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Methods of Capital Budgeting
(a) Pay Back period method:
In this method we find answers of the question: How many years will it take for the cash benefits to pay the original cost of an investment Thus it measures the number of years required for the CFAT to pay back the Cash Out flow required in an Investment proposal. There may be two situations while calculating Payback period.
· When the cash flow stream is in the nature of annuity. In the other words when the annual cash Inflow is constant
PayBack Period =Cash Outflow/Annual Cash Inflow
· When Cash flows are not equal but vary from year to year In this method PB is calculated by the process of cumulating cash flows till the time when cumulative cash flows becomes equal to the original investment outlay. For example:
Years Cash Inflow Cumulative cash inflow
1 50000 50000
2 100000 150000
3 250000 400000*
4 300000
Cash outflow = 500000
After third year we requires only 100000 to recover cash outflow. Hence Pay Back Period"
3 Years + 100000*12/300000
Or 3 Years 4 Months or 3.33 years
Financial Manager has to compare the act will PB period with pre-determined PB period. If the termer is less than the later proposal will be accepted otherwise rejected.
This method is very easy to operate and simple to understand but this approach suffers from serious limitations. Its major shortcoming is that it completely ignores all cash inflows after the pay back period It considers only the recovery period as a whole. It also does not discount the future cash flows to find out present value of rupee, in other words it ignores the time value of money. But this method may be very appropriate for the firms suffering from a liquidity crisis.
(b) Discounted Pay back period method:
This method is similar to first method i.e. Pay Back period method. The difference is that in this method Discounted value of cash inflows is taken for calculation of PB period. Remaining procedure is same as first method. Hence it removes the limitation of first method of ignoring time, value of money but other limitations of first method remains' intact.
(c) Average Rate of Return Method
This method is also known as the accounting rate of return method, It is based on net profit rather than cash flows, There are number of alternative methods for calculating the ARR. The most common method is as follows:
ARR = Average annual profits after depreciation & taxes / Average Investment
Annual Profit after depreciation & taxes = EBIT (1-t)
Average Investment = Working capital + 1/2 (Cost of assets + Salvage value)
Financial Manager has to compare the actual ARR with pre-determined ARR. If the former is more than the later proposal will be accepted otherwise rejected.
This method is very easy to operate and simple to understand but this approach also suffers from serious limitations, Its major shortcoming is that it uses accounting income instead of cash flows. It also does not discount the future cash flows to find out present value of rupee, in other words it ignores the time value of money. It does not differentiate between the sizes of the investment required for each project. Competing investment proposals may have the same ARR, but may require different average investments. It also does not take into consideration the benefits, which a firm can enjoy from the sale of equipment, which is replaced by the new investment.
(iv) Net Present Value Method:
This method is widely used for Capital Budgeting decisions. It takes in to account the time value of money. In this method all cash flows (both inflows and outflows) are expressed in terms of their present values. The word Net Present Value means Summation of Present Value of Cash Inflows less summation of PV of cash outflows.
The decision rule for a project under the NPV is to accept the project if the NPV is positive and reject if it is negative. This method can also be used to make a choice between mutually exclusive projects, the project with the highest NPV would be assigned the first rank.
The most significant advantage of this method is that it explicitly recognizes the time value of money. It considers the total benefits arising out of the proposal over its lifetime. This method is instrumental in achieving the objective of Financial Management, which is the maximization of shareholders wealth.
Limitations of this method includes, it is slightly difficult to calculate. The discount rate is the most important element used in the calculation of the Present values, but calculation of this is very complicated as there is a difference of opinion even regarding the exact method of calculating it. Another: shortcoming of this method is that it is an absolute measure. Prima facie between two projects this method will favor the project, which has higher present value without considering Initial outlay. Thus in case of projects involving different outlays, this method may not give dependable results. This method also does not give satisfactory result when two projects have different effective lives,
(v) Profitability Index Method:
It is similar to the NPV approach. It measures the present value of returns per rupee invested. A major shortcoming of the NPV method is that being an absolute measure, hence it is not a reliable. method to evaluate projects requiring different initial investments. This method removes this shortcoming. In other words, it is a relative measure. It may be defined as the ratio, which is obtained dividing the present value of future cash inflows by the present value of cash outflows. Also know as "Desirability Factor".
PI = Present Value of Cash Inflows / Present Value of Cash Outflows
A project will qualify for an acceptance if its PI exceeds one. When PI equals to 1, the firm is indifferent to project. This approach satisfies almost all the requirements of a sound investment criterion. It considers all the elements of capital budgeting, such as time value of money, totality of benefits and so on. This method is superior to NPV method as it evaluates the worth of projects in terms of their relative return than absolute magnitudes. However in some problems of a mutually exclusive nature, the NPV method would be superior to the PI method.
VI. Terminal Value Method
This method assumes that each cash inflow is reinvested in another project/security at a predetermined rate of interest until the termination of the project. Hence compounded value for cash inflow at maturity is calculated.
For example, if there cash inflow at t1 is Rs. 40000/- and life of the project is 5 year's. It will be assumed that this may be reinvested for 4 years at predetermined rate of interest ay, 8%. The compounded value at maturity will be Rs. 54420/-. Similarly, for other cash inflows generated at t2, t3, t4, compounded value WI maturity will be calculated. After that present value of the sum total of the compounded reinvested cash flows is calculated and if it is greater than the present value of the outflows; project will be accepted otherwise rejected.
vii. Internal Rate of Return Method:
This technique is also called as yield on Investment or Marginal efficiency of capital or rate of return on cost etc. This method considers time value of money. The IRR is usually the rate of return that a project earns. It is defined as the discount rate, which equates the aggregate present value of the net cash inflows with the aggregate present value of cash outflows of a project. In other words, it is the rate, which gives the project's NPV zero. IRR is called so because it depends solely on the outlay & proceeds associated with the investments and not on any rate determined outside the investment. Finance Manager has to compare the actual IRR with pre-determined IRR. If the former is more than the later, proposal will be accepted otherwise rejected.