Capital Budgeting Methods
Content
EvaluationTechniquestraditionalTechniqu esorNondiscountedCashFlowTechniquesDi scountedPaybackFlowPaybackPeriodAcco untingRateofReturnNetPresentValueBenef itCostRatioInternalRateofReturnTimeAdju CAPITAL BUDGETING stedTechniqueorDiscountedCashEvaluatio METHODS nTechniquesTraditionalTechniquesorNon ADVANCED FINANCIAL MANAGEMENT discountedCashFlowTechniquesDiscounte dPaybackFlowPaybackPeriodAccountingR ateofReturnNetPresentValueBenefitCostRa tioInternalRateofReturnTimeAdjustedTec hniqueorDiscountedCashEvaluationTechni quesTraditionalTechniquesorNondiscount edCashFlowTechniquesDiscountedPaybac kFlowPaybackPeriodAccountingRateofRet urnNetPresentValueBenefitCostRatioInter nalRateofReturnTimeAdjustedTechniqueo rDiscountedCashEvaluationTechniquestra ditionalTechniquesorNondiscountedCashF lowTechniquesDiscountedPaybackFlowPa ybackPeriodAccountingRateofReturnNetP resentValueBenefitCostRatioInternalRateo fReturnTimeAdjustedTechniqueorDiscoun tedCashEvaluationTechniquesTraditional
Gopal K Bhimber M-I-1002 Sep-2013
CAPITAL BUDGETING METHODS
INTRODUCTION
Capital budgeting is one of most important issues confronting a corporate finance manager. Other important aspects like financing, liquidity management, and dividend decisions are also of much significance, but how the allocation of capital is done assumes significance. Capital budgeting reflects the long-term vision, direction and business of the firm. The firms spend considerable time in making such decisions and involve top hierarchy from every functional area. Capital budgeting assumes so much significance due to its following features: They involve relatively long time period between initial cash out flow and expected future cash inflows resulting into long-term consequences; Substantial amount of funds are normally involved in such decisions; Involve a relatively high degree of risk; Are nearly irreversible in nature and can be reversed only after incurring much financial losses. Thus, it can be deduced that capital budgeting decisions are of paramount importance to the firm as its success and growth heavily depends on them. The rationale behind these decisions is to bring in the efficiency in the firm‟s operations. A firm must continuously keep on replacing its worn out and obsolete plants and machinery and acquire new assts for current and future operations. These help a firm in any of two ways, i.e., either by expanding revenues or by reducing costs. But such decisions also come with some inbuilt problems. To name a few, they are: Benefits from investment are received in future period and therefore, involves an element of risk due to uncertainties; Costs incurred and benefits received occur in different time periods, therefore, rendering comparison a difficult and complex job; More often than not, it is very difficult to calculate in quantitative terms all the costs and benefits associated to a specific investment decision. “Capital budgeting is process of selecting best long-term investment projects by evaluating the present alternatives in the light of the share holder‟s wealth maximization objective”
CAPITAL BUDGETING PROCESS
Capital budgeting is a complex process comprising five distinct phases a. Identification of potential investment opportunities or proposal generation; b. Evaluation of available alternative proposals in the light of the objective of shareholders‟ wealth maximization;
[Type text]
c. Selection of best project proposal from amongst the available alternatives or decision making; d. Implementation of the selected project proposal; and e. Performance Review or follow-up. Firms are basically confronted with three types of capital budgeting decisions: (i) Accept-reject decisions: In any capital budgeting project this is the most fundamental decision to make. As a normally accepted principle, all those projects which yield a rate of return greater than required rate of return are accepted and rest stand rejected. This principle allows selection of all independent projects. Mutually Exclusive Project Decisions: Such projects are those which compete with other projects in such a way that selection of one of them renders selection of other projects impossible. Hence, amongst from all projects one giving highest return is selected.
(ii)
(iii) Capital Rationing Decisions: If the firm were having unlimited funds, all the independent projects yielding a rate of return higher than required rate of return would have been selected, but in reality such situation seldom prevails. The firm‟s have a fixed capital budget creating a competition among number of alternative proposals. The firm allocates funds to these proposals in such a way as to maximize long-term return. This process is known as capital rationing.
PROJECT CLASSIFICATION
Capital budgeting projects are classified in various categories depending on their complexity and magnitude. While there is no fixed or hard bound system of classification but normally following categories are found present in classification used by various firms: (a) Mandatory Investments: Such projects are required to be implemented to meet statutory requirements. The focus of management in such projects is finding out the most cost-effective way to meet statutory requirement. These projects may range from buying a fire-fighting kit to opening a primary health centre and so on. Replacement Projects: The firms‟ continuously keep on replacing its worm out or obsolete plants and machineries to increase efficiency. Such projects either help by the way expanding revenues or by reducing costs. The focus of firm while evaluating such proposals is quite straight forwards but at times analysis may be a detailed one. Expansion Projects: The name itself suggests that such projects are either for increasing the production capacity or widening the reach in the market place. Since such projects involve substantial amount of risk, and cash outlay they require meticulous analysis involving top management in the process.
