33 Capital Budgeting Techniques

Vishal Kumar

1. Learning Outcome

After completing this module students will be able to:

Understand the financial analysis of the project
Understand Capital Budgeting Techniques
Know the merits and limitations of Capital Budgeting Techniques

2. Introduction

One of the aspects of project management is taking right decision in respect of investment of funds. The success of any business depends upon the investment of funds in such a way as to yield maximum rate of return from an investment. An investment is the employment of funds with the aim of achieving additional income or growth in value over a period of time. An appraisal of any investment proposal is necessary to ensure that the investment of resources will yield desired benefits in future. If the financial resources are in abundance, it would be possible to accept several investment proposals, which satisfy the norms of approval or acceptability. Since the financial resources are limited, therefore an entrepreneur has to choose the best proposal out of the various investment proposals by evaluating their comparative merits. It helps him to identify relatively superior proposals keeping in mind the limited available resources. He has to follow some techniques for making appraisal of investment proposals. So in this module we shall describe the various appraisal methods and acquaint you with their relative merits so that you could identify the best method for appraising investment proposals in different situations.

3. Capital Budgeting Techniques: At each point of time a project manager will have a number of investment proposals regarding various projects in which he can invest money. In such situations he has to compare and evaluate all these projects and decide which one to take up and which one to reject. In order to maximise the value of the firm, it is imperative that the best or most profitable investment projects are selected. There are a number of techniques available for appraisal of investment proposals and can be classified as below:

4. Traditional Methods:

1. Pay-Back Period Method: Pay-back period method also known as pay-off or pay-out method is the most popular and widely accepted traditional method of evaluating capital investment proposals. Pay-Back period is the period in which the total investment in permanent assets pays itself back. It is based on the principle that every capital investment pays itself back over a period of time from the additional earnings of the project itself. It means where the total earnings from investment equals the total outlay, that period is the pay-back period. Suppose, a fixed asset costs Rs1,00,000 and the additional earnings from this asset over the first five years are Rs24,000, Rs36,000, Rs40,000, Rs40,000 and Rs32,000 respectively. The payback period in this case would be three years because the total investment gets fully recovered by the earnings of the first three years i.e. Rs24000 + Rs36,000 +Rs 40,000 = Rs1,00,000. For this purpose, net cash inflow shall be calculated first in the following manner:-

Note:- Since depreciation does not affect the cash inflowtherefore it has not be taken into consideration in calculating net cash inflow. But it is allowed as an admissible deduction under income tax act.

Computation of Pay-back Period Method

Merits of Pay-back Period Method

Pay-back period method is strongly recommended for evaluating the capital investment proposals. The merits of this method are as follows:

1) Easy to calculate and simple to understand. It is a good indicator of how quickly the amount invested is going to be recovered.

2) It provides a convenient measure of the profitability of alternative projects and aids in making the choice.

3) Useful where the firm is suffering from cash deficiency.

4) Liquidity requirement requires earlier cash flows. Hence, firms having high liquidity requirement prefer this tool because it involves minimal waiting time for recovery of cash outflows.

5) Business enterprises facing uncertainty – both of product and technology, prefer this method due to technological obsolescence and product obsolescence.

6) It is a handy tool for evaluating investment proposals where accuracy in estimates of profitability is not vital.

Limitations of Pay-back Period Method

The pay-back method suffers from the following limitations:

1) This method ignores the post pay back annual cash inflows.

2) This method ignores time value of money. Sums to be received in future should be discounted to current values.

3) It overlooks the cost of capital

4) The method is not flexible. A small change in cost of production will affect the cash inflows and as such it will also affect pay-back period.

5) It over-emphasizes the importance of liquidity as a goal of capital investment decisions.

