs related to future activities, including future periodic

maintenance and rehabilitation. All the costs are usually discounted and total to a present

day value known as net present value (NPV). This example can be generalized on any type
of material, product, or system.

In order to perform a LCCA scoping is critical - what aspects are to be included and what

not? If the scope becomes too large the tool may become impractical to use and of limited

ability to help in decision-making and consideration of alternatives; if the scope is too small

then the results may be skewed by the choice of factors considered such that the output

becomes unreliable or partisan. Usually the LCCA term implies that environmental costs are
not included, whereas the similar Whole-Life Costing, or just Life Cycle Analysis (LCA),
generally has a broader scope, including environmental costs.

RETURN ON INVETSMENT
A performance measure used to evaluate the efficiency of an investment or to
compare the efficiency of a number of different investments. ROI measures the
amount of return on an investment relative to the investments cost. To calculate
ROI, the benefit (or return) of an investment is divided by the cost of the investment,
and the result is expressed as a percentage or a ratio.
The return on investment formula:

In the above formula, "Gain from Investment refers to the proceeds obtained from
the sale of the investment of interest. Because ROI is measured as a percentage, it
can be easily compared with returns from other investments, allowing one to
measure a variety of types of investments against one another.

METHODS OF DEPRECIATION
Depreciation Calculation Methods
Various depreciation calculation methods are mentioned below:
i. Base Method
ii. Declining Balance Method
iii. Maximum Amount Method
iv. Multi Level Method
v. Period Control Method
i. Base Method
Base method primarily specifies:

The Type of depreciation (Ordinary/ Special Depreciation)

Depreciation Method used (Straight Line/ Written Down value Method)

Treatment of the depreciation at the end of Planned useful life of asset or when the Net Book
value of asset is zero (Explained in detail later in other related transactions ).

Straight Line Method (SLM)

This is the simple method of depreciation.

It charges equal amount of depreciation each year over useful life of asset.

It first add up all the costs incurred to bring the asset in use and then it divides that by the
useful life of asset in years to calculate the depreciation expense.

E.g.: Say a Computer costs Rs. 30,000 and Rs. 11,000 (as additional setup/installation/maintenance expenses) = Rs 41,000 and it is anticipated that its scrap value will be
Rs. 1,000 at the end of its useful life, of say, 5 yrs.
Total Cost = Cost of Computer + Installation Exp. + Other Direct Costs
Depreciable Amount over No. of years = Total Cost - Salvage Value (At end of useful life)
30,000 +11,000 =41,000 (Total cost)
41,000 1,000 = 40,000 as the Depreciable Amount
Depreciable Amount = Rs. 40,000, Spread out over 5 years = Rs. 40,000/5(Yrs) = Rs. 8000/depreciation per annum.
Written Down Value Method (WDV)

This method involves applying the depreciation rate on the Net Book Value (NBV) of asset. In
this method, depreciation of the asset is done at a constant rate.

In this method depreciation charges reduces each successive period.

This method should be used in those assets, where high depreciation should be charged in
initial years.

Assume the price of a depreciable asset i.e. computer is Rs. 40,000 and its salvage value
after 10 years is 0.

In this method NBV will never be zero.

Depreciation Per year = (1/N) Previous year's value, Where N= No. of years
So in our example, the depreciation amount during the first year is
[Rs. 40,000*1/10] =Rs. 4,000
NBV of computer after 1st year= Rs 40,000- 4,000 = Rs. 36,000
Depreciation for 2nd year is
[Rs. 36,000*1/10] =Rs. 3,600
Declining Balance Method
This is the other name of Written Down Value (WDV) method as mentioned in Base
method above.If the WDV method is specified in Base method then the following additional
settings in this method can be used:

A multiplication factor for determining the depreciation percentage rate. The system multiplies
the depreciation percentage rate resulting from the total useful life by this factor.

A lower limit for the rate of depreciation. If a lower depreciation percentage rate is produced
from the useful life, multiplication factor or number of units to be depreciated, then the system
uses the minimum percentage rate specified here.

An upper limit for the rate of depreciation.If a higher depreciation percentage rate is produced
from the useful life, multiplication factor or number of units to be depreciated, then the system
uses the maximum percentage rate
Maximum Amount Method
Generally, If we uses Straight line method, then depreciation amount should be same for

all years. But depreciation on asset is subject to change due to many factors e.g. any addition to
the asset, change in estimate of useful life, change in estimate of scrap value etc.hence we use
Maximum amount method.
Multi Level Method
As the name itself suggests, this method provides the flexibility to specify different rate of
depreciation for different years/periods. E.g. in some cases depreciation rate required is different
in initial years and after that the rate should be changed.
Period Control method
It is one of the most relevant method to keep control on the calculation of depreciation.
Here we mention the different rules for periods in case of different scenarios for assets. This
method controls the period for which the depreciation is calculated on an asset during the year

REPLACEMENT ANALYSIS

Replacement Analysis Should we replace an asset that we own now or later?

Reasons for replacing an asset
Physical Impairment
Altered Requirements
Technology
The replacement of assets often represents economic opportunity for the firm. We
compare the two alternatives:
The asset that we own: The Defender
The Asset that we might buy to replace it
The Challenger Factors to consider (or ignore)
Sunk Costs
Existing Asset Value and the outsider viewpoint
Income Tax Considerations
Economic Life of the challenger and The defender
An asset has various types of lives
Useful Life
Tax Life
Economic Life
The Economic Life of an asset is
the period of time that minimizes the net annual cost (NAC) for the investment
(when it primarily consists of costs) o
r the period of time that maximizes the net annual worth (NAW) for the
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investment (when it consists of costs and revenues)

.