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Evaluation of Capital budgeting techniques

By: Dhirender Devender Manish Rakesh Fanish Ajay

The Basics of Capital Budgeting


Should we build this plant?

Introduction
Financial management is largely concerned with financing, dividend and investment decisions of the firm with some overall goal in mind.

Capital budgeting is primarily concerned with sizable investment in long term assets.

What is capital budgeting


The term capital budgeting refers to planning for capital assets. Capital budgeting is a process of planning capital expenditure which is to be made to maximize the profitability of the organization. Capital budgeting is a long-term planning exercise in selection of the projects which generates returns over a number of years . It includes a financial analysis of various proposals regarding capital expenditure.

Purpose of capital investments


Expansion Replacement Renovation Acquisition

Importance of capital budgeting decision


They have long term effect on the firm. These are irreversible decision These are the base of all organizational activities. These are decision of investing a big amount of capital.

Process of CB decisions
1. Determine the objective

2. Identify alternative investment proposal


3. Screening of each alternative Cost of alternative projects Evolution of return on each alternatives Suitability with identified constraints 4. Determine the cost of capital to be employed

5. Choose the best one


6. Implementation & follow up

Investment appraisal techniques

Payback period method Discounted payback period method Accounting rate of return method Net present value method IRR method NPV vs. IRR MIRR method Profitability Index method

Payback period method

This method recognizes the recovery of original capital investment in projects. This method specifies the recovery time of the investment
Project L Expected Net Cash Flow Year Project L Project S

0 1 2 3

(Rs100) 10 60 80

(Rs100) (90) (30) 50

Payback L = 2 + Rs30/Rs80 years = 2.4 years. Payback S = 1.6 years.

Merits

It is simple to apply, easy to understand and of particular importance to business which lack the appropriate skills necessary for more sophisticated techniques. In case of capital rationing, a company is compelled to invest in projects having shortest payback period. This method gives an indication to the prospective investors specifying when their funds are likely to be repaid. Ranking projects according to their ability to repay quickly may be useful to firms when experiencing liquidity constraints. They will need to exercise careful control over cash requirements. It does not involve assumptions about future interest rates.

Demerits

It does not indicate whether an investment should be accepted or rejected, unless the payback period is compared with an arbitrary managerial target. The method ignores cash generation beyond the payback period and this can be seen more a measure of liquidity than of profitability. It fails to take into account the timing of returns and the cost of capital. It fails to consider the whole life time of a project. It fails to determine the payback period required in order to recover the initial outlay if things go wrong. This method makes no attempt to measure a percentage return on the capital invested and is often used in conjunction with other methods.

Discounted Payback

In this method the cash flows involved in a project are discounted back to present value terms The cash inflows are then directly compared to the original investment in order to identify the period taken to payback the original investment in present values terms. It ensures the achievement of at least the minimum required return

ARR method

This method employing the normal accounting technique to measure the increase in profit expected to result from an investment by expressing the net accounting profit arising from the investment as a percentage of that capital investment.
Accounting rate of return = Average annual profit after tax X 100 Average or initial investment Initial investment + salvage value 2

Average investment =

Merits

It is easy to calculate because it makes use of readily available accounting information. It is not concerned with cash flows but rather based upon profits which are reported in annual accounts and sent to shareholders. Unlike payback period method, this method does take into consideration all the years involved in the life of a project. Where a number of capital investment proposals are being considered, a quick decision can be taken by use of ranking the investment proposals. If high profits are required, this is certainly a way of achieving them.

Demerits

It does not take into accounting time value of money. If fails to measure properly the rates of return on a project even if the cash flows are even over the project life. It uses the straight line method of depreciation. It is biased against short-term projects in the same way that payback is biased against longer-term ones. The accounting rate of return does not indicate whether an investment should be accepted or rejected, unless the rate is compared with the arbitrary management target.

PI

PVCF Initial investment

Profitability index
The PI method compares the present value of future cash inflows with the initial investment.
PI = Present value of cash inflow Present value of cash outflow

If PI>1, the project is accepted If PI<1, the project is rejected

PI method is closely related to the NPV approach. , if the NPV is positive, the PI>1, if the NPV is negative, PI<1.

The only difference between the NPV and PI is that, in NPV the initially outlay is deducted from the present value of cash inflows, whereas with PI approach the initial outlay is used as a divisor.

