Now that we have understood Capital
Budgeting and Capital Budgeting process the next stage is understanding the
techniques of Capital Budgeting for making investment decision. Investment decision techniques are broadly
classified into two categories Discounting and Non-Discounting criteria. In
discounting criteria the time value of money is considered whereas in
Non-Discounting criteria Time Value of Money is ignored.
Techniques of Capital Budgeting
The Various techniques of
Capital Budgeting are as follows
§ Net Present Value (NPV)
§ Benefit Cost Ratio (PI)
§ Internal Rate of Return (IRR)
§ Pay Back Period (PBP)
§ Accounting Rate of Return (ARR)
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Now let us
understand each evaluation criteria in-depth and know its advantages and
limitations
§ Net Present Value:
It is one of
the most important concept in finance when it comes to evaluate investments,
making financial decisions involving cash flows in multiple periods. It is the
sum of the present values of all the cash flows over the life of the project.
The NPV represents the net benefit with respect to time and risk associated.
Therefore the criteria for accepting a project is that cash flow should be
positive, while reject if the cash flow is negative. NPV can be mathematical
represented as
NPV = Ʃ Ct - Initial Investment
(1+r) t
Properties of NPV
·
Value
of business can be expressed in terms of sum of present values of the cash
flows of project.
·
Business
value increases when a negative NPV based on future expected cash flow project
is rejected and decreases when a business undertakes negative NPV new project.
·
When
a business divests from existing project, the value at which the project is
withdrawn affects the value of the firm.
·
When
acquisition is made and price is paid excessive then the expected present value
of the cash flows it like taking negative NPV and diminish the value of the
firm.
·
The
value of the firm is affected depending upon the expected NPV when a new
project is taken up.
Limitations
·
NPV
is expressed in absolute terms and not in relative terms and doesn’t take into
account the investment required for the project.
·
NPV
doesn’t consider the life of the project.
§ Benefit Cost Ratio :
It
is also known as Profitability Index. It is the ratio between present value
benefit and initial investment. Net benefit Cost ratio is the ratio between
Present Value of Benefit – initial Investment to Initial Investment. The evaluating or decision making criteria
for
BCR
|
NBCR
|
Accept
/ Reject
|
>1
|
>0
|
Accept
|
=1
|
=0
|
Indifferent
|
<1
|
<0
|
Reject
|
While
this method has an argument and is negatively criticized under certain
conditions. It is calculated by the mathematical formula
PI =
Total Present Value
Initial Investment
§ Internal Rate of Return:
It is a
discounting technique which makes the project NPV equal to zero. The difference
between NPV and IRR is that in IRR we determine discount rate (cost of capital)
i.e. “r” by set it to zero while in NPV discount rate (Cost of Capital) is
known.
It is
calculated by the mathematical formula
IRR = LDF + DF
* {PV of LDF – Initial Investment}
PV of LDF – PV of HDF
§ Modified Internal Rate of Return(MIRR):
MIRR is
superior when compared regular IRR. MIRR is superior to IRR because MIRR
considers project cash flows are reinvested at cost of capital whereas IRR
considers cash flows reinvested at the project’s own IRR. MIRR shows the true
profitability of profit.
It is
calculated by the mathematical formula
MIRR = Total
Present Value
(1 + MIRR)1/n
§ Pay Back Period:
This is a
traditional method which is based on how quickly the investment is recovered.
As per PBP criteria the shorter the recovery period for the investment is to be
ranked 1st. It is simple and easy to calculate. It favors those
projects that generate high cash flows in early stage of project. It is a good
criteria when a business is facing the problem of liquidity of cash. This
method measures the capital recovery not the profitability of project. It
reflects projects liquidity and not the business liquidity has a whole.
It is
calculated by the mathematical formula as shown below
PBP = Initial
Investment – Preceding cash flow
§ Accounting Rate of Return:
It is also
known as Average Rate of Return. It is the ratio of the Profit after tax and
book value of investment. The selection criterion is high ARR. It is simple in calculation and the
information is readily available. It has shortcomings like it is based on
accounting profit and not on cash flows; it does not consider Time Value of
Money. It is calculated by the mathematical formula as shown below
ARR = Average
Return * 100
Average
Investment
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