Capital budgeting evaluation methods/techniques
The techniques/methods of evaluation of capital budgeting proposals are as under:
(i) Degree of urgency method.
(ii) Pay-back period method.
(iii) Unadjusted rate of return method.
(iv) Present value method.
- (a) Time Adjusted Rate of Return method.
- (b) Net present value method.
1. Urgency Method
As a matter of fact, urgency method does not suggest any evaluation method/technique but suggests about adhoc decision. There are some projects which need spot and immediate decision while others are postponed for some future date. The example to illustrate urgency is: Breakdown due to loss of a component of the machine which is to be replaced otherwise production will suffer.
Thus, it will be given priority over other projects pending with management for approval. This method is very simple to understand and use. No method is used, only decision of management is final with regard to urgency.
(2) Payback Period Method
This method is also known as pay-off or replacement period method. It is a method where in number of years required to cover the original investment. This method is based on the theory of capital expenditure pays itself back over a number of years. It speaks about the time in which the original investment is equal to the earnings generated by that investment. Thus, it is that point of time when original investment or outflow of cash is equal to the inflow of cash.
Thus, the formula to calculate the payback period is as under:
payback period = Original Investment / Annual cash-inflow
The payback period can be :
(i) When even cash-inflow: Means equal amount of income every year.
(ii) When uneven cash-inflow: When cash inflow is not uniform.
(i) Cash inflow uniform
Example
A Project cost $2,00,000, annual income $40,000 its working life is 8 years. Calculate its pay back-period.
Solution
Payback period = Original Investment / Annual cash inflow
= $2,00,000 / $40,000 = 5 years
Example
A project cost $10,00,000. Its annual income $1,60,000 after depreciation @20% p.a., but before tax which is 50%. Calculate payback period.
Solution
$ | |
Profit before tax | 1,60,000 |
Less: 50% tax | 80,000 |
Profit after tax | 80,000 |
Add: Depreciation 20% (10,00,000) | 2,00,000 |
2,80,000 |
Annual cash inflow payback period = Cash investment / Annual cash inflows
= 10,00,000 / 2,80,000 = 3.57 years
When cash inflow is not uniform
Year | Annual cash inflow |
1 | 20,000 |
2 | 25,000 |
3 | 25,000 |
4 | 30,000 |
Solution
Year | Annual cash inflow ($) | Commulative cash-inflow ($) |
1 | 20,000 | 20,000 |
2 | 25,000 | 45,000 |
3 | 25,000 | 70,000 |
4 | 30,000 | 1,00,000 |
Pay back period = 4 years
Evaluation
The shorter the payback period, the better to select such proposals. This method is very popular in U.S.A and U.K for evaluating capital proposals.
Advantages of Payback Period
The main advantages of payback period method are as under:
(i) Easy in calculation. The main merit of this method is that it is very simple to understand and use.
(ii) Knowledge of Payback Period. The knowledge of payback period is useful in decision-making, the shorter the period better the project.
(iii) Protection from loss due to obsolescence. This method is very suitable to such industries where mechanical and technical charges are routine matter in such industries thus, shorter payback period view avoid such losses.
(iv) Useful for reliable conclusion. This method is suitable to an organization which has shortage of cash, it might had borrowed the sum for capital expenditure. The shorter period will result in short term return of borrowed capital, thus, useful conclusions are drawn by this method.
Demerits of payback period method
The main demerits of this method are as:
(i) No thought to after payback period. This method suffers from this effect that it only suggests the payback period. What will be the reviews after payback period no thought is given to such reviews.
(ii) No thought to Pattern of Income. This method does not give any thought to pattern of income, of course, the two projects have the same payback period. The proposal whose cash inflow is large in the initial year is preferred over the proposal which generates large cash inflows in later years.
(iii) Cost of Capital. Under this method the cost of acquiring capital is not taken into account, of course, it is very important point in Capital Expenditure Planning.
(iv) Delicate and Rigid method. No doubt this method is very delicate in its approach. A charge in operation cost will affect the cash flows and as such payback period shall also be changed and there are changes the entire decision will be charged.
(v) No thought to profitability of the projects. In this method, no thought is given to profitability of the project over its life cycle. This technique is not suitable to long-term projects.
(3). Unadjusted Rate of Return Method
This is popularly known as accounting Rate of Return (ARR) method as here accounting statements are used to measure profitability of the projects. Various proposals are ranked in order to their earnings. The project of higher rate of return is selected. The Accounting Rate of return can be known by dividing the average income over the life of the project.
Thus ARR = Average income / Average investment
There are two approaches
(a) Original investment method.
(b) Average investment method.
(a) Original investment method.
In this method, average annual earnings or profits over the life of the project are divided by the outlay of capital cost. Thus ARR is the Ratio between Average Annual profit and original investment.
ARR = Average annual profit during life of the project / Original investment
Example
A project costs $600,000, its scrap is $40,000 after five years, profit after Depreciation and taxes during five years are: 50,000, $70,000, $60,000 and $30,000. Calculate Average rate of return on investment.
