The survival of a business depends upon management’s ability to conceive, analyze, and select investment opportunities that are profitable. The firm must select such projects that maximize the returns of the business. Capital budgeting is the allocation of available resources to various proposals.
It involves estimation of cost and benefits of a proposal, estimation of required rate of return and evolution of different proposals in order to select one. These cost and benefits are expressed in terms of cash flows arising out of a proposal. The cash flows are estimated and are compared to required rate of return; and the proposal with the optimal return and investment is accepted using the following capital-budgeting techniques.
The various commonly used methods are as follows: 1. Traditional Methods 2. Time-Adjusted or Discounted Cash Flow Methods.
1. Traditional Methods:
(a) Payback Method:
This method represents the period in which the total investment in permanent assets is paid back with the additional earnings generated from the investments. The firm prefers making investment in that proposal where the capital invested is recovered as early as possible.
Payback period is defined as the period required for the proposal’s cumulative cash flows to be equal to its cash outflows. The payback period is usually stated in terms of number of years, it is the period for a proposal to “break even” on its net investment.
The payback period can be ascertained in the following manner:
i. Calculate annual net earnings (profits) before depreciation and after taxes; these are called annual cash inflows.
ii. Divide the initial cost of the project by the annual cash inflow, where the project generates constant annual cash inflows.
Thus, PBP = Cash outlay (cost) of the project/Annual cash inflows
iii. Where the annual cash inflows are unequal, the cash flows are added up until the total is equal to the initial cash outlay of the project.
(b) Improvements in Traditional Approach to Payback Method – Discounted Payback Period:
To overcome the limitations of the traditional approach, improvements to the method with regard to cash inflows-generated post-payback period and time value of money are made.
Under this method present value of cash outflows and future cash inflows are computed at an appropriate discount rate. The project which gives discounted payback period is accepted.
(c) Rate of Return Method (ARR):
Rate of return method is also known as accounting rate of return or average rate of return. It is based on the concept of rate of return. It measures the return on the project with regard to investment required for the project. The return is measured in terms of the average profit earned by the project over the duration of the project.
APR = (Average annual profit (after tax) x 100)/Average investment in the project
Average profit = Average accounting profit earned over the project duration
= Total of annual profit earned over the duration/Number of years of project duration
It is the average investment/amount of fund that remained invested or blocked in the project over its economic life.
= ½ (Initial cost + Installation expenses – Salvage value) + Salvage value + Additional working capital if required
2. Time-Adjusted or Discounted Cash Flow Methods:
Time-adjusted methods take into account the profitability and also the time value of money unlike in the traditional methods.
These methods are popular in the modern days and also known as discounted cash flow methods.
The traditional techniques of pay back and ARR cannot be regarded as sound and efficient techniques. These techniques do not consider the total benefits emanating from a proposal. They ignore the time value of money. Investment decision techniques based on discounted cash flows replace accounting income with cash flows.
They explicitly consider the time value of money. These techniques are also called the present values techniques and fulfill all the requisites of a good evaluation technique.
Cash flows occurring at different points of time do not have the same economic worth. Cash flows that occur earlier in time are worth more than cash flows that occur later on account of factors such as inflation and interest rates. These cash flows must be discounted with reference to the time gap between different cash flows and a predetermined discount rate.
Time Value of Money:
The concept of time value of money refers to the fact that the money received today is different in its worth from the money receivable at some other time in future. For example, if you were offered a choice between receiving Rs.1000 today and receiving Rs.1000 after one year, the obvious choice of any person would be to receive Rs.1000 today. It is a better option as Rs.1000 received today can be invested in a bank or any other instrument and the value of such investment one year later would be higher.
Assuming that you can invest the Rs.1000 after one year. Thus, the earlier we receive money, the better and more valuable it is. Similarly, money payable today is more valuable than money payable after one year. This preference for current money as against future money is captured by the concept of time value of money.
Reasons for Time Value of Money:
There are several reasons for this preference towards current money.
They are as follows:
Money received today is in our hands. One can be sure about it. One cannot be so sure about the money that is receivable after one year. There can be unforeseen developments during the year that may deprive one of receiving the promised money. Current money is more valuable as it comes without any apprehension that the other party (the debtor) may become insolvent or untraceable.
2. Preference for Present Consumption:
If money is in hand, one has the choice of using it whichever way one likes. If money is receivable in future, even if it is sure to be received, it can be used only after some time. The benefits accruing from spending the money will not be enjoyed if it were in our hands today.
It is observed that the prices of almost all products and services go up with the passage of time. This phenomenon of a continuous rise in prices is termed as inflation. Current money is preferred to future money as it is known that on account of inflation lesser things can be bought with the same amount of money in future that can be bought today.
4. Reinvestment Opportunities:
Present money is also preferred because it can be reinvested to earn some additional return. This opportunity to get returns will not be available if the money is not invested now. The existence of reinvestment opportunities and the urge to earn a return by investing this current money is one of the strong reasons for the time preference for money.
5. Frequently Encounter Situations that Cash Flows over Several Periods of Time:
For example, a fixed asset purchased today will generate cash flows in terms of revenue generated over a number of years. A firm may raise funds today by issuing debentures on which interest will have to be paid for several years together with redemption amount in one or several installments. Decision making in such situations should be based upon the cash flows that are comparable.