2. Accounting Rate of Return: A reasonable rate of return on investment is desired by every business house. So this method takes into account the earnings expected on investment over their whole life. Where the decision is to be taken for the purpose of evaluating capital investment proposals, earnings from the capital investment is being calculated. It is the minimum rate of return (called as cut-off rate) below which the firm may decide that they will not undertake any project. The rate of return is to be decided by the management. Under this method, profits are taken on the basis of accounting concept i.e. profits after depreciation and tax. Out of the various alternative capital projects, the one that gives the highest rate of return, in general, would be more acceptable than others. Profitability, thus, becomes the basis of capital expenditure decision. Average Rate of Return (or Accounting Rate of Return) method calculates the profitability of the different proposals in the following manner:

What is Rate of Return?

‘Rate of Return’ is the ratio of earnings to investment. There are, however, two principal variations in this

Average Annual Earnings

These are computed by totaling the expected annual profits (after taxes) of all the years during the life term of the project and dividing the total y the number of years. Average Annual Earnings may be expressed in three ways:

a) Earnings before depreciation and taxes.

b) Earnings before depreciation but after taxes.

c) Earnings after depreciation and taxes.

The management should, obviously, use the similar connotation for all capital decisions.

Original Investment

It refers to the Total Cost of Project till its commissioning minus any Salvage value.

Average Investment

It means the original cost divided by 2 and where there is some salvaged value recoverable at the end of the life of the asset, it would be:

= ½(Original Cost-Salvaged Value) + Salvaged Value.

The average investment approach is more realistic than the original investment approach, since, the investment gradually decreases over the number of years. It is assumed that the value of the asset at the end of its life is reduced to zero or its Salvaged value is based on the straight line method of depreciation.

Most Popular Formulation

Out of the variations of Average Annual Earnings given above, the most widely adopted variation is, Earnings After Depreciation and Taxes, hence, the most popular formulation for Average Rate of Return is as below:

Merits of Average Rate of Return Method

The main advantage is that it is simple and easy to calculate.
Easy to understand as it provides a accurate estimate of the time needed for the organization to recoup the cash invested.
The concept of accounting rate of return is a familiar concept to calculate ROI. The profits are calculated on the basis of accounting concept. i.e Profit after depreciation and taxes.
It provides sound yardsticks for comparing the profitability of different projects.
ARR considers all net incomes over the entire life of the project and provides a measure of the investment‟s profitability.

Limitations:

ARR method also ignores the time value of money and considers the value of all cash flows to be equal.
This technique uses accounting numbers that are dependent on the organization‟s choice of accounting procedures and practices.
The method uses net income rather than cash flows. While net income is a useful measure of profitability, the net cash flow is a better measure of an investment‟s performance.
Ascertainment of fair rate of return on capital invested is quite difficult.

5. Discounted Cash Flow Methods

Discounted cash flow methods sometimes also called as Time-adjusted techniques, are an important tool in the hands of the management to evaluate the profitability of the capital expenditure. The basic characteristic of these techniques is the concept of Cash Flow. The cash flows are discounted to the present value because the value of a rupee today cannot be equivalent to the value of a rupee after two years. So time value of money is considered both for amount invested and cash flows generated from that investment.

Discounted cash flow techniques, thus, overcome the shortcoming of the Pay-back Period method by taking into account the entire period of use. These techniques are mainly of two types:

Net Present Value Method (NPV Method)
Internal Rate of Return Method (Time Adjusted Rate of Return/IRR Method)

1. Net Present Value Method

Net Present Value (NPV) is considered as the most suitable technique of evaluating the capital investment proposals. It takes into account the time value of money. An investment has cash flows throughout its life, and it is assumed that a rupee of cash flow in the early years of an investment is worth more than a rupee of cash flow in a later year.

Where the decision is to be taken for evaluating the capital investment proposals cash inflows and cash outflows associated with a particular project are firstly be worked out. Then present value of cash inflows and present value of cash outflows are calculated at the rate of return which is acceptable to the management. This rate of return is considered as the “Cut off rate” and is generally determined on the basis of cost of capital suitably adjusted to allow for risk element involved in the project. Cash outflows represent the investment and commitment of cash at different point of time and Cash inflows represent the profits before depreciation and after tax. Net present value (NPV) is the difference between the present value of the future cash inflows from an investment and the present value of cash outflows. Present value of the expected cash inflows is computed by discounting them at the required rate of return.

