Methods or Techniques of Capital Budgeting
*Dr.P.Shanmukha Rao **Dr.N.V.S.Suryanarayana
There are many methods for evaluating the profitability of investment proposals. The various commonly used methods are:
Traditional methods:
(I) Payback period method (P.B.P)
(II) Accounting Rate of return method (A.R.R)
Time adjusted or discounting techniques:
(I) Net Present value method (N.P.V)
(II) Internal rate of return method (I.R.R)
(III) Profitability index method (P.I)
Techniques of Capital Budgeting
Traditional Methods Time adjusted methods
Pay back 1.N.P.V
Accounting rate of return 2.I.R.R
3.P.I
Pay-back period method:
The pay back some times called as payout or pay off period method represents the period in which total investment in permanent assets pay back itself. This method is based on the principle that every capital expenditure pays itself back with in a certain period out of the additional earnings generated from the capital assets.
Decision rule:
A project is accepted if its payback period is less than the period specific decision rule. A project is accepted if its payback period is less than the period specified by the management and vice-versa.
Pay Back Period
Initial Cash Outflow
=
——————————
Annual Cash Inflows
Advantages:
Ø Simple to understand and easy to calculate.
Ø It saves in cost; it requires lesser time and labour as compared to other methods capital budgeting.
Ø In this method, as a project with a shorter pay back period is preferred to the one having a longer pay back period, it reduces the loss through obsolescence.
Ø Due to its short-term approach, this method is particularly suited to a firm which has shortage of cash or whose liquidity position is not good.
Disadvantages:
Ø It does not take into account the cash inflows earned after the pay back period and hence the true profitability of the project cannot be correctly assessed.
Ø This method ignores the time value of the money and does not consider the magnitude and timing of cash inflows.
Ø It does not take into account the cost of capital, which is very important in making sound investment decisions.
Ø It is difficult to determine the minimum acceptable pay back period, which is subjective decision.
Ø It treats each asset individually in isolation with other assets, which is not feasible in real practice.
Accounting Rate of Return Method
This method takes into account the earnings from the investment over the whole life. It is known as average rate of return method because under this method the concept of accounting profit (NP after tax and depreciation) is used rather than cash inflows. According to this method, various projects are ranked in order of the rate of earnings or rate of return.
Decision rule
ü The project with higher rate of return is selected and vice – versa.
ü The return on investment method can be used in several ways, as
Average Rate of Return Method
Under this method average profit after tax and depreciation is calculated and then it is divided by the total capital out lay.
Average Annual profits (after dep. & tax)
Average rate of return = —————————————————x 100
Net Investment
Advantages:
Ø It is very simple to understand and easy to calculate.
Ø It uses the entire earnings of a project in calculating rate of return and hence gives a true view of profitability.
Ø As this method is based upon accounting profit, it can be readily calculated from the financial data.
Disadvantages:
Ø It ignores the time value of money.
Ø It does not take in to account the cash flows, which are more important than the accounting profits.
Ø It ignores the period in which the profits are earned as a 20% rate of return in
2 ½ years is considered to be better than 18% rate if return in 12 years.
Ø This method cannot be applied to a situation where investment in project is to be made in parts.
Net Present Value Method
The NPV method is a modern method of evaluating investment proposals. This method takes in to consideration the time value of money and attempts to calculate the return on investments by introducing time element. The net present values of all inflows and outflows of cash during the entire life of the project is determined separately for each year by discounting these flows with firms cost of capital or predetermined rate. The steps in this method are
1. Determine an appropriate rate of interest known as cut off rate.
2. Compute the present value of cash outflows at the above-determined discount rate.
3. Compute the present value of cash inflows at the predetermined rate.
4. Calculate the NPV of the project by subtracting the present value of cash outflows from present value of cash inflows.
Decision rule
Accept the project if the NPV of the project is 0 or +ve that is present value of cash inflows should be equal to or greater than the present value of cash outflows.
Advantages:
ü It recognizes the time value of money and is suitable to apply in a situation with uniform cash outflows and uneven cash inflows.
ü It takes in to account the earnings over the entire life of the project and gives the true view of the profitability of the investment
ü Takes in to consideration the objective of maximum profitability.
Disadvantages:
ü More difficult to understand and operate.
ü It may not give good results while comparing projects with unequal investment of funds.
ü It is not easy to determine an appropriate discount rate.
Internal Rate of Return Method
The internal rate of return method is also a modern technique of capital budgeting that takes in to account the time value of money. It is also known as time-adjusted rate of return or trial and error yield method. Under this method the cash flows of a project are discounted at a suitable rate by hit and trial method, which equates the net present value so calculated to the amount of the investment. The internal rate of return can be defined as “that rate of discount at which the present value of cash inflows is equal to the present value of cash outflows”.
Decision Rule:
Accept the proposal having the higher rate of return and vice versa.
If IRR>K, accept project. K = cost of capital.
If IRR<K, reject project.
Determination of IRR
a) When annual cash flows are equal over the life of the asset.
Initial Outlay
Factor = ————————— x 100
Annual Cash Inflow
b) When the annual cash flows are unequal over the life of the asset:
Pv of cash inflows at lower rate – Pv of cash outflows
IRR = LR + ————————————————————————- (hr-lr)
Pv of cash inflows at lower rate-Pv of cash inflows at higher rate
The steps are involved here are…
Prepare the cash flow table using assumed discount rate to discount the net cash flows to the present value.
Find out the NPV, & if the NPV is positive, apply higher rate of discount.
If the higher discount rate still gives a positive NPV, increase the discount rate further. Until the NPV becomes zero.
If the NPV is negative, at a higher rate, NPV lies between these two rates.
Advantages:
It takes into account, the time value of money and can be applied in situations with even and even cash flows.
It considers the profitability of the projects for its entire economic life.
The determination of cost of capital is not a pre-requisite for the use of this method.
It provides for uniform ranking of various proposals due to the percentage rate of return.
This method is also compatible with the objective of maximum profitability.
Disadvantages:
It is difficult to understand and operate.
The results of NPV and IRR methods may differ when the projects under evaluation differ in their size, life and timings of cash flows.
This method is based on the assumption that the earnings are reinvested at the IRR for the remaining life of the project, which is not a justified assumption.
Profitability index method:
It is also a time-adjusted method of evaluating the investment proposals. PI also called benefit cost ratio or desirability factor is the relationship between present value of cash inflows and the present values of cash outflows. Thus
PV of cash inflows
Profitability index = ————————————
PV of cash outflows
Advantages:
Unlike net present value, the profitability index method is used to rank the projects even when the costs of the projects differ significantly.
It recognizes the time value of money and is suitable to applied in a situation with uniform cash outflows and uneven cash inflows.
It takes into an account the earnings over the entire life of the project and gives the true view of the profitability of the investment.
Takes into consideration the objective of maximum profitability.
Disadvantages:
More difficult to understand and operate.
It may not give good results while comparing projects with Unequal investment funds.
It is not easy to determine and appropriate discount rate.
It may not give good results while comparing projects with unequal lives as the project having higher NPV but have a longer life span may not be as desirable as a project having some what lesser NPV achieved in a much shorter span of life of the asset
Tags: accounting rate of return, capital assets, capital budgeting, capital expenditure, cash inflows, cash outflow, decision rule, index method, initial cash, internal rate of return, investment proposals, labour, payback period, period method, present value, profitability index, rao, rate of return, shanmukha, suryanarayana