(b)
(c)
[Type text]
(d)
Diversification Projects: The proposals may be about producing a product or service new to the firm or at times new to the world. These may also be about entering into a totally new and unknown market. Such projects besides substantial risk and cash out lay, require great managerial efforts also. They also represent the future strategy and business of the firm. All these circumstances force a threadbare analysis of the proposal with significant involvement of top management and Board of Directors. Research and Development Projects: The firms need to invest in research and development (R&D) projects if they want to keep ahead of competitions and survive in long-term. The focus of the firm while evaluating such projects is based much on gut feeling or managerial judgment than on quantitative data. Miscellaneous Projects: All other projects except those described above find their place in this category. Examples may include buying car to carry CEO or a bungalow for COO or furnishing and decoration of visitors‟ room. These proposals are selected based on preferences as usual; of top management more than on anything else.
(e)
(f)
EVALUATION TECHNIQUES
Numerous techniques for judging the worth whileness of a project have been developed. These can be broadly grouped in two categories namely (i) Traditional or Non-Discounted Cash Flow Techniques and (ii) Time-Adjusted or Discounted Cash Flow techniques. These have been shown below:
Evaluation Techniques
Traditional Techniques or Non-Discounted Cash Flow Techniques
Time-Adjusted Techniques or Discounted Cash Flow Techniques
Payback Period
Accounting Rate of Return
Net Present Value
Benefit Cost Ratio
Internal Rate of Return
Discounted Payback
Evaluation Techniques
[Type text]
Non Discounted cash Flow Techniques
These techniques of project evaluation do not take into account the time of money. In these one rupee today is treated equivalent to one rupee even after „x‟ time period. Two prominent techniques are being discussed below: (a) Payback Period (PB) Method: Payback period is the length of time required to recover the initial cash outlay on a project or to say in other words, how much time will be required by the cash benefits to recover the original investment. It is simplest quantitative method of evaluating a capital budgeting project and, therefore, widely accepted one. Computation: There are two methods for calculating payback period depending upon the nature of future stream of cash inflows first, when future cash inflow is in the nature of annuity through out the life of the project, then following formula may be applied: Initial cost of Investment PB = Constant Annual Cash Inflow Illustration: Suppose an investment of Rs 45,000.00 in a project is expected to produce a cash inflow of Rs. 9,000.00 for next 8 years, then Rs. 45,000.00 PB = Rs 9,000.00 Second, when future cash inflows from the project are not uniform i.e., they result in a mixed stream of cash inflows then payback period is calculated by cumulating the cash inflows till the time they become equal to original investment. Illustration: Suppose initial cash outlay on purchase of machine A or B is Rs. 50,000.00. The future cash inflows given for a period of 5 years from Machine A are Rs 15,000.00, Rs 15,000.00, Rs. 20,000.00, Rs. 10,000.00 and Rs. 25,000.00 whereas from Machine B are Rs. 25,000.00, Rs. 25000.00, Rs. 10,000.00, Rs. 10,000.00 and Rs. Rs. 10,000.00. The payback period will be calculated as below: Years 1. 2. 3. 4. 5. Machine A 15,000.00 15,000.00 20,000.00 15,000.00 20,000.00 Machine A Cumulative 15,000.00 30,000.00 50,000.00 65,000.00 85,000.00 Machine B 25,000.00 25,000.00 10,000.00 10,000.00 10,000.00 Machine B Cumulative 25,000.00 50,000.00 60,000.00 70,000.00 80,000.00 = 5 years
Here, payback period for Machine A is 3 years whereas for Machine B is 2 years. [Type text]
Accept – Reject Criterion: The selection of projects based on payback period method can be done in two ways: (i) Management of the firm may have set a guideline for maximum period in which initial investment may be recovered. The projects may be selected by making a comparison between projects‟ payback period and maximum duration set by management for recovery of initial investment. (ii) Payback period can also be utilized to rank the mutually exclusive projects according to length of period and one with shortest payback period may be selected. Merits: (i) (ii) (iii) Demerits: (i) (ii) (iii) It does not take into consideration time-value of money. It completely ignores all cash inflows after the pay-back period. It can be turned as a measure of capital recovery and not profitability. It is easy to calculate and simple to understand as it does not involve abstract concepts and tedious calculations. It is a smooth and readymade method for dealing with risk as it favours projects with shorter payback periods. It assumes much significance when firm is hard pressed regarding liquidity issues.
(b) Accounting Rate of Return (ARR) method: This method is also known as average rate of return method. The method is based on accounting information rather than cash flows. Computation: ARR may be calculated by using following formula: Profit after Tax ARR = Book value of the Investment OR Average Annual Profits after Taxes ARR = Average investment over the life of the project The numerator in this ratio may determined by adding up the after tax profits over the life of the investment and denominator as average book value of fixed assets committed to the project. [Type text] × 100
Illustration: Consider the given data on a project Year Book value of investment 1. 2. 3. 4. 5. The ARR = 1,00,000 80,000 80,000, 70,000 60,000
Profit after tax 22,000 26,000 20,000 28,000 24,000
(22000 + 26000 + 20000 + 28000 + 24000) /5 × 100 (100000 + 90000 + 80000 + 70000 + 60000) /15
Accept-reject criterion: The selection of projects based on ARR method can be done in two ways: (i) Management of the firm may have set a guideline for minimum required rate of return for any project to be accepted. Thus, by comparing actual ARR with this standard a project may be accepted or rejected. ARR can also be utilized as ranking tool for mutually exclusive projects. Obviously, one having highest ARR will be ranked and others succeeding it in same order.
