The techniques and methods for evaluating capital budgeting proposals are:
- Degree of urgency method
- Payback period method
- Unadjusted rate of return method
- Present value method
The present value method is further divided into the following:
- Time-adjusted rate of return method
- Net present value method
An overview of each of these methods, along with examples, is given in this article.
1. Urgency Method
The urgency method does not suggest any specific evaluation method or technique; instead, it provides suggestions about ad hoc decisions. There are some projects or tasks that require immediate decisions, whereas others are postponed until a future date.
An example of an urgent situation that requires an immediate decision is the breakdown of a machine due to the loss of a key component. If the component is not replaced, production will suffer, and so it will be prioritized over other projects pending with management for approval.
The urgency method is simple to understand and use. In essence, this is because no method is used at all; only the decision of management is final with regard to urgency.
2. Payback Period Method
This method is also known as the pay-off method or replacement period method. It is a method where a number of years are required to cover the original investment.
This method is based on the theory that capital expenditure pays itself back over a number of years. It highlights the time when the original investment is equal to the earnings generated by that investment.
Thus, the payback period is the time taken to reach the point when the value of the original investment or outflow of cash is equal to the inflow of cash.
The formula to calculate the payback period of an investment is the following:
Payback period = Original investment / Annual cash inflow
The payback period can be:
- (A) When even cash inflow: This means an equal amount of income every year.
- (B) When uneven cash inflow: This means when cash inflow is not uniform.
(A) Uniform Cash Inflow
Example
A project costing $200,000 has an annual income of $40,000 and a working life amounting to 8 years. Calculate the payback period.
Solution
Payback period = Original investment / Annual cash inflow
= $200,000 / $40,000 = 5 years
Example
A project costing $1,000,000 has an annual income of $160,000 after depreciation @ 20% p.a. but before tax (which is 50%). Calculate the payback period.
Solution
$ | |
Profit before tax | 160,000 |
Less: 50% tax | 80,000 |
Profit after tax | 80,000 |
Add: Depreciation @ 20% (10,00,000) | 200,000 |
280,000 |
Annual cash inflow payback period = Cash investment / Annual cash inflows
= 10,00,000 / 2,80,000 = 3.57 years
(B) Non-uniform Cash Inflow
Year | Annual Cash Inflow |
1 | 20,000 |
2 | 25,000 |
3 | 25,000 |
4 | 30,000 |
Solution
Year | Annual Cash Inflow ($) | Cumulative Cash Inflow ($) |
1 | 20,000 | 20,000 |
2 | 25,000 | 45,000 |
3 | 25,000 | 70,000 |
4 | 30,000 | 100,000 |
Payback period = 4 years
Evaluation
The shorter the payback period, the greater the viability of the investment. Noteworthily, the payback period method is popular in both the United States and the United Kingdom when evaluating capital proposals.
Advantages of Payback Period Method
The main advantages of the payback period method are the following:
(i) Easy calculations. The main merit of this method is that it is simple to understand and use.
(ii) Knowledge of payback period. Knowing the payback period is valuable for decision-making. Generally, the shorter the payback period, the better the project.
(iii) Protection from loss due to obsolescence. This method is suitable in industries where mechanical and technical changes are routine. If investments with a short payback period are prioritized, losses due to obsolescence can be avoided.
(iv) Useful for reliable conclusions. This method is suited for cash-short companies that have taken a loan for capital expenditure. Shorter periods will result in the short-term return of borrowed capital, meaning that the method offers useful conclusions.
Disadvantages of Payback Period Method
The main disadvantages of the payback period method are as follows:
(i) No thought to period after payback period. The method only focuses on the payback period and, as such, gives little thought to the status of an investment after the period.
(ii) No thought to pattern of income. The pattern of income is not considered. If two projects have the same payback period, the project with a large cash inflow in the initial year is preferred over the project that 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, this is a critical point in capital expenditure planning.
(iv) Delicate and rigid method. The method is delicate in its approach. A change in operational cost will affect cash flows and, as such, the payback period will also change.
