Evaluation Technique in Capital Budgeting
There are two types of evaluation technique in Capital Budgeting namely discounted cash flow and non discounted cash flow technique. Discounted cash flow technique considers times value of money whereas other technique ignores it.
1. Traditional Method or non discount method
- Pay backs period method or pay out or pay off method
- Accounting Method
2. Time adjusted Method or discount method
- Net present value method
- Internal rate of return method
- Profitability Index
1. Traditional Method
1. Pay Back Period Method:
It is a non discount evaluation technique in capital budgeting. It represents the period in which the total investments in permanent assets pay backs itself. This method is based on the principal that every capital expenditures pays itself back within a certain period out of the additional earnings generated from the capital assets thus it measures the period of time for the original cost of a project to be recovered from the additional earnings of the project itself.
In case of evaluation of a single project, it is adopted if it pays back itself within a period specified by the management and if the project does not pay back itself within the period specified by the management than it is rejected. The payback period can be ascertained in the following manner: Calculate annual net earning (profit) before depreciation and after taxes; these are called the annual cash flows.
Where the annual cash inflows are equal, Divide the initial outlay (cost) of the project by annual cash flows, where the project generates constant annual cash inflows. Where the annual cash inflows are unequal, the pat back period can be found by adding up the cash inflows until the total is equal to the initial cash outlay of project or original cost of the asset.
Payback period = Cash outlay of the project or original cost of the asset
Annual cash Inflows
Illustration 1. A project costs Rs1, 00,000 and yields annual cash inflow of Rs. 20,000 for 8 years. Calculate its pay back period.
= 1, 00,000 = 5 years
Advantages of Pay Back Period
- It is simple to understand and easy to calculate.
- It saves in cost and requires lesser time and labor as compared to other methods of capital budgeting.
- This method is particularly suited to firm, which has shortage of cash or whose liquidity position is not particularly good.
Disadvantages of Pay Back Period
- Ignores cash inflows earned after the pay back period and hence the true profitability of the project cannot be correctly assessed.
- It ignores the time value of money and does not consider the magnitude and timing of cash inflows. it treats all cash flows as equal though they occur in different time periods.
- Completely ignores cost of capital, which is very important; factor in making sound investment decision.
- It treats each asset individually in isolation with other asset, which is not feasible in real practice.
- It does not measure the true profitability of the project, as the period considered under this method is limited to a short period only and not the full life of the asset.
b. Accounting Method:
This method take into account the earnings expected from the investment over their whole life. It is known as accounting rate if Return method for the reasons that under this method, the accounting Concept of profit is used rather than cash inflows. According to this method, various projects are ranked in order of the rate of earnings. The project with the higher rate of return is selected as compared to the one with the lower rate of return.
This method can be used to make decisions as to accepting or rejecting a proposal. The expected return is determined and the project with a higher rate of return than the minimum rate specified by the firm called cut-off rate, is accepted and the one which gives a lower expected rate of return than the minimum rate is rejected. The return in investment can be used in several ways as follows:
Average rate of return method (ARR):
Under this method average profit after tax and deprecation is calculated and than it is divided by the total capital outlay or total investment in the project.
Total Profits (after dep. & taxes) X 100
Net Investment in project x No. Of years of profits
Average annual profit X 100
Net investment in the Project
Return per unit of investment method:
This method is small variation of the average rate of return method. In this method, the total profit after tax and depreciation is divided by the total investment i.e.
Return per Unit of Investment = Total profit (after depreciation and tax) X 100
Net investment in the project
Return on average Investment method:
In this method the return on average investment is calculated. Using of average investment for the purpose of return in investment is referred because the original investment is recovered over the life of the asset on account of depreciation charges.
Return on Average Investment = Total profit (after depreciation and tax) X 100
Total Net investment/2
Advantages of Rate of Return Method
- It is very simple to understand and easy to operate.
- This method is based upon the accounting concept of profits; it can be readily calculated from the financial data.
- It uses the entire earnings of the projects in calculating rate of return.
Disadvantages of Rate of Return Method
- It does not take into consideration the cash flows, which are more important than the accounting profits.
