Introduction

Background
Capital budgeting is the process in which a business determines and
evaluates potential expenses or investments that are large in nature. These
expenditures and investments include projects such as building a new plant
or investing in a long-term venture. Often times, a prospective project's
lifetime cash inflows and outflows are assessed in order to determine
whether the potential returns generated meet a sufficient target benchmark,
also known as "investment appraisal."
Many formal methods are used in capital budgeting, including the techniques
such as

Accounting rate of return

Average accounting return

Payback period

Net present value

Profitability index

Internal rate of return

Modified internal rate of return

Equivalent annual cost

Real options valuation

These methods use the incremental cash flows from each potential
investment, or project. Techniques based on accounting earnings and
accounting rules are sometimes used - though economists consider this to be
improper - such as the accounting rate of return, and "return on investment."
Simplified and hybrid methods are used as well, such as payback
period and discounted payback period.

Types of Capital Budgeting Decession

Identify several basic methods used by businesses to evaluate projects and
to decide whether they should be accepted for inclusion in the capital
budget. These methods are; Payback period, net present value and internal
rate of return. The payback period method is a non discounting technique
since it does not consider the time value of money. NPV and IRR are referred
to as discounting techniques since they take into account time value of
money.

1. Pay Back Period

Define payback period as the number of years required to recover the
original investment. Its the simplest and the oldest formal method used to
evaluate capital budgeting method. Using the pay back to make capital
budgeting decisions is based on the concept that its better to recover the
cost of a project sooner rather than later. As a general rule a project is
considered acceptable if its payback period is less than the maximum cost
recovery time established by the firm. The major limitations of this method
are the failure to recognize the time value of money and cash flows beyond
the payback period.
Payback period =initial cash outlay
Annual cash inflows

2. Net present Value

Defines NPV as a method of evaluating capital investment proposals by
finding the present value of future net cash flows discounted at a rate
of return required by the firm. To implement this approach, we find the
present value of all future cash flows a project is expected to generate
and then subtract its initial investment to find the net benefit the firm
will realize from investing in the project. If the net benefit computed on
a present value basis is positive, then the project is considered
acceptable investment. The advantage of this method is that it
recognizes the time value of money.

3. Internal Rate of Return (IRR)

IRR is the discount rate that equates the PV of the cash inflows with initial
investment associated with the project. As long as the projects IRR is greater
than the rate of return required by the firm for such an investment, the
project is accepted. The technique has two major limitations. First, when a
project has unconventional cash flow patterns, there is a likelihood of getting
multiple IRRs. This is because there exists an IRR solution for each time the
direction of the cash flows associated with a project changes. Secondly, in the
case of mutually exclusive projects, the technique can result in the
acceptance of the lesser viable project. This is because the IRR method
assumes that the interim cash flows are reinvested at the projects discount
rate. (Bringham & Besley, 2000)

IRR :

CFt
n
$0 NPV

t 0 1 IRR t

4. Profitability Index
The profitability index is an index that attempts to identify the
relationship between the costs and benefits of a proposed project
through the use of a ratio calculated as:

PV of future cash flows/Investment

A ratio of 1.0 is logically the lowest acceptable measure on the index,
as any value lower than 1.0 would indicate that the project's PV is less
than the initial investment. As values on the profitability
index increase, so does the financial attractiveness of the proposed
project.

http://www.engropolymer.com/investors/pdfs/Engro-AR-2015.pdf