Discuss capital budgeting techniques including: the Payback Rule, IRR, NPV, and the Profitability Index. Be sure to discuss the advantages and disadvantages of each one.
Discuss capital budgeting techniques including: the Payback Rule, IRR, NPV, and the Profitability Index. Be sure to discuss the advantages and disadvantages of each one.
Solution:-
Capital Budgeting is a managerial tool to enhance the value of a company by evaluating, comparing and selecting among projects which are financially more rewarding compared to the rest.
The capital Budgeting techniques are as follows :
Payback Rule : Payback period in simple terms is the total amount of time taken to recover initial investment of the project.
For ex: Consider the following investment, in which the initial cost of the project is $10,000, which thereafter yields $2000 annually. Hence to recover the initial investment of $10,000, the project will take 5 years. This period of 5 years is called the payback period, the cumulative inflow of which equals the initial investment.
The advantage of payback rule :
ü Beneficial for companies who want to know when they can recover their initial investment.
ü Easy to select between multiple projects based on how earliest can the initial investment be recovered.
ü Easy to apply and use.
The disadvantage of pay back rule is :
ü It does not consider cash flows after the payback period.
ü It treats all the inflows at different time intervals at the same value, hence it does not consider the time value of the money.
ü If a company has a cut-off payback period for accepting a project, it may discard a profitable project with growing inflows after the payback period.
Internal Rate of Return :
IRR is the annualized effective compounded rate of return at which if we discount all the cash flows of a project, the net present value of the project becomes zero.
NPV= SUM(Cn / (1+R)^n)
NPV= Net present value, if we consider R as an independent variable and assign NPV=0, the value of R we get shall be the internal rate of return.
Cn = Cash Flows
R= Internal Rate of Return
N= Number of years
In general if the IRR of the project is higher than the cost of capital the project is accepted, or else rejected.
IRR> Cost of Capital -> Project Accepted
IRR< Cost of Capital-- > Project Rejected
The advantages of IRR are as follows:
ü IRR takes into consideration the time value of cash flows,
ü IRR discounts all the Cash Flows uniformly
ü Using IRR one can decide whether to invest in a project, or compare with expected rate of return in other investments, and invest in the project with higher rate of return, other things remaining unchanged.
ü Calculation of cost of capital is not required.
The disadvantages of IRR are as follows:
ü IRR does not distinguish between 2 projects, of which one is lending and the other is borrowing, hence we cannot take decision based on IRR, since we need lower IRR for borrowing and vice versa for lending.
ü IRR assumes that the Cash Flows received are reinvested at the internal rate of return at all points of time, which might not be practical.
ü In some cases we get multiples values of IRR for the same project, since it is derived mathematically.
ü If we have a project in which cash flow stream changes sign multiple times, computing IRR becomes difficult.
ü IRR ignores the scale of the project. If 2 projects are to be compared, one with an investment of $1million, and another with an investment of $1000, with subsequent inflows. The IRR method shall only select the project which has higher rate of return, but the net value earned from the project is ignored.
Net Present Value (NPV):
NPV is defined as difference between the present value of cash inflows and PV of cash outflows.
Formula,
NPV= SUM( Ct/(1+i)^t)
Where Ct is the Cash Flow in the t'th period, t is the time, i is the discount rate
In general a project is accepted if the NPV is greater than zero, and in between two projects the one with higher NPV is accepted. Higher the NPV, higher the Value created in the project.
The advantages of NPV are:
ü It utilizes time value of money.
ü For finding out NPV, the succeeding and preceding cash flow over the time period are taken into consideration.
ü Importance is given to risk and profits.
ü It assumes that the Cash flows are reinvested at the discount rate, which often for companies is the opportunity cost of capital, so is more realistic.
ü It maximizes the company's value, since it measures the value created in terms of Currency.
The disadvantages of NPV are :
ü Difficult to chose the right discounting rate.
ü Finding the discount rate for risky projects could be erroneous.
ü NPV ignores the efficiency, payback periods of the projects.
ü NPV may be inappropriate when projects may be of different time span
Profitabilty Index:
It is defined as the present value of the future cash flows divided by initial investment
The advantages of profitability index are :
ü It considers all cash flows of the project
ü It considers time value of money
ü It is useful in choosing and ranking the projects
The disadvantages of Profitability index are :
ü It requires an estimation of cost of capital
ü In mutually exclusive projects, it may not be viable
2. Give an example of each capitalbudgeting technique above using your own numbers including cash flows, interest rate, and duration of the hypothetical project analyzed. Be creative with it. You do not need to use an Excel spreadsheet. You can insert your numbers in the word document.
Solution2:
Let us consider a project and evaluate it with respect to the above discussed techniques. For simplicity we take a project which has an initial investment of $10,000 and subsequent inflows as follows
Year1 Year2 Year3 Year4 Year5
2000 2500 3000 2500 3000
The company has a cost of capital of 10% pa. We need to find the NPV, IRR, Payback Period and profitability index.
Now the company can evaluate the project with above capital budgeting techniques as following-
NPV
In this case, the discount rate used shall be equal to the opportunity cost of capital of the company, which is the best rate of return the company can earn on a different project with similar risk.
NPV=
-10000+2000/(1+.1)+2500/(1+.1)^2+3000/(1+.1)^3+2500/(1+.1)^4+3000/(1+.1)^5
=-10000+1818.18+2066.12+2253.94+1707.53+1862.74
=-$291
Hence the project gives a NPV of -$291 at 10% discount rate, hence it can be rejected.
IRR
Now to find the IRR of this project we need to assign the value of NPV to 0, and solve for IRR
NPV=-10000+2000/(1+r)+2500/(1+r)^2+3000/(1+r)^3+2500/(1+r)^4+3000/(1+r)^5
=8.914%
Hence the IRR of this project is 8.91%, which is lesser than the cost of capital 10%, hence the project should be rejected by IRR considerations.
Here it is noteworthy that the NPV of the project is zero at 8.91%, hence if we discount the cash flows at any rate higher than 8.91 we shall get a negative NPV which is validated by the NPV calculations taking discount rate of 10%.
Payback Period
Net Cash Inflow=-10000+2000+2500+3000+2500+3000
Here the initial cost of 10000$ is recovered at the end of 4 Years, hence the Payback period is 4 years. So if the company has a cut off rate of less than 4 years the project shall be rejected else accepted.
Profitability index
Profitability Index= NPV/ Initial investment
=-291/10000
=-.0291
3. Explain which capitalbudgeting technique is superior to the rest and why.
Solution3
We have discussed a few capital budgeting techniques and their advantages and disadvantages. Out of the discussed techniques NPV and IRR are the two most effective tools. However they both have their drawbacks. NPV ignores the efficiency of the project. Also to evaluate a project, the discount rate used must be the rate of return on a similar risk project. In case of evaluating risky projects, calculating the risk premium is a tough call. On the other hand in case of projects with alternating streams of cash flow, IRR may give erroneous values. Also IRR shall assume the inflows to be reinvested at the same IRR, which may not be feasible. Sometimes to eliminate this error, we use modified IRR which reinvests the inflows at market rate of return and not IRR. Hence these two are superior techniques depending on the kind of project, since mostly they would give the same outcome if we compare projects, but in cases when they select different options then we need to look into other factors like the amount of investment involved, the timeframe the company wants to invest for .