(ii)
Merit: (i) (ii) (iii) Demerits: (i) (ii) (iii) The computation is based on book profits and not on actual cash flows. It does not make any adjustment for time value of money and treats two projects with equal ARRs and varying cash inflows as similar. It does not differentiate between the size of investment required for each projects. It considers benefits flowing in through out the life of the project. Information required for computation of ARR is readily available in the books of accounts. It is easy to calculate and understand.
Discounted Cash Flow Techniques
These techniques are also known as time-adjusted techniques of project evaluation, as they take into account time value of money. These methods apply a certain discount rate to the future cash inflows. This discount rate is applied to take care of the effect of cost of [Type text]
capital. These techniques also take into consideration all the costs and benefits accruing throughout the life of the project. The discussion on these techniques is followed below: (a) Net Present Value (NPV): This technique recognizes the value of one rupee today is not equal to the value of one rupee tomorrow. This means that the value of streams of cash flows at different periods of time differs and can be compared only when their present value is calculated. Computation: The total present value is summation of present value of all the future cash inflows resulting throughout the life of the project. Where as net present value is summation of all cash inflows which are treated as positive cash flows and cash out flows which are treated as negative cash flows. Thus, the formula for NPV can be put as
NPV
1 r
t 1
n
Ct
t
Co
Notations used are NPV = Net Present Value Σ = Summation symbol Ct = Cash flow at the end of year t n = life of project r = discount rate Co = Initial Investment t = time Illustration: Consider a project having following cash flow streams: Year Cash Flow 0 -1,00,000 1 20,000 2 30,000 3 40,000 4 50,000 5 30,000 The cost of capital, r, for the firm is per cent. The net present value of the proposal is: 1,00,000 NPV = (1.12)
0
(20,000) + (1.12)
1
(30,000) + (1.12)
2
(40,000) + (1.12)
3
(50,000) + (1.12)4
(30,000) + (1.12)5 [Type text]
= - 1,00,000 + 17,860 + 23,910 + 28,480 + 31,800 + 17,010 = 19,060 The NPV represents the net benefit over and above the compensation for time and risk. Decision Rule: (i) (ii) (iii) Accept the project proposal if NPV is positive. Reject the project proposal it NPV is negative. If NPV is equal to zero, an indifferent approach may be adopted.
Important Note: NPV can also be calculated by applying varying discount rates in context of time. The risk increases/ decreases with respect to time, differential discount rates can be applied. Merits: (i) (ii) (iii) (iv) Demerits: (i) (ii) (iii) As compared to payback period method and ARR, it is bit complex and difficult to understand. It is an absolute measure and therefore does not factor in the scale of investment. It also does not consider the life of project and has a bias towards projects having longer life. It has additive property, i.e., NPV of a number/bundle of projects is sum of NPV of individual projects. It explicitly recognizes the time value of money. It takes into account total benefits and costs arising throughout the life of the project. It considers differential discount rates also, if so required by the nature of the project.
(b) Benefit Cost (B/C) Ratio: This technique is also known as Profitability Index (PI) method. It is much similar to NPV approach. The basic difference lies in the fact that while NPV measures the difference between the present values of cash outflows and inflows, the Benefit cost ratio measures the present values of returns per rupee invested. Computation: Two methods can be adopted to define the relationship between benefits and costs: Present value of Benefits (PVB) Benefit-cost Ratio (BCR) = Initial Investment (I) OR [Type text]
Present value of Benefits (PV) – Initial Investment (I) Net Benefit – Cost Ratio (NBCR) = Initial Investment (I)
PVB – I = I NBCR = BCR – 1 =
PVB I
I I
Illustration: Assume evaluating a project, for which the cost of capital for the firm is 12 percent. Initial Investment 1,00,000 Benefits Year 1 20,000 Year 2 30,000 Year 3 40,000 Year 4 50,000 Year 5 30,000 (20,000) + (1.12) BCR = 1,00,000 (1.12)
2
(30,000) +
(40,000) + (1.12)
3
(50,000) + (1.12)
4
(30,000) (1.12)5
17,860 + 23,910 + 28,480 + 31,800 + 17,010 = 1,00,000 1,19,060 = 1,00,000 NBCR = BCR – 1 = 1.19 – 1 = 0.19 Decision Rule: BCR >1 =1 <1 Merits: [Type text] NBCR >0 +0 <0 Decision Accept Indifferent Reject = 1.19
(i) (ii) Demerits: (i) (ii)
It makes adjustment for all elements of capital budgeting like time value of money and totality of benefits etc. It measures the net present value per rupee of outlay, it can be used in disseminating large and small investments.
It does not have any additive effect like NPV. It more complicated and involves mole calculations a compared to other methods discussed above.