Solution
Total Profits = $50,000 + 70,000 + 80,000 + 60,000 + 30,000 = $2,90,000
= 2,90,000 / 5 = $58,000
Net investment ($6,00,000 – 40,000) = $5.60,000
Average rate of return = (Av. Annual Profit / Net investment) x 100
= (58,000 / 56,000) x 100
= 10.35%
(b). Average Investment method
In this method average profit after Depreciation and taxes are divided by the average amount of investment. Thus,
Average Return on Average investment = (Av. annual profit after Dep. and taxes / Average investment) x 100
Example
Average profit = $50,000
Net Investment = $5,00,000
= 50,000 / 2,50,000 = 20%
Average investment = 5,00,000 / 20 = $2,50,000
Advantages of Rate of Return method
1. Simple method. This method is simple to use and easy to explain.
2. Uses entire earnings. Like payback period it does not take earnings upto payback period but all years earnings are taken into account.
3. Based on Profit. The Accounting projects are easily available from financial data.
Demerits of Rate of Return method
The main demerits are as under:
1. Based on Accounting Profit. It lays emphasis on accounting profit and no thought to cash inflows by the use of capital projects.
2. No thought to time value of money. In this method the time value of money is not considered, of course, it is very useful for capital expenditure. Variation in projects is not taken into Account.
3. Rate of Return. In this method rates of two or more proposals are compared and not the period of project which is a vital factor for decision making.
4. No thought to Re-investment of Profits. This method does not give any thought to re-investment which always affects the rate of return.
5. No thought to the sale of existing plant. This method does not consider the sale value of the existing investment. No thought to incremental cash outflows should be taken to arrive at a correct financial decision.
Time adjusted or discounted cash flow methods
All the above methods discussed so far lacked the study of equal weight to present and future flow of incomes. These methods do not take into account the time value of money, of course, the fact is that a dollar earned today has more value than a dollar earned after five years. This method takes into account the profitability and the time value of money.
The discounted cash flow method can be:
(a) Net Present value method.
(b) Internal Rate of return method.
(c) Profitability Index method.
(a) Net Present value method
This is a modern method of evaluating capital budgeting proposals. In this method, the time value of money is calculated on different investment proposals. The value of one dollar earned today is more than the same dollar earned tomorrow. The net present of all inflows and outflows of cash occufring during the entire life of the project is determined separately for each year by discounting these flows by the firm’s cost of capital.
Steps
The following are the steps to evaluate the capital budgeting proposals using net present value method.
(i) Cut-off rate. This is the rate of return below which the investor considers that it does not pay him to invest.
(ii) Calculation of Net Present Value. Cash outflows arc calculated at the determined rate of discount.
(iii) Calculate the present value of total investment proceeds in cash outflows at the specified discount rate.
(iv) Calculate the net present value of each project by subtracting the present value of cash inflows from the present values of cash outflows for each project.
(v) When inflows are less than outflows, reject the proposals.
Advantages of Net Present Value
The following are the merits of NPV:
(i) Entire Economic Life. Under this method, the entire economic life of the project is taken into account.
(ii) Due Weight to time factor. This method is most suitable for long term capital expenditure decision.
(iii) Due coverage to risk and uncertainty. Under this method risk and uncertainty are studied, it is a measure of profitability of capital expenditure by reducing the earnings to the present value of each investment.
(iv) Suitable method for evaluation. This method is most suitable when cash inflows are not uniform. Here cash inflows and cash outflows are associated with decision making whereas in other methods average revenues are taken into consideration.
Demerits/Limitations of NVP
(i) Complicated method. Discounted cash flow method is full of complicated calculations which are not accepted by many analysts.
(ii) Economic Life. The determination of Economic life of the machine is not so easy to forecast.
(iii) Problem of Rate determination. The determination of discounting rate is not so simple.
Example
Calculate NPV for the A and B Proposals when discount Rate is 10%.
Year | A | B |
$ | $ | |
1 | 5,000 | 20,000 |
2 | 10,000 | 10,000 |
3 | 10,000 | 5,000 |
4 | 3,000 | 3,000 |
5 | 2,000 | 20,000 |
A | B | |
Investment ($) | 20,000 | 30,000 |
Life of Investment | 5 years | 5 years |
Scrap value ($) | 1,000 | 2,000 |
Above cash flows before depreciation and after takes.
Solution
Year | Cash inflow | 10% Discount | NPV | Cash Flow | NPV |
1 | 5,000 | .909 | 4,545 | 20,000 | 18,180 |
2 | 10,000 | .826 | 8,260 | 10,000 | 8,260 |
3 | 10,000 | .751 | 7,510 | 5,000 | 3,755 |
4 | 3,000 | .683 | 2,049 | 3,000 | 2,049 |
5 | 2,000 | .621 | 1,242 | 2,000 | 1,242 |
Scrap value | 1,000 | .621 | 621 | 2,000 | 1,242 |
24,227 | 34,728 | ||||
Less: Capital Investment | 20,000 | 30,000 | |||
Net Present Value | 4,227 | 4,728 |