TECHNIQUES OF CAPITAL BUDGETING

 TECHNIQUES OF CAPITAL BUDGETING 

PAYBACK PERIOD: This method is used to know how much time it will take to recover the investment. Payback is the number of years required to recover the original cash outlay invested in a project.

If the project generates constant annual cash inflows. the payback period can be computed by dividing cash outlay by the annual cash inflow. 

FORMULA 

Payback = Initial Investment/ Annual Cash Inflow

EXAMPLE 

Assume that a project requires an outlay of Rs 50,000 and yields annual cash inflow of Rs 12,500 for 7 years. The payback period for the project is:

PB = Rs 50,000/ 12,000 =Rs 4 years

YOU CAN ALSO READ :- PYQ FINANCIAL MANAGEMENT 

ADVANTAGES OF PAYBACK PERIOD

- Simple to use and easy to understand

-Quick solution

- The formula is straightforward to know and calculate

- Helps in project evaluation quickly.

- It helps in reducing the risk of losses.

DISADVANTAGES OF PAYBACK PERIOD 

- Doesn't take into consideration X the inflow of cash after the payback period.

- It doesn't take time value of money into consideration.

- Ignores Time Value of Money

- Not all cash flows covered

- Not realistic & ignores profitability

YOU CAN ALSO READ :- CAPITAL BUDGETING 

 DISCOUNTED PAYBACK PERIOD:  Same as payback period method. Only difference is that it considers discounted cash flows.

ACCOUNTING RATE OF RETURN: It is an accounting technique to measure profit expected from an investment.

The accounting rate of return is the ratio of the average after-tax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly.

FORMULA

ARR= Average income /Average investment

A variation of the ARR method is to divide average earnings after taxes by the original cost of the project instead of the average cost.

Acceptance Rule

This method will accept all those projects whose ARR is higher than the minimum rate established by the management and reject those projects which have ARR less than the minimum rate.

This method would rank a project as number one if it has highest ARR and lowest rank would be assigned to the project with lowest ARR.

Evaluation of ARR Method

1.The ARR method may claim some merits

2.Simplicity

3.Accounting data

4..Accounting profitability

5.Serious shortcoming

ADVANTAGES OF ARR

1. It is simple and easy to calculate.

2. It takes into account all the savings over the entire period of investment.

3. It is based on accounting profit rather than cash inflow. Accounting profit can be easily obtained from financial statements.

4.Easy to compare with target and or other investment projects

DISADVANTAGES OF ARR

- Is based on profit and not Cash Inflows. So affected by non cash items such as depreciation

- Ignores timing of profit

PROFITABILITY INDEX:  It defines how much you will earn per dollar.

                                                  OR

Profitability index is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment.

FORMULA

EXAMPLE 

The initial cash outlay of a project is Rs 100,000 and it can generate cash inflow of Rs 40,000 Rs 30,000, Rs 50,000 and Rs 20,000 in year 1 through 4. Assume a 10 per cent rate of discount. The PV of cash inflows at 10 per cent 

discount rate is: PV=R S 40,000000(PVF 1,0,10 )+ R 30,0,0000(PVF 2,0,10 )+ R 3,50,000(PVF 2,0,0,10 )+R*20,00000000VF 4,0,10 ) *R 3 40.000*0.909+R 3 .30.09*0.26+R 5 S0.000*0.751*R5.20.000*0.68 NPV=Rs112,350-Rs 100,000-Rs12,350

Pl= Rs 1;12 350 Rs 1,00,0000 =1.1235

Acceptance Rule

The following are the P, acceptance rules:

* Accept the project when Pl is greater than one. p  >1

* Reject the project when Pl is less than one. PI <1  

* May accept the project when Pl is equal to one. p =1

The project with positive NPV will have Pl greater than one. Pl less than means that the project's NPV is negative.

Evaluation of PI Method

It recognises the time value of money. It is consistent with the shareholder value maximisation principle. A project with PI greater than one will have positive NPV and if accepted, it will increase shareholders' wealth.

In the PI method, since the present value of cash inflows is divided by the initial cash outflow, it is a relative measure of a project's profitability.

Like NPV method, Pl criterion also requires calculation of cash flows and estimate of the discount rate. In practice, estimation of cash flows and discount rate pose problems.