(c) Internal Rate Return (IRR) method: It is yet another time adjusted technique applied for evaluation of capital investment proposals. Like the net present value method, it also takes into account the time-value of money by applying a proper discount rate to cash flows. Put differently IRR of a project is the discount rate which makes NPV equal to zero. Important Note: In case of NPV, the discount rate is predetermined required rate of return, usually cost of capital. The determinates of this rate or external to the proposal under consideration. Whereas in IRR the rate depends entirely on the initial cash outlay and stream of future cash inflows of the project under consideration. Thus, IRR can be defined as the discount rate (r), which equates the present value of stream of future cash inflows with that of initial cash outflow or initial investment. Computation: In calculating NPV it is assumed that the discount rate, usually cost of capital, is given, while calculating IRR, we put NPV equal to zero and determine the discount rate that meets this condition, thus
NPV
1 r
t 1 n
n
Ct
t
Co 0
Therefore,
Co
t 1
1 r t
Ct
Or Initial Investment
t 1
n
1 r t
Ct
Notations: Co = Initial Investment / Investment Σ = Summation Ct = Cash flow at the end of year t r = Internal Rate of Return (IRR) n = life of the project t = time Illustration: Let us take an example [Type text]
Year 0 1 2 3 4
Cash flow (1,00,000) 30,000 30,000 40,000 45,000
Note: Figures in brackets represent negative cash flows: Now, the value of IRR is that meets flowing equation 30,000 1,00,000 = (1 + r)
1
30,000 + (1 + r)
2
40,000 + (1 + r)
3
45,000 + (1 + r)4
The computation of „r‟ involves a process of trial and error. We will have to try different values of „r‟ till we arrive at a value that equates right hand side to 1,00,000. Now guess estimation can tell you that value should fall some where between 15 and 16 percent. Step 1 So let us do the computation initially for 15 percent: 30,000 + (1.15) Step 2 Now for 16 per cent 30,000 + (1.16) Step 3 Take the total of absolute values obtained in step 1 and Step 2: 802 + 1,359 = 2,161 (1.16)
2
30,000 + (1.15)
2
40,000 + (1.15)
3
45,000 = 1,00,802 (1.15)
4
30,000 +
40,000 + (1.16)
3
45,000 = 98,641 (1.16)
4
Step 4 Compute the ratio of net present value of smaller discount rate, found in step 1 to sum obtained in step 3: 802 = 0.37 2,161 [Type text]
Step 5 Add the number obtained in step 4 to the smaller discount rate: 15 + 0.37 = 15.37% This method of calculation leads to very close approximation to real internal rate of return. Decision Rule: If IRR > Cost of Capital If IRR < Cost of Capital If IRR = Cost of Capital Merits: (i) (ii) Demerits: (i) (ii) It involves tedious calculations and is a bit complicated method for common people. It assumes that intermediate cash inflows are being reinvested at the internal rate of return. It takes into consideration timer value of money and cash flows through out the life of project. It does not use the concept of required rate of return of the cost of capital, but itself provides a rate of return indicative of profitability of project proposal.
Accept Reject Indifferent
(d) Discounted payback period The discounted payback period can be defined as the period required for the initial cash investment in a project to equal the discounted value of the expected cash inflows . The discounted payback method is similar to the payback period in that it looks at the length of time it takes a project to "payback." The difference lies in the discounting of the cash flows with the discounted payback period, while the cash flows are not discounted in the traditional payback period. The discounted payback period is a better gauge of break-even than the payback period because it is a period beyond which a project generates economic profit rather than accounting profit. The discounted payback period is also a more conservative approach to capital budgeting than the traditional payback period. The weighted average cost of capital of the firm should be used as the discount rate in calculating the cash flows of the project. Another limitation of the discounted payback period is that it is much harder to calculate than the traditional payback period. It does, however, make a suitable substitute for the traditional payback period for a small business owner because it is almost as easy to understand as the traditional payback period
[Type text]
Illustration: We plan on purchasing a new assembly machine for $ 25,000.. It will cost $ 2,000 to have the new machine installed and we expect a $ 1,000 net increase in working capital. By making the investment, we will reduce our annual operating costs by $ 7,000 and we expect to save $ 500 a year in maintenance. The new machine will require $ 750 each year for technical support. We will depreciate the machine over 5 years under the straight-line method of depreciation with an expected salvage value of $ 5,000. The effective tax rate is 35%. Annual Savings in Operating Costs Annual Savings in Maintenance Annual Costs for Technical Support Annual Depreciation Revenues Taxes @ 35% Net Project Income Add Back Depreciation (non cash item) Relevant Project Cash Flow * $ 25,000 - $ 5,000 / 5 years = $ 4,000 $ 5,788 ( 962) 1,788 4,000 ( 750) ( 4,000) * $ 2,750 $ 7,000 500
We will receive $ 5,788 of cash flow each year by investing in this new assembly machine. Since we have a salvage value, we have a terminal cash flow associated with this project. Soln: Year 1 2 3 4 5 5 Cash Flow x P.V. Factor = P.V. Cash Flow Total to Date $ 5,788 5,788 5,788 5,788 5,788 3,250 .893 .797 .712 .636 .567 .567 $ 5,169 4,613 4,121 3,681 3,282 1,843 $ 5,169 9,782 13,903 17,584 20,866 22,709
Under the Discounted Payback Period, we would never receive a payback on our project; i.e. the total to date present cash flows never reached $ 24,100 (net investment). If we had [Type text]
relied on the regular payback calculation, we would falsely assume that this project does payback in the fourth year. Computation: Same as the payback period, only discounted cash flow is used instead of normal cash flow. Decision Rule: An investment is good or acceptable if its discounted payback period is less than some predetermined no. of years. Merits: (i) Considers the time value of money (ii) Considers the riskiness of the project's cash flows (through the cost of capital) Demerits: (i) Requires anestimate of the cost of capital inorder to calculate the payback (ii) Ignores cash flows beyond the discounted payback period
SUMMURY
* Capital budgeting decisions relate to long-term commitment of funds into assets which provide future streams of benefits over a period of time. * Capital budgeting process may be divided in following phases: (i) identification of potential investment proposals, (ii) Evaluation of available alternative proposals; (iii) selection of best project proposal, (iv) Implementation, and (v) Performance Review. * Capital budgeting projects can be grouped in following categories: (i) Mandatory investments, (ii) Replacement projects; (iii) Expansion projects; (iv)Diversification projects; (v) R & D projects; and (vi) Miscellaneous projects. * A wide range of techniques are applied to judge the worth whileness of a project. These techniques may be grouped in two categories; (i) Non-Discounted Cash Flow Techniques and (ii) Discounted Cash flow Techniques. * In non-discounted cash flow techniques, two most often applied methods are payback period method and accounting rate of return. * Discounted cash flow techniques applied for evaluation are Net present value method, Benefit-cost Ratio or Profitability Index method, Internal rate of Return Method.
