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Techniques of Capital Budgeting

Investment Evaluation Criteria



Investment Evaluation CriteriaThree steps are involved in the evaluation of an

investment:

Estimation of Cash flows

Estimation of required RoR (i.e., the OCC)

Application of a decision rule for making the

choiceThe first two steps are assumed as given. The third

step is where we focus on its merits and demerits.



Investment Decision Rule The rule may be referred to as capital

budgeting techniques, or investment criteria.

The essential property of a sound techniqueis that it should maximize the shareholders¶wealth.

A sound appraisal technique should be usedto measure the economic worth of aninvestment project.



Evaluation CriteriaDiscounted Cash Flow (DCF) Criteria:

Net Present Value (NPV)

Internal Rate of Return (IRR)

Profitability Index (PI)

Non-discounted Cash Flow Criteria: Payback Period (PB)

Accounting Rate of Return ( ARR)



Net Present Value It is a DCF technique that explicitly

recognizes the time value of money.

It correctly postulates that CFs arising atdifferent times differ in value;

And are comparable only when their

equivalents ± PVs ± are found out. Following steps are involved in calculating

the NPV:



CFs of the project should be forecastedbased on realistic assumptions.

Appropriate discount rate should beidentified to discount the forecasted CFs.This rate is the project¶s OCC, which is

equal to the required RoR expected byinvestors on investments of equivalent risk.

PV of CFs should be calculated using theOCC as the discount rate.

NPV should be found out by subtracting PVof cash outflows from PV of cash inflows.

The project should be accepted if NPV is

positive. That is,N

PV > 0.



Example Assuming that project X costs Rs.2500 now

and is expected to generate year-end cash

inflows of Rs.900, 800, 700, 600, and 500

in years 1 thru 5. The OCC may be assumed

to be 10%. The NPV for the project can be

calculated by referring to the PV table. The calculations are as follows:



NPV = [(900 x 0.909) + (800 x 0.826) + (700 x 0.751) +

(600 x 0.683) + (500 x 0.620)] ± 2500

NPV = 2725 ± 2500 = Rs.225

Project X¶s PV of Cash inflows (Rs.2725) is greater than that of theCash outflow (Rs.2500).

Thus, it generates a positive NPV (Rs.225). This project adds to the

Wealth of owners, therefore, it should be accepted.



Evaluation of the NPV Method

It recognizes the time value of money.

It uses all CFs occurring over the entire life of the project in calculating its worth. Hence, it is ameasure of project¶s true profitability.

If we know the NPVs of individual projects, thevalues of the firm will increase by the sum of their NPVs. This refers to the Value-additive principle. Inother words, if we know values of individual assets,the firm¶s value can be found simply by adding their values. That is, NPV(A + B) = NPV(A) + NPV(B).

This method is always consistent with the objectiveof the shareholder value maximization. This is thegreatest virtue of the method.



Internal Rate of Return

It is the rate that equates the investmentoutlay with the PV of cash inflow receivedafter one period.

This also implies that the RoR is thediscount rate which makes NPV = 0. That is,

when there is no difference between the PV of cashoutflow and cash inflows.

There is no satisfactory way of defining thetrue RoR of a long-term asset.

IRR is the best available concept.



The IRR equation is the same as the one

used for the NPV method.

In the NPV method, the required RoR is

known and the NPV is found;

While in the IRR method the value of µr¶

has to be determined at which the NPV

becomes zero.



Level Cash Flows

Let us assume that an investment would cost Rs 20,000 and

provide annual cash inflow of Rs 5,430 for 6 years.The IRR of the investment can be found out as follows:

6,

6,

6,

NPV Rs 20,000 + Rs 5,430(PVAF ) = 0

Rs 20,000 Rs 5,430(PVAF )

Rs 20,000

PVAF 3.683Rs 5,430

r

r

r

!

!

! !



The rate, which gives a PVIFA of 3.683 for 6 years, is the project¶s IRR. Looking at the

table across the 6-year row, we find it

approximately under the 16% column.

Thus, 16% is the project¶s IRR that equates

the present value of the initial cash outlay

(Rs.20,000) with the constant annual cash

flows (Rs.5,430 per year) for 6 years.



NPV Profile and IRR NPV of a project declines as the discount

rate increases;

And for discount rates higher than the project¶s IRR, NPV will be negative.

At 16%, the NPV is zero; therefore, it is the

IRR of the project. NPV profile of the project at various

discount rates is shown in the next slide:



Evaluation of IRR Method

Merits of this method are as under:

Recognizes the time value of money.

Considers all CFs occurring over the entire life

of the project to calculate its of return. Gives the same acceptance rule as the NPV

method.

Consistent with the objective of maximizingshareholders¶ wealth. Whenever a project¶s IRR is greater than the OCC, the wealth will beenhanced.



