Benefit to cost ratio is used to calculate the NPV in a proportion or ratio format. Here, the present value of future cash flows is calculated on proportion method, though, the method of calculation is similar to NPV method.
Benefit to cost= Present value of investment/ present value (PV) of future inflows.
If the ratio is more than 1, the project is considered for implementation and if it is less than 1, the proposal may be rejected.
Suppose, the proposed investment is Rs.200 crore and present value (PV) of future inflows works out to Rs.250 crore. In this case, the NPV would be positive by Rs.50 crores and hence, the company may accept the project for implementation. If the present value of future revenue works out to Rs.150 Crore, the NPV would be negative by Rs.50 crore.
From the above example, we observe that benefit to cost ratio is 1.25 in the first case and as per the rule, the project should be executed and in the second example, the ratio is 0.75 which is less than 1, so the project is likely to be rejected.
Payback period: In the above example, let us presume the revenue stream of Rs.50 crore considered for the first 5 years. Then, the payback period is 200/50 = 4 years. In effect, during the period of first 4 years, the company gets its investment back and revenue after this period is the profit for the company. Payback period is the method of evaluation where no discounting of cash flow comes into play.
Related articles:
- What is capital budgeting?
- What are NPV, IRR, DCF, Hurdle rate, Accounting rate of return in capital budgeting?