The absolute cash flows of different time periods can be made comparable by applying the concept of time value of money. The cash flows of different time periods are made comparable by adjusting them with reference to the required rate of return. This is done in such a way so as to express them in the amounts of the same date. These equivalent values can be expressed as future values or as present values.
6. Future Value of Money:
The future value of an amount may be defined as the value of that amount if it were to be received at the end of a defined period of time. For example, say Rs.1,000 is deposited in a bank account at 10% interest for a period of one year. This deposit of Rs.1,000 will become Rs.1,100 after one year inclusive of interest, Rs.1,100 is the FV if today’s Rs.1,000 at 10% interest after one year. Similarly, the future of Rs.1,000 after two years, considering a required rate of return of 10% will be Rs.1,000 x 1.1 x 1.1 = 1,210. The future value of Rs.1,000 after three years, considering the same required rate of return, will be Rs.1,000 x 1.1 x 1.1 x 1.1 = Rs.1,331.
7. Present Value of Money:
The present value of future money is the present worth of that money. The present value can be calculated by applying the required rate of return to the future value. For example, the present value of Rs.1,100 receivable at the end of one year, considering a required rate of return of 10% is Rs.1,000.
Similarly, the present value of Rs.1,331 receivable at the end of three years, considering a required rate of return of 10% also is Rs.1,000. Thus, present value and future value of money are mathematically related and the relationship can be stated as under –
where r – rate of interest per time period, and
n = number of time periods.
For example, a deposit of Rs.10,000 is made in a bank for five years with interest at 8% p.a (annually cumulative). The FV of this deposit is –
FV = PV (1 + r)n
= Rs.10,000 (1 + .08)5 = Rs.14,693.28
Similarly, the present value of Rs.10,000 receivable after three years and considering the interest at 10% is as follows –
PV = FV/(1 + R)nPV = Rs.10,000/(1 + .10)3
The concept of future value and present value is widely applied in capital budgeting process. In evaluating a capital budgeting proposal, the cash outflows and cash inflows of different time periods are made comparable. This can be done by calculating the present value and/or future value of the various cash flows such that they reflect the cash flow of particular chosen time period.
The technique used for calculating the future value of a cash flow is called compounding and the technique used for calculating the present value of a cash flow is called discounting.
(a) Net Present Value Method:
In this method, return on investments are calculated by introducing the factor of time element. It recognizes the fact that a rupee earned today is worth more than the same rupee earned tomorrow. The net present values of all inflows and outflows of cash occurring during the entire life of the project is determined separately for each year by discounting these flows by the firm’s cost of capital or a pre-determined rate.
The steps are to be followed are listed here:
1. Determine the “cut-off” rate or “discount rate.” It should be the minimum rate of return below which the investor considers that it does not pay him to invest rather it should reflect the opportunity cost of capital of the investor.
2. Compute the present value of cash outflow using the discount rate.
3. Compute the present value of cash inflows (profit before depreciation and after tax) at the predetermined rate.
4. Calculate the net present value of each project by subtracting the present value of cash inflows from the present value of cash outflows (NPV).
5. If the NPV is zero, the proposal may be accepted. If the NPV is negative, reject the proposal.
6. If projects are mutually exclusive, the projects should be ranked in order of NPVs and the first preference should be given to the proposal having the maximum positive NPV.
NPV = Present value of cash inflows – present value of initial investment.
(b) Internal Rate of Return (IRR):
IRR is defined as the discount rate at which the NPV of the proposal works out to be zero; it equates the present value of cash inflows with present value of cash outflows.
In this method, internal rate of return and the cash inflows of a project are discounted at a suitable rate by hit and trial method, which equates the net present value so calculated to the amount of the investment.
As the discount rate is determined internally, this method is called the internal rate of return method.
To practice the internal rate of return method, the steps listed here are important:
1. Determination of cash inflows for the entire economic life of the project; profits before depreciation but after taxes are estimated.
2. Determination of the rate of discount.
3. Acceptance of the proposal if IRR is higher than or equal to the minimum required rate of return; rejection of the proposal if the IRR is lower than the cost of cut-off rate.
4. In case of alternative proposals, select the proposal with the highest rate of return as long as the rates are higher than the cost of capital or cut-off rate.
IRR (if the annual cash flows are equal over the life of the asset)
Present value factor = Initial outlay/Annual cash-flow
(c) Profitability Index or Benefit Cost Ratio:
It is the relationship between present value of cash inflows and the present value of cash outflows that is measured.
Profitability index = Present value of cash inflow/Present value of cash outflow
PI = PV of cash inflows/Initial cash outlay
PI may be found for net present values of inflows.
PI (net) = NPV/Initial cash outlay
The net PI = Gross PI – 1
The proposal with PI more than one is accepted, and is rejected if PI is less than one.
Merits and Limitations of Profitability Index Method:
As the net present value method does not rank projects particularly when the costs are significantly different, this method is most suitable. It is simply a modification of the net present value method. Limitation of profitability index method is similar to that of net present value method.