Like the NPV method, the IRR method is

also theoretically a sound investmentevaluation criterion.

However, IRR rule can give misleading andinconsistent results under certaincircumstances.

Also, properly stated, the two criteria areformally equivalent, the IRR rule contains

several pitfalls. The problems that IRR rule may suffer from

is mentioned in the subsequent slides.



Profitability Index

Profitability index is the ratio of the presentvalue of cash inflows, at the required rate of return, to the initial cash outflow of the

investment. The initial cash outlay of a project is Rs

100,000 and it can generate cash inflow of Rs40,000, Rs 30,000, Rs 50,000 and Rs 20,000in year 1 through 4. Assume a 10 per cent rateof discount. The PV of cash inflows at 10 per cent discount rate is:



.1235.11,00,000s

1,12,350sI

12,350s100,000s112,350s

0.6820,000s0.75150,000s0.82630,000s0.90940,000s

)20,000(s)50,000(s)30,000(s)40,000(s 0.104,0.103,0.102,0.101,

!!

!

vvvv

!

The following are the PI acceptance rules:

Accept the project when PI is greater than one. PI > 1

Reject the project when PI is less than one. PI < 1

May accept the project when PI is equal to one. PI = 1

The project with positive NPV will have PI greater than one.

PI less than means that the project¶s NPV is negative.



Evaluation of PI Method

It recognises the time value of money.

It is consistent with the shareholder valuemaximisation principle. A project with PI greater than one will have positive NPV and if accepted, itwill increase shareholders¶ wealth.

In the PI method, since the present value of cashinflows is divided by the initial cash outflow, it is arelative measure of a project¶s profitability.

Like NPV method, PI criterion also requirescalculation of cash flows and estimate of thediscount rate. In practice, estimation of cash flowsand discount rate pose problems.



Payback Method

Payback is the number of years required to

recover the original cash outlay invested in a

project.

If the project generates constant annual cash

inflows, the payback period can be computed

by dividing cash outlay by the annual cash

inflow. That is:

0Initial InvestmentPayback

nnual ash Inflow

C

C



Assume that a project requires an outlay of Rs

50,000 and yields annual cash inflow of Rs12,500 for 7 years. The payback period for the

project is:

Rs 50,000PB = = 4 yearsRs 12,000

Unequal cash flows In case of unequal cash

inflows, the payback period can be found out

by adding up the cash inflows until the total is

equal to the initial cash outlay.



Suppose that a project requires a cash outlay of Rs 20,000, and generates cash inflows of Rs

8,000; Rs 7,000; Rs 4,000; and Rs 3,000 duringthe next 4 years. What is the project¶s payback?

3 years + 12 × (1,000/3,000) months

3 years + 4 months

The project would be accepted if its payback period is less than the maximum or standardpayback period set by management.

As a ranking method, it gives highest ranking tothe project, which has the shortest payback period and lowest ranking to the project withhighest payback period.



Evaluation of Payback

Certain virtues

± Simpl icity. Simple to understand and easy to

calculate.

± o st effective. That is, not a sophisticated technique. ± Short-term effects. Favourable for short term effects

on EPS.

± Ri sk shield . By having a shorter payback period as a

Standard reduces risk.

± Liquid ity. Such situation is created when there is

early recovery of the investment.



Serious limitations

± Ca sh f l ow s a fter pa yback . Does not take account of cash flows after payback period.

± Ca sh f l ow s ignored . That is, does not consider allcash flows.

± Ca

sh f l ow pa

ttern s. That is, it gives equal weightsto returns of equal amounts even though they occur in different times periods.

± Admini str ative d ifficul tie s. Difficulties indetermining maximum acceptable payback period.

± Incon si stent wit h sharehold er value. Share valuesdo not depend on payback periods of investment projects.



Book Rate of Return Method Also known as Accounting Rate of Return is the ratio of

the average after-tax profit divided by the average

investment. The average investment would be equal to

half of the original investment if it were depreciatedconstantly.

A variation of the ARR method is to divide average

earnings after taxes by the original cost of the project

instead of the average cost.

Average incomeARR

Average investmentor Book Income / Book Assets



Acceptance Rule

This method will accept all those projectswhose ARR is higher than the minimum

rate established by the management and

reject those projects which have ARR lessthan the minimum rate.

This method would rank a project as

number one if it has highest ARR and

lowest rank would be assigned to the

project with lowest ARR.



Evaluation of ARR Method

The ARR method may claim some merits

± Simpl icity

± Accounting d at a. Easy availability of information.

± Accounting profit abil ity. Incorporates entire stream of income.

Serious shortcoming

± Ca sh f l ow s ignored

± T ime value ignored

± Arbitr ary cut-off. Generally, this yardstick is the firm¶s currentreturn on its assets (book value). Because of this, the growth

companies earning very high rates on their existing assets may

reject profitable projects (positive NPVs).

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