ADVANTAGES OF PROFITABILITY INDEX

- Accept or Reject a Project

- Assist in Choosing Projects that Fit within the Budget.

- Closely related to NPV, generally leading to identical decisions.

- Easy to understand and communicate

- May be useful when available investment funds are limited

DISADVANTAGES PROFITABILITY INDEX

-  Ignoring Sunk Cost 

- Difficulty in Determining the Required Rate of Return

- Optimistic Projections

-  Estimating Opportunity Cost

- Different Lives of Different Projects

- May lead to incorrect decisions in comparisons of mutually exclusive investments

INTERNAL RATE OF RETURN : It brings the cost of the project & its future cash flow at par with the initial investment

The internal rate of return (IRR) is the rate that equates the investment outlay with the present value of cash inflow received after one period. This also implies that the rate of return is the discount rate which makes NPV = 0.

Calculation of IRR

Uneven Cash Flows: Calculating IRR by Trial and Error

The approach is to select any discount rate to compute the present value of cash inflows.

 If the calculated present value of the expected cash inflow is lower than the present value of cash outflows, a lower rate should be tried. 

On the other hand, a higher value should be tried if the present value of inflows is higher than the present value of outflows. 

This process will be repeated unless the net present value becomes zero.

Acceptance Rule

Accept the project when r>k.

Reject the project when r<k.

May accept the project when r = k.

In case of independent projects, IRR and NPV rules will give the same results if the firm has no shortage of funds.

Evaluation of IRR Method

IRR method has following merits:

- Time value Profitability measure

-Acceptance rule

- Shareholder value

IRR method may suffer from:

Multiple rates Mutually exclusive projects

Value additivity

ADVANTAGES OF IRR 

1. Time Value of Money is being considered while calculating IRR.

2. No requirement of finding Hurdle Rate / Required Rate of Return

3.  Simple to interpret after the IRR is calculated.

DISADVANTAGES OF IRR 

1. Economies of Scale is ignored

2. .If later cash inflows are not sufficient to cover initial investment calculation of IRR is not possible

3. Dependent or contingent project are being ignored while calculating IRR.

4. Mutually exclusive project are ignored.

5. Different terms of project is not considered by IRR method

YOU CAN ALSO READ:- CAPITAL BUDGETING 

NET PRESENT VALUE : It is the sum of all future discounted cash-flow less initial investment.Cash flows of the investment project should be forecasted based on realistic assumptions.

Appropriate discount rate should be identified to discount the forecasted cash flows. The appropriate discount rate is the project's opportunity cost of capital.

Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate.

The project should be accepted if NPV is positive (i.e., NPV > 0).

Net present value should be found out by subtracting present value of cash outflows from present value of cash inflows. The formula for the net present value can be written as follows:

Acceptance Rule

Accept the project when NPV is positive NPV > 0

Reject the project when NPV is negative NPV <0

May accept the project when NPV is zero NPV = 0

The NPV method can be used to select between mutually exclusive projects; the one with the higher NPV should be selected.

FORMULA 

NPV= Rt/(1 + i)

NPV = net present value

Rt= net cash flow at time t

i= discount rate

t= time of the cash flow

ADVANTAGES OF NPV 

- Accounts for the time value of money

- Uses cash flows, not accounting profit

- Takes into account timing and amount of project cash flows

- Takes account of all relevant cash flows over the life of a project

DISADVANTAGES OF NPV 

- Accepting all projects with positive NPV only possible in a perfect capital market

- Cost of capital may be difficult to find

- Cost of capital may change over project life, rather than being constant

Modified Internal Rate of Return (MIRR)

The modified internal rate of return (MIRR) is the compound average annual rate that is calculated with a reinvestment rate different than the project's IRR. 

The modified internal rate of return (MIRR) is the compound average annual rate that is calculated with a reinvestment rate different than the project's IRR.

HOW TO CALCULATE ?

The Modified IRR can be calculated using four simple steps as provided under:

. Discount all the negative cash flows at firm's financing cost and add them.

Compounds all the positive cash flows at the firm's cost of capital and add them.

. Now, we have one initial cash outlay on year 0 and one future cash inflow at the end the last year. Assume all the cash flows in between as 0.

. Calculate normal Internal Rate of Return (IRR)