***
[Type text]
Gopal K Bhimber M-I-1002 Sep-2013
CAPITAL BUDGETING METHODS
INTRODUCTION
Capital budgeting is one of most important issues confronting a corporate finance manager. Other important aspects like financing, liquidity management, and dividend decisions are also of much significance, but how the allocation of capital is done assumes significance. Capital budgeting reflects the long-term vision, direction and business of the firm. The firms spend considerable time in making such decisions and involve top hierarchy from every functional area. Capital budgeting assumes so much significance due to its following features: They involve relatively long time period between initial cash out flow and expected future cash inflows resulting into long-term consequences; Substantial amount of funds are normally involved in such decisions; Involve a relatively high degree of risk; Are nearly irreversible in nature and can be reversed only after incurring much financial losses. Thus, it can be deduced that capital budgeting decisions are of paramount importance to the firm as its success and growth heavily depends on them. The rationale behind these decisions is to bring in the efficiency in the firm‟s operations. A firm must continuously keep on replacing its worn out and obsolete plants and machinery and acquire new assts for current and future operations. These help a firm in any of two ways, i.e., either by expanding revenues or by reducing costs. But such decisions also come with some inbuilt problems. To name a few, they are: Benefits from investment are received in future period and therefore, involves an element of risk due to uncertainties; Costs incurred and benefits received occur in different time periods, therefore, rendering comparison a difficult and complex job; More often than not, it is very difficult to calculate in quantitative terms all the costs and benefits associated to a specific investment decision. “Capital budgeting is process of selecting best long-term investment projects by evaluating the present alternatives in the light of the share holder‟s wealth maximization objective”
CAPITAL BUDGETING PROCESS
Capital budgeting is a complex process comprising five distinct phases a. Identification of potential investment opportunities or proposal generation; b. Evaluation of available alternative proposals in the light of the objective of shareholders‟ wealth maximization;
[Type text]
c. Selection of best project proposal from amongst the available alternatives or decision making; d. Implementation of the selected project proposal; and e. Performance Review or follow-up. Firms are basically confronted with three types of capital budgeting decisions: (i) Accept-reject decisions: In any capital budgeting project this is the most fundamental decision to make. As a normally accepted principle, all those projects which yield a rate of return greater than required rate of return are accepted and rest stand rejected. This principle allows selection of all independent projects. Mutually Exclusive Project Decisions: Such projects are those which compete with other projects in such a way that selection of one of them renders selection of other projects impossible. Hence, amongst from all projects one giving highest return is selected.
(ii)
(iii) Capital Rationing Decisions: If the firm were having unlimited funds, all the independent projects yielding a rate of return higher than required rate of return would have been selected, but in reality such situation seldom prevails. The firm‟s have a fixed capital budget creating a competition among number of alternative proposals. The firm allocates funds to these proposals in such a way as to maximize long-term return. This process is known as capital rationing.
PROJECT CLASSIFICATION
Capital budgeting projects are classified in various categories depending on their complexity and magnitude. While there is no fixed or hard bound system of classification but normally following categories are found present in classification used by various firms: (a) Mandatory Investments: Such projects are required to be implemented to meet statutory requirements. The focus of management in such projects is finding out the most cost-effective way to meet statutory requirement. These projects may range from buying a fire-fighting kit to opening a primary health centre and so on. Replacement Projects: The firms‟ continuously keep on replacing its worm out or obsolete plants and machineries to increase efficiency. Such projects either help by the way expanding revenues or by reducing costs. The focus of firm while evaluating such proposals is quite straight forwards but at times analysis may be a detailed one. Expansion Projects: The name itself suggests that such projects are either for increasing the production capacity or widening the reach in the market place. Since such projects involve substantial amount of risk, and cash outlay they require meticulous analysis involving top management in the process.
(b)
(c)
[Type text]
(d)
Diversification Projects: The proposals may be about producing a product or service new to the firm or at times new to the world. These may also be about entering into a totally new and unknown market. Such projects besides substantial risk and cash out lay, require great managerial efforts also. They also represent the future strategy and business of the firm. All these circumstances force a threadbare analysis of the proposal with significant involvement of top management and Board of Directors. Research and Development Projects: The firms need to invest in research and development (R&D) projects if they want to keep ahead of competitions and survive in long-term. The focus of the firm while evaluating such projects is based much on gut feeling or managerial judgment than on quantitative data. Miscellaneous Projects: All other projects except those described above find their place in this category. Examples may include buying car to carry CEO or a bungalow for COO or furnishing and decoration of visitors‟ room. These proposals are selected based on preferences as usual; of top management more than on anything else.
