Edited by Anamika Anand
Capital budgeting is the most important decision in financial management. Capital budgeting is concerned with a long-term investment of funds to create production capacity of a firm in anticipation of an expected flow of benefits over a long period of time. The capital budgeting techniques or evaluation of investment proposals have considerably gained importance. This is truer in the modern business environment. Techniques can be classified into two categories
Non Discounted Cash Flow Techniques
Payback Period Method
Payback period method is traditional and simple most method of capital budgeting. It is defined as the length of time that is required for a stream of cash inflows from the investment to recover the original cash outlay invested in the project.
When periodic cash inflows from the investment are equal, the following formula is used to compute the payback period:
The Cottage Gang is considering the purchase of $150,000 of equipment for its boat rentals. The equipment is expected to last seven years and has a $5,000 salvage value at the end of its life. The annual cash inflows are expected to be $250,000 and the annual cash outflows are estimated to be $200,000.
For the Cottage Gang, the cash payback period is three years. It was calculated by dividing the $150,000 capital investment by the $50,000 net annual cash flow ($250,000 inflows ‐ $200,000 outflows)
The shorter the payback period, the sooner the company recovers its cash investment. Whether a cash payback period is good or poor depends on the company’s criteria for evaluating projects. Some companies have specific guidelines for a number of years, such as two years, while others simply require the payback period to be less than the asset’s useful life.
Average Rate of Return Method(ARR)
The annual rate of return is a percentage calculated by dividing the expected annual net income by the average investment. Average investment is usually calculated by adding the beginning and ending project book values and dividing by two.
Assume the Cottage Gang has expected annual net income of $5,572 with an investment of $150,000 and a salvage value of $5,000. This proposed project has a 7.2% annual rate of return ($5,572 net income ÷ $77,500 average investment).
ARR=Average Annual Profit / Initial Investment
The annual rate of return should not be used alone in making capital budgeting decisions, as its results may be misleading. It uses the accrual basis of accounting and not actual cash flows or time value of money.
Discounted Cash Flow Techniques
Net Present Value Method
This method takes into account the time value of money by discounting an investment’s future return to a present value. The premise of the time value of money is that in-hand money today is worth more than the same money in the future. In more sophisticated capital budgeting valuations, this discount is taken into consideration when the present value of the future return is assessed against the present value of the cash outflows on an investment
Where, CFn=net cash flow during the period n
n=no.of time periods
Project with NPV > 0, increases stockholder return
Project with NPV < 0,decreases stockholder return
A project requires an initial investment of $225,000 and is expected to generate the following net cash inflows:
Year 1: $95,000
Year 2: $80,000
Year 3: $60,000
Year 4: $55,000
Required: Compute the net present value of the project if the minimum desired rate of return is 12%.
The cash inflow generated by the project is uneven. Therefore, the present value would be computed for each year separately:
The project seems attractive because its net present value is positive.
Internal Rate of Return(IRR)
Like NPV internal rate of return (IRR) method also takes into account the time value of money. It analyzes an investment project by comparing the internal rate of return to the minimum required rate of return of the company. The internal rate of a return sometimes known as the yield on a project is the rate at which an investment project promises to generate a return during its useful life. It is the discount rate at which the present value of a project’s net cash inflows becomes equal to the present value of its net cash outflows.
Under this method, If the internal rate of return promised by the investment project is greater than or equal to the minimum required rate of return, the project is considered acceptable otherwise the project is rejected.
Let us say a company has an option to replace its machinery. The cost and return are as follows:
Initial investment = Rs.5,00,000
Incremental increase per year = Rs.2,00,000
Replacement value = Rs.45,270
Life of asset = 3 years
If we assume IRR to be 13%, the computation will be as follows.
The total of the column Discounted Cash Flows approximately sums up to zero making the NPV equal to Zero. Hence, this discounted rate is the best rate.
As can be seen from the above, using the rate of 13%, the cash flows, both positive and negative become minimum. Hence, it is the best rate of return on investment.
The cost of capital of the company is 10%. Since the IRR is higher than the cost of capital, the project can be selected.
If the company has another opportunity to invest the money in a project that gives a 12% return, the company will still go in for the machinery replacement since it gives the highest IRR.
The Profitability Index is the ratio of benefit arrived and the cost incurred for the project. However, the benefits are the present value of cash flows occur during the period of project and cost is the present value of cash outflows on the project. However, the benefits are the present value of cash flows occur during the period of project and cost is the present value of cash outflows on the project