- It ignores the time value of money as the profits earned at different points of time are given the equal weighs.
2. Time Adjusted or Discounted Cash Flows Methods
The traditional methods of capital budgeting suffer from serious limitations that give the equal weights to present and future flow of income. These do not take into accounts the time value of money. Following are the discounted cash flow methods:
a. Net Present Value Method:
NPV is one of the most effective evaluation technique in Capital Budgeting. This method is the modern method of evaluating the investment proposals. This method takes into consideration the time value of money and attempts to calculate the return in investments by introducing the factor of time element. It recognizes the fact that a rupee earned today is more valuable earned tomorrow. The NPV 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. Following are the necessary steps for adopting this method of evaluating investment proposals.
- Determine appropriate rate of interest that should be selected as the minimum required rate of return called discount rate.
- Compute the present value of total investment outlay.
- Compute the PV of total investment proceeds.
- Calculate the NPV of each project by subtracting the present value of cash inflows from the present value of cash outflows for each project.
- If the NPV is positive or zero, you may either accept or reject the project.
Advantages of Net Present Value
- It recognizes the time value of money. It is applicable in cash of both even cash flows as well as uneven cash flows.
- Considers earnings over the entire life of the projects and the true profitability of the investment proposal can be evaluated.
- It takes into consideration the on\objective of maximum profitability.
Disadvantages of Net Present Value
- This method is more difficult to understand and operate.
- It is not easy to determine an appropriate discount rate.
- It may not give good results while comparing projects with unequal lives and investment of funds.
b. Internal Rate of Return Method:
It is a modern technique of capital budgeting that takes into account the time value of money. It equates the net present value so calculated to the amount of the investment.
The discount rate determine internally, hence the method is also known as IRR. It refers to the rate of discount at which the present value of cash inflows is equal to the present value of cash outflows. Steps required for calculating the IRR.
- Determine the future net cash flows during the entire economic life of the project. It considers cash inflows for future profits before depreciation and after taxes.
- Determine the rate of discount at which the value of cash inflows is equal to the present value of cash outflows.
- Accept the proposal if the IRR is higher than or equal to the minimum required rate of return.
- In case of alternative proposals select the proposals with the highest rate of return as long as the rates are higher than the cost of capital.
Determination of Internal Rate of Return:
- When the annual net cash flows are equal over the life of the assets.
Present value Factor = Initial Outlay
Annual cash Flows
- When the annual net cash flows care Unequal over the life of the assets.
Following are the steps
- Prepare the cash flow table using an arbitrary assumed discount rate to discount the net cash flows to the present value.
- Find out the net present value by deducting from the present value of total cash flows calculated in above the initial cost of the investment
- Positive NPV apply higher rate of discount.
- If the higher discount rate still gives a positive NPV, increase the discount rate further the NPV becomes become negative.
- If the NPV is negative at this higher rate, the internal rate of return must be between these two rates.
Advantages of Internal Rate of Return Method
- It takes into account the time value of money. In addition to this, it is also applicable in case of uneven cash flows.
- Considers profitability of the project for its entire economic life.
- It provides for uniform ranking of various proposals due to the % rate of return.
Disadvantages of Internal Rate of Return Method
- It is difficult to understand.
- This method assumes that firm reinvest the earnings at internal rate of return for the remaining life of the project.
- The result of NPV and IRR method may differ when the project under evaluation differ their size.
c. Profitability Index or PI:
A non discount evaluation technique in Capital Budgeting. This is also known as benefit cost ratio. This is similar to NPV method. The major drawback of NPV method that not does not give satisfactory results while evaluating the projects requiring different initial investments. Profitability Index method provides solution to this. Therefore, PI is:
PI = Present value of cash Inflows
Present value of cash outflows
If PI > 1, accept project, if PI<1 then reject project and if PI= 1 then decision is
based on non-financial consideration.
Advantages of PI method
- It considers Time value of money
- It considers all cash flow during life time of project.
- More reliable than NPV method when evaluating the projects requiring different initial investments.
Disadvantages of PI method
- This method is difficult to understand.
- Calculations under this method arte complex