The following are the steps to calculate net present value:-
Determine the net cash inflows in each year of the investment
Select the desired rate of return
Find the discount factor for each year based on the desired rate of return selected
Determine the present values of the net cash inflows by multiplying the cash inflows by the discount factors.
Total the amounts of cash inflows discounted at the cut off rate for all years in the life of the project
Lastly subtract the present value of initial capital investment.

Accept or Reject Criteria:

If NPV≥Zero Accept the proposal

If NPV<Zero Reject the Proposal

Symbolically it is written as:

Where, Net Present value of (NPV) of the future sum (C) to be received after a period „n‟ for which discounting is done at an interest rate of ‘r’.

Merits of Net Present Value Method

Present Value Method is a definite improvement upon the traditional methods. So many good points have been attributed to it:

1) While assessing the profitability of a project, it takes into account the total working life of the asset.

2) It is more objective in its approach, since subjective decisions like depreciation do not have any effect upon it.

3) Discounting of the cash inflows arising in future allows a proper appreciation of the soundness of the project or otherwise. It is suitable for long term investment decision.

4) This method has the unique characteristic of matching of cost of borrowing money for investment into fixed assets with the expected return on such investment. This comparison is made valid by calculating the present values of amounts receivable in the time to come.

5) By taking time factor into consideration, possible risk and uncertainly of a project are dully recognised.

Limitations of NPV Method

The pay-back approach suffers from the following limitations

1) Forecasting of sales and costs to determine future inflows of cash is a difficult task. Errors in such forecasting may lead to serious mistakes at decision-making.

2) What is the appropriate rate of interest? To answer this question it is not easy. Various rates of interest can be considered. A discount (or interest) rate appropriate at present may be totally irrelevant in a future period.

3) It involves too many calculations. When alternative projects are considered, the task of finding out cash inflows and determining their present values requires time, labour and energy.

The criticisms are more apparent than real. As Anthony and Reece put it, “Those managers who do use one of the discounting methods argue that the extra work involved is small, and that the results, although admittedly rough, are nevertheless better than the results of calculation that do not take into account the time value of money.

2. Internal Rate of Return (IRR) Method

IRR method which is sometime called as Time-adjusted rate of return method, Project rate of return of method, Yield method, Trial and Error Yield method, is also a modern technique for evaluating the capital investment proposals which discounts the cash flows according to time involved. Under present value method a discount rate was used to calculate the present values of cash inflows. And while evaluating the project, the project which has the highest Net Present Value was ranked at the top.

Under the Internal Rate of Return (IRR) method, no rate of interest is given, rather the rate of interest is to be found out which makes the present values of cash inflows exactly equal to the amount invested in the project. The Internal Rate of Return of a project is thus that discount rate which equates the total present value of the cash inflows (net) with the total initial cost. In other words, it is a rate at which the net present value becomes Zero.

Internal Rate of Return:

Discounted sum of Inflows = Discounted sum of Outflows

How to find out the Internal Rate of Return?

The following steps may be taken to calculate IRR:

Scenario 1: For an investment with uniform cash flows over its life, the following equation is used:

Step 1: Calculate the Present Value Factor by dividing the cost of investment by annual cash flow i.e.

Step 2: Once the Present Value Factor has been calculated, compare the Present Value Factor with the number of years equal to the life of the asset with the help of Present Value Annuity Tables. The rate of discount at which Present Value of an Annuity for estimated life of the project equates the Present Value Factor, will be the Internal Rate of Return of the project.