(e)
(f)
EVALUATION TECHNIQUES
Numerous techniques for judging the worth whileness of a project have been developed. These can be broadly grouped in two categories namely (i) Traditional or Non-Discounted Cash Flow Techniques and (ii) Time-Adjusted or Discounted Cash Flow techniques. These have been shown below:
Evaluation Techniques
Traditional Techniques or Non-Discounted Cash Flow Techniques
Time-Adjusted Techniques or Discounted Cash Flow Techniques
Payback Period
Accounting Rate of Return
Net Present Value
Benefit Cost Ratio
Internal Rate of Return
Discounted Payback
Evaluation Techniques
[Type text]
Non Discounted cash Flow Techniques
These techniques of project evaluation do not take into account the time of money. In these one rupee today is treated equivalent to one rupee even after „x‟ time period. Two prominent techniques are being discussed below: (a) Payback Period (PB) Method: Payback period is the length of time required to recover the initial cash outlay on a project or to say in other words, how much time will be required by the cash benefits to recover the original investment. It is simplest quantitative method of evaluating a capital budgeting project and, therefore, widely accepted one. Computation: There are two methods for calculating payback period depending upon the nature of future stream of cash inflows first, when future cash inflow is in the nature of annuity through out the life of the project, then following formula may be applied: Initial cost of Investment PB = Constant Annual Cash Inflow Illustration: Suppose an investment of Rs 45,000.00 in a project is expected to produce a cash inflow of Rs. 9,000.00 for next 8 years, then Rs. 45,000.00 PB = Rs 9,000.00 Second, when future cash inflows from the project are not uniform i.e., they result in a mixed stream of cash inflows then payback period is calculated by cumulating the cash inflows till the time they become equal to original investment. Illustration: Suppose initial cash outlay on purchase of machine A or B is Rs. 50,000.00. The future cash inflows given for a period of 5 years from Machine A are Rs 15,000.00, Rs 15,000.00, Rs. 20,000.00, Rs. 10,000.00 and Rs. 25,000.00 whereas from Machine B are Rs. 25,000.00, Rs. 25000.00, Rs. 10,000.00, Rs. 10,000.00 and Rs. Rs. 10,000.00. The payback period will be calculated as below: Years 1. 2. 3. 4. 5. Machine A 15,000.00 15,000.00 20,000.00 15,000.00 20,000.00 Machine A Cumulative 15,000.00 30,000.00 50,000.00 65,000.00 85,000.00 Machine B 25,000.00 25,000.00 10,000.00 10,000.00 10,000.00 Machine B Cumulative 25,000.00 50,000.00 60,000.00 70,000.00 80,000.00 = 5 years
Here, payback period for Machine A is 3 years whereas for Machine B is 2 years. [Type text]
Accept – Reject Criterion: The selection of projects based on payback period method can be done in two ways: (i) Management of the firm may have set a guideline for maximum period in which initial investment may be recovered. The projects may be selected by making a comparison between projects‟ payback period and maximum duration set by management for recovery of initial investment. (ii) Payback period can also be utilized to rank the mutually exclusive projects according to length of period and one with shortest payback period may be selected. Merits: (i) (ii) (iii) Demerits: (i) (ii) (iii) It does not take into consideration time-value of money. It completely ignores all cash inflows after the pay-back period. It can be turned as a measure of capital recovery and not profitability. It is easy to calculate and simple to understand as it does not involve abstract concepts and tedious calculations. It is a smooth and readymade method for dealing with risk as it favours projects with shorter payback periods. It assumes much significance when firm is hard pressed regarding liquidity issues.
(b) Accounting Rate of Return (ARR) method: This method is also known as average rate of return method. The method is based on accounting information rather than cash flows. Computation: ARR may be calculated by using following formula: Profit after Tax ARR = Book value of the Investment OR Average Annual Profits after Taxes ARR = Average investment over the life of the project The numerator in this ratio may determined by adding up the after tax profits over the life of the investment and denominator as average book value of fixed assets committed to the project. [Type text] × 100
Illustration: Consider the given data on a project Year Book value of investment 1. 2. 3. 4. 5. The ARR = 1,00,000 80,000 80,000, 70,000 60,000
Profit after tax 22,000 26,000 20,000 28,000 24,000
(22000 + 26000 + 20000 + 28000 + 24000) /5 × 100 (100000 + 90000 + 80000 + 70000 + 60000) /15
Accept-reject criterion: The selection of projects based on ARR method can be done in two ways: (i) Management of the firm may have set a guideline for minimum required rate of return for any project to be accepted. Thus, by comparing actual ARR with this standard a project may be accepted or rejected. ARR can also be utilized as ranking tool for mutually exclusive projects. Obviously, one having highest ARR will be ranked and others succeeding it in same order.
(ii)
Merit: (i) (ii) (iii) Demerits: (i) (ii) (iii) The computation is based on book profits and not on actual cash flows. It does not make any adjustment for time value of money and treats two projects with equal ARRs and varying cash inflows as similar. It does not differentiate between the size of investment required for each projects. It considers benefits flowing in through out the life of the project. Information required for computation of ARR is readily available in the books of accounts. It is easy to calculate and understand.