NPV method

The net present value(NPV) of an investment is the present value of the cash inflows minus the present value of the cash outflows. NPV = PVB PVC

Therefore, if the NPV is: Positive, the benefits are large enough to repay the company for the asset's cost Zero, the benefits are barely enough to cover all three but you are at breakeven Negative, the benefits are not large enough to cover all costs, and therefore the project should be rejected.

Merits

It is based on the assumption that cash flows, and hence dividends, determine shareholders wealth. It recognizes the time value of money. It considers the total benefits arising out of proposals over its life time. The future discount rate normally varies due to longer time span. This rate can be applied in calculating the NPV by altering the denominator. This method is particularly useful for the selection of mutually exclusive projects.

Demerits

It is difficult to calculate as well as understand it as compared to accounting rate of return or payback period method. Calculation of the desired rates of return presents serious problems, as desired rates of return will vary from year to year. This method is an absolute measure. When two projects are being considered, this method will favor the project which has higher NPV. This method may not give satisfactory results where two projects having different effective lives are being compared. This method may not give dependable results.

IRR method
The Internal Rate of Return (IRR) is the rate of return that an investor can expect to earn on the investment. IRR is a percentage discount rate used in capital investment appraisals which brings the cost of a project and its future cash inflows into equality. IRR is a rate which equates the present value of anticipated net cash with the initial outlay.

Merits

It considers the time value of money. It takes into account the total cash inflows and cash outflows. It is easier to understand. For example if told that IRR of an investment is 20% as against the desired return on an investment is Rs 15,396.

Demerits

It does not use the concept of desired rate of return, whereas it provides the rate of return which is indicative of the profitability of investment proposal. It involves tedious calculations, based on trial and error method. It produces multiple rates which can be confusing. Project selected based on higher IRR may not be profitable. Unless the life of the project can be accurately estimated, assessment of cash flows cannot be correctly made.

MIRR method
The MIRR is similar to the IRR, but is theoretically superior in that it overcomes two weaknesses of the IRR; MIRR correctly assumes reinvestment at projects cost of capital. MIRR avoids the problem of multiple IRRs.

3 basic steps of the MIRR

Estimate all cash flows as in IRR. Calculate the future value of all cash inflows at the last year of the projects life. Determine the discount rate that causes the future value of all cash inflows determined in step 2, to be equal to the firms investment at time zero. This discount rate is known as the MIRR.

Terminal Value method


Under this method it is assumed that each cash flow is reinvested in another project at a predetermined rate of interest. It is also assumed that each cash inflow is reinvested elsewhere immediately until the termination of the project. If the present value of the outflows the proposed project is accepted otherwise not.

Merits

Cash inflows reinvested once they are received. Easier to compute as compared to IRR It is better suited to cash budgeting requirement.

However, the major problem of this method lies in projecting the future rates of interest at which the cash inflows will be reinvested.

Cost of Capital

Cost of capital is the rate that must be earned in order to satisfy the required rate of return of the firms investors. It can be define as rate of return on investment at which the price of firms equity share will remain unchanged.

Computing the cost of capital

Determine the capital structure mix Equity Shares Preference Share Debentures Loans Determine individual cost of capital Determine total cost of capital

Factors affecting the cost of capital


General economic condition Market condition Amount of finance required Firms operating & financial decisions

Impact of inflation on capital budgeting


Inflation can simply be defined as an increase in the average price of goods and services. The changes in price of the various factors which may increase the project cost e.g. wage rates, sales prices, material costs, energy costs, transportation charges and so on. Synchronized and Differential Inflation Money Cash Flows and Real Cash Flows

Impact of Taxation on capital budgeting


Taxation causes a change in cash flows, it is a factor to be considered in project appraisal. Taxation affects a project in numerous ways, but probably the most significant three effects are:

Corporate taxes on project profits and losses Investment incentives, where applicable The reduction of WACC, because interest payments are allowable against tax.

Impact of investment incentives on capital budgeting


Investment incentives take a variety of forms, including rates relief, rent-free periods for land and buildings, and lump-sum grants towards the costs of an investment project. Therefore, the effect of such incentives is to change the cash flow pattern of an investment. Any reduction in cash outflows resulting from investment incentives can serve to convert a negative NPV into a positive one.

There are two basic types of investment incentives; cash grants and accelerated depreciation allowances. Cash grants: When these are receivable they should be brought into the project appraisal in the period in which they are receivable. Capital allowances: These allowances have an equivalent cash inflow value of assuming sufficient profits are being earned to cover all the allowances. The cash inflow effect will be lagged to an appropriate period. One year should be assumed unless stated to the contrary.