Scenario 2: When the net cash flows are not uniform over the life of the investment, the determination of the discount rate can involve trial and error and interpolation between interest rates. The following steps should be followed:

i. Assume the rate of discount at which Present Values of Cash Inflows should be factored.

ii. Calculate the present value of cash inflows by using the assumed discount rate.

iii. Compare the total present value of cash inflows with the cost of the project.

iv. If the total present value is more than the capital cost, then assume the higher rate of discount at which the present values should be factored.

v. If the total present value is less than the capital cost, then assume the lower rate of discount at which the present values should be factored.

vi. Repeat the procedure until the present value of cash inflows equals to the cost of the project.

Merits of Internal Rate of Return Method

Time adjusted calculations are definitely better to use than unadjusted amounts. This method has also the same advantages as the Net present Value method claims as is given below:

It takes into account the full span of the working of an asset.
It is more objective since subjective considerations like depreciation etc. to not prejudice it.
Money has a time value. This method recognizes the importance of this in its analysis.
Ranking of the projects becomes purposeful as this method matches the present value of cash outlay and cash inflows.
Comparison becomes valid only when the earnings are discounted to present values, since different investments have different earnings patterns.
Due recognition is given to risk and uncertainty in future.

Limitations of Internal Rate of Return Method

IRR method, no doubt, considers the time value of money but still this method bears certain limitations which are discussed as follows:

Tedious calculation process if there are more than one cash outflows.
This approach creates a special situation if we compare two projects with different inflow/outflow patterns.
Under this method it is assumed that all the future cash inflows of a proposal are reinvested at a rate equal to the IRR. It is difficult to imagine that the same firm has an ability to reinvest the cash flows at a rate equal to IRR.
If an investment is to be made in two mutually exclusive projects which have considerably different cash outlays. A project with a larger commitment of funds but lower IRR contributes more in terms of absolute NPV and increases the shareholders‟ wealth. In such situation decisions taken only on the basis of IRR criterion may not be correct.

Summary: The success of any business depends upon the investment of funds in such a way as to yield maximum rate of return from an investment. An investment is the employment of funds with the aim of achieving additional income or growth in value over a period of time. An appraisal of any investment proposal is necessary to ensure that the investment of resources will yield desired benefits in future. Since the financial resources are limited, therefore an entrepreneur has to choose the best proposal out of the various investment proposals by evaluating their comparative merits. He has to follow some techniques for making appraisal of investment proposals. At each point of time a project manager will have a number of investment proposals regarding various projects in which he can invest money. In such situations he has to compare and evaluate all these projects and decide which one to take up and which one to reject. Capital budgeting techniques help him to identify relatively superior proposals keeping in mind the limited available resources. The techniques of capital budgeting are broadly discussed in two categories i.e. traditional techniques and discounted cash flow techniques. Traditional techniques are Pay-back period and Accounting Rate of Return and Modern techniques or Discounted Cash Flow techniques are Net Present Value and Internal Rate of Return.

Learn More

Suggested Readings:

Projects: Planning, Analysis, Selection, Implementation & Review, Prasanna Chandra, Tata McGraw-Hill Publishing
Project Management: A Managerial Approach, Jack R. Meredith, Wiley Publications
Project Management: A Development Perspective, Goyal B.B., Deep & Deep Publications.
Project Planning and Control, Mohsin M., Vikas Publishing House.
Project Management, Chaudhary, S., Tata Mc Graw Hill Publications.
Project Management, Maylor, Pearson Education
United Nations Industrial Development Organization, Guide to Practical Project Appraisal–Social Benefit Cost Analysis in Developing Countries, Oxford & IBH.

Points to ponder:

Pay-Back periodis the period in which the total investment in permanent assets pays itself back.
ARR the minimum rate of return (called as cut-off rate) below which the firm may decide that they will not undertake any project.
Net Present Value (NPV) is considered as the most suitable technique of evaluating the capital investment proposals.
Net present value (NPV) is the difference between the present value of the future cash inflows from an investment and the present value of cash outflows.
The Internal Rate of Return of a project is thus that discount rate which equates the total present value of the cash inflows (net) with the total initial cost.