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):
Year
|
Cash Flow ($)
|
0
|
-800
|
1
|
400
|
2
|
400
|
3
|
400
|
PV = $400(0.9091) + $400(0.8264) + $400(0.7513)
= $363.64 + $330.56 + $300.52
= $994.72
= $363.64 + $330.56 + $300.52
= $994.72
NPV = $994.72 - $800.00
= $194.72
= $194.72
c.
Internal
Rate of Return (IRR):
Year (
|
Cash flow (
|
0
|
-4000
|
1
|
1200
|
2
|
1410
|
3
|
1875
|
4
|
1050
|
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.
YEAR
|
CF
|
PV
@ 10%
|
PV
|
1
|
18000
|
0.909
|
16362
|
2
|
12000
|
0.827
|
9924
|
3
|
10000
|
0.752
|
7520
|
4
|
9000
|
0.683
|
6147
|
5
|
6000
|
0.621
|
3726
|
Total present value
|
43679
|
||
(-) Investment
|
40000
|
||
NPV
|
3679
|
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.
ü Use
cash flows and not earnings
ü Consider
ALL relevant cash flows.
ü Accounts
for the time value of money
ü Able
to correctly select among mutually exclusive projects.
ü Have
a consistent and easy to apply decision rule.
ü If
properly applied lead to higher shareholder value.
ü Relatively
easy to explain and understand.
Hence NPV
technique is the most superior of all the techniques.