Financial Management

MMS – Sem I

Professor Ajit

Compiled by:
Ritika.Poojari
(44)

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 Evaluation Techniques of Capital
Budgeting

Capital Budgeting is a process of evaluating and selecting long term investments that are
consistent with the goal of shareholders wealth maximization. Capital Budgeting decisions
are of prime importance in financial decision making.

A capital expenditure is an outlay of cash for a project that is expected to produce a cash
inflow over a period of time exceeding one year. Examples of projects include investments
in property, plant, and equipment, research and development projects, large advertising
campaigns, or any other project that requires a capital expenditure and generates a future
cash flow.

Because capital expenditures can be very large and have a significant impact on the financial
performance of the firm, great importance is placed on project selection. This process is
called capital budgeting.

There are 6 evaluation techniques which are as

follows:-
1) Payback Method
2) Discounted Payback Period
3) Annual rate of return
4) Internal rate of return
5) Net Present value (NPV)
6) Profitability Index (PI)

1) Payback Method – Payback period is the length of time required to recover the
cost of an investment. In this method the year is calculated in which initial capital commitment or
cash outflow can be recovered. For example, Rs.1000 investment which returned Rs. 500 per year
would have a two year payback period. It intuitively measures how long something takes to "pay for
itself." Shorter payback periods are preferable to longer payback periods (all else being equal).
Payback period can be calculated as follows: [CCF (Y1) – CCF (Y0)/12] + Y0. To calculate we add
a column i.e. cumulative cash flow in whichever year CCF is greater than outflow. In the formula,
the present year is considered as Y1 and previous year Y0.

Advantages:-
• The calculation of this method is easy.
• The method is simple to understand and use.

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• It is based on the cash flow analysis.

Disadvantages:-
• The major shortcoming of the payback period method is that it does not take into account
cash flows after the payback period and is therefore not a measure of the profitability of an
investment project.
• It does not take into account the entire life of the project during which cash flows are
generated.
• It does not measure correctly even the cash flows expected to be received within the
payback period as it does not differentiate between projects in terms of the timing or magnitude
of cash flow.

2) Discounted Payback Period – Discounted payback takes the time value of money
into account. When an investment is made in a project today, that investment needs to return more in
the future because Rs. 100 today is worth more than Rs. 100 in the future. The amount of Rs. 100
could have been invested elsewhere, especially in less risky investment venture, so not only does a
Rs. 100 investment have to compete with inflation, but it competes with other opportunities. With a
discounted payback period, the costs and benefits of the project are discounted as they occur over
time to take into account the lost opportunity of investing the cash elsewhere and further by a
relative measure of the projects risk. For projects with long payback periods, discounted payback
periods are more accurate at determining the real payback, but for shorter projects, a non-discounted
payback period is normally a good enough indicator.

Advantages:-
• This method considers the Time value of money
• It helps in judgment of the project risk.
• The total benefits associated with the project are taken into account while calculating
ARR.

Disadvantages:-
• This method is not useful for assessing profitability of the whole project.

3) Accounting rate of return - This ratio does not take into account the concept of
time value of money. ARR calculates the return, generated from net income of the proposed capital
investment. ARR provides a quick estimate of a project's worth over its useful life. It is a method of
evaluating proposed capital expenditure and is also known as accounting rate of return. ARR is
derived by finding profits before taxes and interest. ARR can be calculated as follows:
ARR – (Average annual profits / Project Investments) * 100; here Average Investment Project is
½(Initial cost + Installation cost – Salvage value) + Salvage value + additional working capital.

Advantages:-
• The calculation of this method is easy.
• The method is simple to understand and use.

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 • The total benefits associated with the project are taken into account while calculating
ARR.

Disadvantages:-
• The major drawback of ARR is that it uses profit rather than cash flows.
• The method does not account for the time value of money.
• The ARR criteria of measuring the worth of investment does not differentiate between
the sizes of the investment required for each project.

4) Internal rate of return (IRR) - The IRR of an investment is the interest rate at
which the costs of the investment lead to the benefits of the investment. The discount rate often used
in capital budgeting that makes the net present value of all cash flows from a particular project equal
to zero. The higher a project's internal rate of return, the more desirable it is to undertake the project.
As such, IRR can be used to rank several prospective projects a firm is considering.
Assuming all other factors are equal among the various projects, the project with the highest IRR
would probably be considered the best and undertaken first. This means that all gains from the
investment are inherent to the time value of money and that the investment has a zero net present
value at this interest rate.

Advantages:-
• The method considers the time value of money.
• It takes into account the total cash inflows and outflows.
• This method is easier to understand.
• The method is consistent with the objective of maximizing shareholder’s wealth.

Disadvantages:-
• The method involves tedious calculations.
• It produces multiple rates which are confusing.
• Under this method, it is assumed that all intermediate cash flows are reinvested at the
IRR.

5) Net Present Value (NPV) – NPV is described as the summation of the present
values of cash proceeds (CFAT) in each year minus the summation of present values of net cash
outflows in each year. If the NPV of a prospective project is positive, it should be accepted.
However, if NPV is negative, the project should probably be rejected because cash flows will also
be negative. The formula of NPV is Discounted cash inflows – Discounted cash outflows.

Advantages:-
• The method considers the time value of money.
• It is a sound method of appraisal in which it considers total benefit arising out of the
proposal over its lifetime.

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 • A changing discount rate can be built into the NPV calculations by altering the
denominator.
• The method instrumental with the objective of maximizing shareholder’s wealth.

Disadvantages:-
• The method is difficult to understand
• This method has tedious calculations.
• The calculation of the required rate of return to discount the cash flows is difficult.

6) Profitability Index (PI) – It is another time-adjusted capital budgeting technique

which is also known as benefit-cost ratio. It is similar to NPV approach. The PI index approach
measures the present value of returns per rupee invested. It may be defined as a ratio which is
obtained by dividing the present value of future cash inflows by the present value of cash outlays. PI
= Discounted Cash Inflows/Discounted cash outflows.

Advantages:-
• The method considers the time value of money.
• It is a sound method of appraisal in which it considers total benefit arising out of the
proposal over its lifetime.
• It is a better evaluation technique than NPV in a situation of capital rationing.
• The method instrumental with the objective of maximizing shareholder’s wealth.

Disadvantages:-
• The method is difficult to understand
• This method has tedious calculations.

Comparison between all the techniques is as follows:-

1) As far as size of the project is considered, the project with higher Profitability Index
should be considered. If PI > 1, then accept the project; if PI < 1 then reject the project and if PI
= 1then the investment will have neither profit nor loss.
2) All other things being equal, the better investment is the one with the shorter payback
period.
3) The higher a project's internal rate of return, the more desirable it is to undertake the
project. Assuming all other factors are equal among the various projects, the project with the
highest IRR would probably be considered the best and undertaken first.
4) If NPV > 0 then it means that the investment would add value to the firm and hence the
project may be accepted. If NPV < 0 then it means that the investment would subtract value from
the firm and hence the project should be rejected. Lastly, if NPV = 0 then it means that the
investment would neither profit nor lose value for the firm and we should be indifferent in the
decision whether to accept or reject the project. This project adds no monetary value. Decision

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should be based on other criteria, e.g. strategic positioning or other factors not explicitly
included in the calculation.
5) The investment which will fetch higher ARR should be considered.