(v) No thought to project profitability. In this method, no thought is given to the profitability of a project over its life cycle. This technique is not suitable for long-term projects.
3. Unadjusted Rate of Return Method
This is popularly known as the accounting rate of return (ARR) method because accounting statements are used to measure project profitability. Various proposals are ranked in order of their earnings, and the project with a higher rate of return is selected.
ARR can be calculated by dividing the average income over the life of the project by the average investment. In other words:
ARR = Average income / Average investment
There are two approaches to the unadjusted rate of return method:
- (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 the original investment. This can be expressed as follows:
ARR = Average annual profit during project lifetime / Original investment
Example
A project costs $600,000, its scrap is $40,000 after five years, and profits after depreciation and taxes over five years are $50,000, $70,000, $60,000 and $30,000. Calculate the average rate of return on investment.
Solution
Total profits = 50,000 + 70,000 + 80,000 + 60,000 + 30,000 = $2,90,000
= 290,000 / 5 = $58,000
Net investment ($600,000 – 40,000) = $560,000
Average rate of return = (Average annual profit / Net investment) x 100
= (58,000 / 56,000) x 100
= 10.35%
(B) Average Investment Method
In this method, the average profits after depreciation and taxes are divided by the average amount of investment. This can be written as follows:
Average return on average investment = (Average annual profit after depreciation 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. Similar to the payback period method, it does not consider earnings up to the payback period but earnings for all years are taken into account.
3. Based on profit. Accounting projects are easily available from financial data.
Demerits of Rate of Return Method
1. Based on accounting profit. The method lays emphasis on accounting profit and no thought is given 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, this is a useful concept for capital expenditure. As such, variation in projects is not taken into account.
3. Rate of return. In this method, the rates of two or more proposals are compared and not the period of the 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 sale of existing plant. This method does not consider the sale value of the existing investment. No thought is given to incremental cash outflows, which should be considered to arrive at a correct financial decision.
4. Time-adjusted or Discounted Cash Flow Methods
The methods discussed so far lack the study of equal weight to present and future flow of incomes. Furthermore, these methods neglect to consider the time value of money (i.e., that a dollar earned today has more value than a dollar earned after five years).
By contrast, time-adjusted or discounted cash flow methods take into account both profitability and the time value of money. The available methods in this category are the following:
- (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 value 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.
The steps used to evaluate capital budgeting proposals using the net present value method are the following:
(i) Cut-off rate. This is the rate of return below which investment is deemed not worthwhile.
(ii) Calculation of net present value. Cash outflows are calculated at the determined rate of discount.
(iii) Calculate present value of total investment: This involves proceeds in cash outflows at the specified discount rate.
(iv) Calculate net present value of each project: This involves subtracting the present value of cash inflows from the present value of cash outflows for each project.
(v) Rejection: When inflows are less than outflows, reject the proposals.
Advantages of Net Present Value Method
(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 decisions.
(iii) Due coverage to risk and uncertainty. Under this method, risk and uncertainty are adequately analyzed. It is a measure of the profitability of capital expenditure that involves reducing the earnings to the present value of each investment.
(iv) Suitable method for evaluation. This method is most suitable when cash inflows are non-uniform. Here, cash inflows and cash outflows are associated with decision-making, whereas in other methods, average revenues are taken into consideration.
Disadvantages of Net Present Value Method
(i) General complexity. The discounted cash flow method is replete with complex calculations that many analysts find difficult to perform.
(ii) Economic life. Determining the economic life of the machine is not simple.
(iii) Complex rate determination. Determining the discount rate is also not simple.
Example
Calculate the net present value for Proposals A and B when the discount rate is 10%. The cash flows shown below are before depreciation and after takes.
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 ($) | 20,000 | 30,000 |
Life of Investment (years) | 5 | 5 |
Scrap Value ($) | 1,000 | 2,000 |
Solution
Year | Cash Inflow | 10% Discount | Net Present Value | Cash Flow | Net Present Value |
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 |