Discounted Cash Flow Techniques
These techniques are also known as time-adjusted techniques of project evaluation, as they take into account time value of money. These methods apply a certain discount rate to the future cash inflows. This discount rate is applied to take care of the effect of cost of [Type text]
capital. These techniques also take into consideration all the costs and benefits accruing throughout the life of the project. The discussion on these techniques is followed below: (a) Net Present Value (NPV): This technique recognizes the value of one rupee today is not equal to the value of one rupee tomorrow. This means that the value of streams of cash flows at different periods of time differs and can be compared only when their present value is calculated. Computation: The total present value is summation of present value of all the future cash inflows resulting throughout the life of the project. Where as net present value is summation of all cash inflows which are treated as positive cash flows and cash out flows which are treated as negative cash flows. Thus, the formula for NPV can be put as
NPV
1 r
t 1
n
Ct
t
Co
Notations used are NPV = Net Present Value Σ = Summation symbol Ct = Cash flow at the end of year t n = life of project r = discount rate Co = Initial Investment t = time Illustration: Consider a project having following cash flow streams: Year Cash Flow 0 -1,00,000 1 20,000 2 30,000 3 40,000 4 50,000 5 30,000 The cost of capital, r, for the firm is per cent. The net present value of the proposal is: 1,00,000 NPV = (1.12)
0
(20,000) + (1.12)
1
(30,000) + (1.12)
2
(40,000) + (1.12)
3
(50,000) + (1.12)4
(30,000) + (1.12)5 [Type text]
= - 1,00,000 + 17,860 + 23,910 + 28,480 + 31,800 + 17,010 = 19,060 The NPV represents the net benefit over and above the compensation for time and risk. Decision Rule: (i) (ii) (iii) Accept the project proposal if NPV is positive. Reject the project proposal it NPV is negative. If NPV is equal to zero, an indifferent approach may be adopted.
Important Note: NPV can also be calculated by applying varying discount rates in context of time. The risk increases/ decreases with respect to time, differential discount rates can be applied. Merits: (i) (ii) (iii) (iv) Demerits: (i) (ii) (iii) As compared to payback period method and ARR, it is bit complex and difficult to understand. It is an absolute measure and therefore does not factor in the scale of investment. It also does not consider the life of project and has a bias towards projects having longer life. It has additive property, i.e., NPV of a number/bundle of projects is sum of NPV of individual projects. It explicitly recognizes the time value of money. It takes into account total benefits and costs arising throughout the life of the project. It considers differential discount rates also, if so required by the nature of the project.
(b) Benefit Cost (B/C) Ratio: This technique is also known as Profitability Index (PI) method. It is much similar to NPV approach. The basic difference lies in the fact that while NPV measures the difference between the present values of cash outflows and inflows, the Benefit cost ratio measures the present values of returns per rupee invested. Computation: Two methods can be adopted to define the relationship between benefits and costs: Present value of Benefits (PVB) Benefit-cost Ratio (BCR) = Initial Investment (I) OR [Type text]
Present value of Benefits (PV) – Initial Investment (I) Net Benefit – Cost Ratio (NBCR) = Initial Investment (I)
PVB – I = I NBCR = BCR – 1 =
PVB I
I I
Illustration: Assume evaluating a project, for which the cost of capital for the firm is 12 percent. Initial Investment 1,00,000 Benefits Year 1 20,000 Year 2 30,000 Year 3 40,000 Year 4 50,000 Year 5 30,000 (20,000) + (1.12) BCR = 1,00,000 (1.12)
2
(30,000) +
(40,000) + (1.12)
3
(50,000) + (1.12)
4
(30,000) (1.12)5
17,860 + 23,910 + 28,480 + 31,800 + 17,010 = 1,00,000 1,19,060 = 1,00,000 NBCR = BCR – 1 = 1.19 – 1 = 0.19 Decision Rule: BCR >1 =1 <1 Merits: [Type text] NBCR >0 +0 <0 Decision Accept Indifferent Reject = 1.19
(i) (ii) Demerits: (i) (ii)
It makes adjustment for all elements of capital budgeting like time value of money and totality of benefits etc. It measures the net present value per rupee of outlay, it can be used in disseminating large and small investments.
It does not have any additive effect like NPV. It more complicated and involves mole calculations a compared to other methods discussed above.
(c) Internal Rate Return (IRR) method: It is yet another time adjusted technique applied for evaluation of capital investment proposals. Like the net present value method, it also takes into account the time-value of money by applying a proper discount rate to cash flows. Put differently IRR of a project is the discount rate which makes NPV equal to zero. Important Note: In case of NPV, the discount rate is predetermined required rate of return, usually cost of capital. The determinates of this rate or external to the proposal under consideration. Whereas in IRR the rate depends entirely on the initial cash outlay and stream of future cash inflows of the project under consideration. Thus, IRR can be defined as the discount rate (r), which equates the present value of stream of future cash inflows with that of initial cash outflow or initial investment. Computation: In calculating NPV it is assumed that the discount rate, usually cost of capital, is given, while calculating IRR, we put NPV equal to zero and determine the discount rate that meets this condition, thus
NPV
1 r
t 1 n
n
Ct
t
Co 0
Therefore,
Co
t 1
1 r t
Ct
Or Initial Investment
t 1
n
1 r t
Ct
Notations: Co = Initial Investment / Investment Σ = Summation Ct = Cash flow at the end of year t r = Internal Rate of Return (IRR) n = life of the project t = time Illustration: Let us take an example [Type text]
Year 0 1 2 3 4
Cash flow (1,00,000) 30,000 30,000 40,000 45,000
Note: Figures in brackets represent negative cash flows: Now, the value of IRR is that meets flowing equation 30,000 1,00,000 = (1 + r)
1
30,000 + (1 + r)
2
40,000 + (1 + r)
3
45,000 + (1 + r)4
The computation of „r‟ involves a process of trial and error. We will have to try different values of „r‟ till we arrive at a value that equates right hand side to 1,00,000. Now guess estimation can tell you that value should fall some where between 15 and 16 percent. Step 1 So let us do the computation initially for 15 percent: 30,000 + (1.15) Step 2 Now for 16 per cent 30,000 + (1.16) Step 3 Take the total of absolute values obtained in step 1 and Step 2: 802 + 1,359 = 2,161 (1.16)
2
30,000 + (1.15)
2
40,000 + (1.15)
3
45,000 = 1,00,802 (1.15)
4
30,000 +
40,000 + (1.16)
3
45,000 = 98,641 (1.16)
4
Step 4 Compute the ratio of net present value of smaller discount rate, found in step 1 to sum obtained in step 3: 802 = 0.37 2,161 [Type text]
Step 5 Add the number obtained in step 4 to the smaller discount rate: 15 + 0.37 = 15.37% This method of calculation leads to very close approximation to real internal rate of return. Decision Rule: If IRR > Cost of Capital If IRR < Cost of Capital If IRR = Cost of Capital Merits: (i) (ii) Demerits: (i) (ii) It involves tedious calculations and is a bit complicated method for common people. It assumes that intermediate cash inflows are being reinvested at the internal rate of return. It takes into consideration timer value of money and cash flows through out the life of project. It does not use the concept of required rate of return of the cost of capital, but itself provides a rate of return indicative of profitability of project proposal.
