Capital Budgeting Techniques - Analysis

1.CAPITAL BUDGETING TECHNIQUES are explained as follows:

a. Payback (Pb) Rule: This is the most basic rule/technique of capital budgeting, where one determines the time period in which the periodic cash flows will be able to completely recover the initial investment of a particular project. In simple words, how long it takes to recover its initial investments?

Pb Period = No. of Years to recover Initial Outlay = Initial Cash Outlay / Future Cash Inflows.

According to this approach, the shorter the time period, the more attractive is the investment proposal.

Advantages:

i. Easy to use and understand.

ii. The decision is based to the both short-term and long-term cash flows. Thus it may be used as a measure of liquidity.

Disadvantages:

i. Considers the cash flows in absolute terms and ignores the concept of Time Value of Money (TVM).

ii. Completely ignores the cash flows after the payback period. Thus it is biased against the long-term projects.

iii. It also ignores the NPV of a project. A project might be selected on the basis of Payback Rule, but it might have a negative NPV.

This approach is very traditional & basic and it is hardly used in practice, nowadays.

b. Net Present Value (NPV) : NPV of a project is the present value of the net cash flows, as deducted/subtracted by the initial cash outlay. Under the NPV approach, first the net cash flows are discounted to their present values and then they are compared with the initial capital outlay. The difference between the two values is NPV.

NPV = Sum of PV if Future Cash Flows (net) – Initial Cash Outlay

If the NPV, as calculated above is zero or positive then the project is accepted. Otherwise, it is rejected (i.e. when the NPV is negative).

In case of multiple investment proposals, project with highest NPV is selected.

Advantages:

i. It considers all the cash flows.

ii. It takes into account the time value for money.

iii. Under this approach, cash flows are assumed to be reinvested at a hurdle/discount rate, which is a rational business practice.

iv. It estimates the PV of cash flows using a discount rate equal to the cost of capital.

Disadvantages:

i. It is difficult to ascertain and understand the concept of cost of capital.

ii. This approach ignores many of the qualitative/managerial factors, which are important for a project evaluation.

This approach is the primary and most commonly used technique of capital budgeting.

c. Internal Rate of Return (IRR): IRR is that discount rate at which the present value of all future net cash flows equals the initial cash outflow of the project. In other words, IRR is the discount rate where NPV is equal to zero.

At IRR, NPV = Sum of PV if Future Cash Flows (net) – Initial Cash Outlay = 0

It is a trial and error method, where different discount rates are used, till it gives a zero NPV.

An investment proposal is selected, where the IRR exceeds the required rate of return. In case of multiple investment proposals, the project with highest IRR is selected.

Advantages:

i. The advantages of this approach are the similar as in NPV approach.

ii. The calculation of cost of capital is not a pre-requisite under this approach.

iii. It is easy to understand and communicate

Disadvantages:

i. It is a trial and error method; hence it is complicated to adopt.

ii. There might be multiple IRR for a given project. It is difficult determine IRR with accuracy.

iii. It does not distinguish between investing and borrowings. Hence there are problems, where there are mutually exclusive investments.

This approach is an extension to the NPV approach only, except the fact it is subjective in nature.

d. Profitability Index (PI) : PI is the ratio of the present value of net future cash inflows TO the initial cash outflow of the project.

PI = Sum of PV of Future Cash Inflows / Initial Cash Outlay.

The project having PI greater than 1 is selected. Where there are more than one investment alternative, project with highest PI is selected.

Advantages:

i. All mentioned as in NPV approach.

ii. Allows comparisons of different scale of projects. Hence it enables correct decision when evaluating independent projects.

iii. This technique is effective when the available investible funds are limited.

iv. It is simple to understand and communicate.

Disadvantages:

i. Same as in NPV approach.

ii. Ranking problem may occur in case of mutually exclusive problems.

iii. It provides only relative profitability.

2. EXAMPLES ON CAPITAL BUDGETING TECHNIQUES

a. Payback (Pb) Rule:

Project costs $1000, pays back$ 300 per year

Payback = 3.33 years

b. Net Present Value (NPV):

PV = $400(0.9091) + $400(0.8264) + $400(0.7513)
= $363.64 + $330.56 + $300.52
= $994.72

NPV = $994.72 - $800.00
= $194.72

c. Internal Rate of Return (IRR):

then the IRR () is given by

In this case, the answer is 14.3%.

Second Example

What is the IRR of an equal annual income of $20 per annum which accrues for 7 years and costs $120?

= 6

From the tables = 4%

d. Profitability Index (PI):

Investment = $40000/-

Life = 5 years.

PI = 43679 / 40000

= 1.091

= >1

= Accept the project

3. EVALUATION OF A CAPITAL BUDGETING TECHNIQUES

Out of all the capital budgeting techniques, NPV technique is the most ideal technique, since it satisfies all the criteria of ideal technique.

a. Use cash flows and not earning

b. Consider ALL relevant cash flows.

c. Accounts for the time value of money.

d. Able to correctly select among mutually exclusive projects.

e. Have a consistent and easy to apply decision rule.

f. If properly applied lead to higher shareholder value.

g. Relatively easy to explain and understand.

Hence NPV technique is the most superior of all the techniques.