Capital Budgeting is the process by which the firm decides which long-term investments to make. Capital Budgeting projects, i.e., potential long-term investments, are expected to generate cash flows over several years. The decision to accept or reject a Capital Budgeting project depends on an analysis of the cash flows generated by the project and its cost.
To find the attractiveness of any investment proposal, the financial manager should keep in mind following things;-
The amount expended
The potential benefits
Economic life of project
Traditional or non-discounting techniques
Traditional method does not consider time value of money. It considers that prset value is equal to future value. Traditional method is also called non discounted or unsophisticated method.
There are two methods of evaluation:-
Pay back period method
Payback period is defined as the number of years required for the proposal's cumulative cash inflows to be equal to its cash outflows.
In other words, the payback period is the length of time required to recover the initial cost of the project.
It can be computed in two ways.
When annual inflows are equal:- When the cash inflows being generated by a proposal time period which means the cash inflows are in the form of annuity, the payback period can be calculated by dividing the cash outflow by the amount of annuity.
When the annual cash inflows are unequal:- In cash the cash inflows from the proposal are not in annuity form then the cumulative cash inflows are used to compute the payback period.
The decision rule:- Payback period does not give clear indication of the decision rule. If the payback period is more than the target period , then proposal should be rejected and vice versa.
Advantages of payback period
It is very simple to understand and easy to calculate.
This method is cheap, fast and cost of labour is very less.
It reduces the loss through obsolescence as a project which have shorter payback period is always preferred.
This method is best suited for those firms whose liquidity position is not good.
Disadvantages of payback period
By this method true profitability of the project can not be assessed.
This method does not take into account the magnitude and timing of cash inflows .
It does not consider the cost of capital, which is needed to make good investment decisions.
It is not practical in nature as it treats every asset individually in isolation with other assets.
Accounting rate of return:-
This method uses the concept of accounting profit rather than cash inflows.
It takes into account the earnings from the investment over the whole life span. According to this method, projects are ranked in order of the rate of earnings or rate of return.
Computation of ARR=
(Average annual profit / average investment in the project)*100
Decision rule:-
The project with higher average rate of return is selected and will have higher priority while project with lowest average rate of return will be assigned lowest priority.
Advantages and disadvantages of ARR:-
This method is very easy to calculate and gives true value of profitability.
It is based upon accounting profit and hence it can be easily calculated from financial data.
The drawbacks of this method are:-
It does not consider time value of money, and cash flows and ignores the period in which the profit has been earned.
Time adjusted or discounted cash flows
This method considers the time value of money. It is a more practical approach to decision making. This method assumes that present value of any amount is much more worth than future value. So, before evaluating any project first of all the estimated cash flows must be converted into present value. This is called discounted value.it makes decision and hence it is called discounted method.
The following methods are used under discounted method.
Net Present Value
Profitability Index
Internal Rate of Return
Terminal Value
Net present value:- NPV is a new method for evaluating investment proposals. It takes into account the time value of money and tries to calculate the return on investment by using time element. The NPV of all cash (inflows and outflows) during the whole duration of project is determined year by year by discounting these flows with firms cost of capital or predetermined rate.
Computation of NPV: - (PV of cash inflows- PV of cash outflows)
Decision rule:- Project should be accepted when value of NPV of the project is 0 or positive or cash inflows are greater than the present value of cash outflows.
Advantages and disadvantages of NPV: This method can be used in situation with uniform cash outflows uneven inflows and it also recognizes the time value of money. It gives the true view of profitability of the investment, and considers the objectives of maximum profitability.
It is difficult to understand and operate and does not give good results while comparing projects with unequal investment of funds.
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.
Computation of PI: - (PV of cash inflows / PV of cash outflows)
Decision rule: - If the PI of a project is more than 1 then accept it and reject the proposal if it is less than 1.
Advantages and Disadvantages of PI:-
Unlike net present value, the profitability index method is used to rank the projects even when the costs of the projects differ significantly. And also gives the true view of the profitability of the investment.
It is difficult to understand and operate.
Internal rate of return
This method is an important technique of capital budgeting that takes into account the time value of money. It is also known as time adjusted rate of return or trial and error yield method. The cash flows are discounted at a rate by hit and trial method which equates the net present value to the amount of investment.
Decision rule
IF IRR >K then accept the project, K= cost of capital
If IRR<K then reject the project
Calculation of IRR:-
When annual cash flows are equal over the life of the asset
Factor = (initial outlay / annual cash inflows)
When the annual cash flows are unequal over the life of the asset
(PV of cash inflows at lower rate - PV of cash outflows)
LR+ _______________________________________________
PV of cash inflows at lower rate - PV of cash inflows at higher rate
Advantage and Disadvantages of IRR:-
This method considers the profitability of the projects for its entire economic life and determination of cost of capital is not a pre requisite for the use of this method.
The result of NPV and IRR methods may differ when the projects under evaluation differ in their life and timings of cash flows.
Calculation of payback period method:-
Machine 1 machine 2 machine 3
Initial investment (A) Rs 300000 Rs. 300000 Rs 300000
Sales (B) 500000 400000 450000
Costs:
Direct Material 40000 50000 48000
Direct Labor 50000 30000 36000
Factory Overhead 60000 50000 58000
Depreciation 130000 91667 90000
Administrative costs 20000 10000 15000
Selling Costs 10000 10000 10000
Total Costs(C) 310000 241667 257000
Profit before Tax (B-C) 190000 158333 193000
Less: tax @40% 76000 63333 77200
PAT 114000 95000 151800
ADD: Depreciation 130000 91667 90000
Net cash flow (D) 244000 186667 205800
Payback period (A/D) 1.23 1.61 1.46
Machine 1 has lowest pay back period, so it may be preferred over the other two Machines.