Accept Reject Indifferent
(d) Discounted payback period The discounted payback period can be defined as the period required for the initial cash investment in a project to equal the discounted value of the expected cash inflows . The discounted payback method is similar to the payback period in that it looks at the length of time it takes a project to "payback." The difference lies in the discounting of the cash flows with the discounted payback period, while the cash flows are not discounted in the traditional payback period. The discounted payback period is a better gauge of break-even than the payback period because it is a period beyond which a project generates economic profit rather than accounting profit. The discounted payback period is also a more conservative approach to capital budgeting than the traditional payback period. The weighted average cost of capital of the firm should be used as the discount rate in calculating the cash flows of the project. Another limitation of the discounted payback period is that it is much harder to calculate than the traditional payback period. It does, however, make a suitable substitute for the traditional payback period for a small business owner because it is almost as easy to understand as the traditional payback period
[Type text]
Illustration: We plan on purchasing a new assembly machine for $ 25,000.. It will cost $ 2,000 to have the new machine installed and we expect a $ 1,000 net increase in working capital. By making the investment, we will reduce our annual operating costs by $ 7,000 and we expect to save $ 500 a year in maintenance. The new machine will require $ 750 each year for technical support. We will depreciate the machine over 5 years under the straight-line method of depreciation with an expected salvage value of $ 5,000. The effective tax rate is 35%. Annual Savings in Operating Costs Annual Savings in Maintenance Annual Costs for Technical Support Annual Depreciation Revenues Taxes @ 35% Net Project Income Add Back Depreciation (non cash item) Relevant Project Cash Flow * $ 25,000 - $ 5,000 / 5 years = $ 4,000 $ 5,788 ( 962) 1,788 4,000 ( 750) ( 4,000) * $ 2,750 $ 7,000 500
We will receive $ 5,788 of cash flow each year by investing in this new assembly machine. Since we have a salvage value, we have a terminal cash flow associated with this project. Soln: Year 1 2 3 4 5 5 Cash Flow x P.V. Factor = P.V. Cash Flow Total to Date $ 5,788 5,788 5,788 5,788 5,788 3,250 .893 .797 .712 .636 .567 .567 $ 5,169 4,613 4,121 3,681 3,282 1,843 $ 5,169 9,782 13,903 17,584 20,866 22,709
Under the Discounted Payback Period, we would never receive a payback on our project; i.e. the total to date present cash flows never reached $ 24,100 (net investment). If we had [Type text]
relied on the regular payback calculation, we would falsely assume that this project does payback in the fourth year. Computation: Same as the payback period, only discounted cash flow is used instead of normal cash flow. Decision Rule: An investment is good or acceptable if its discounted payback period is less than some predetermined no. of years. Merits: (i) Considers the time value of money (ii) Considers the riskiness of the project's cash flows (through the cost of capital) Demerits: (i) Requires anestimate of the cost of capital inorder to calculate the payback (ii) Ignores cash flows beyond the discounted payback period
SUMMURY
* Capital budgeting decisions relate to long-term commitment of funds into assets which provide future streams of benefits over a period of time. * Capital budgeting process may be divided in following phases: (i) identification of potential investment proposals, (ii) Evaluation of available alternative proposals; (iii) selection of best project proposal, (iv) Implementation, and (v) Performance Review. * Capital budgeting projects can be grouped in following categories: (i) Mandatory investments, (ii) Replacement projects; (iii) Expansion projects; (iv)Diversification projects; (v) R & D projects; and (vi) Miscellaneous projects. * A wide range of techniques are applied to judge the worth whileness of a project. These techniques may be grouped in two categories; (i) Non-Discounted Cash Flow Techniques and (ii) Discounted Cash flow Techniques. * In non-discounted cash flow techniques, two most often applied methods are payback period method and accounting rate of return. * Discounted cash flow techniques applied for evaluation are Net present value method, Benefit-cost Ratio or Profitability Index method, Internal rate of Return Method.
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