Techniques of Capital Budgeting, Pay Back Period Method, ARR, NPV, IRR and Profitability Index

[Techniques of Capital Budgeting, Pay-back period method, Average Rate of Retunr Method, Net Present Value Method, Internal Rate of Return Method, Profitability Index Method, Merits and Limitations]

Techniques of Capital Budgeting

Most commonly used technique in investment decision making are given below:

1) Payback period Method: 

It is one of the simplest methods to calculate period within which entire cost of project would be completely recovered. It is the period within which total cash inflows from project would be equal to total cash outflow of project. It is calculated by dividing initial investments in project by annual cash inflows. Here, cash inflow means profit after tax but before depreciation.

Merits of Payback period Method

a) This method of evaluating proposals for capital budgeting is simple and easy to understand, it has an advantage of making clear that it has no profit on any project until the payback period is over i.e. until capital invested is recovered. This method is particularly suitable in the case of industries where risk of technological services is very high.

b) In case of routine projects also, use of payback period method favours projects that generates cash inflows in earlier years, thereby eliminating projects bringing cash inflows in later years that generally are conceived to be risky as this tends to increase with futurity.

c) By stressing earlier cash inflows, liquidity dimension is also considered in selection criteria. This is important in situations of liquidity crunch and high cost of capital.

d) Payback period can be compared to break-even point, the point at which costs are fully recovered but profits are yet to commence.

e) The risk associated with a project arises due to uncertainty associated with cash inflows. A shorter payback period means that uncertainty with respect to project is resolved faster.

Limitations of payback period

a) It stresses capital recovery rather than profitability. It does not take into account returns from the project after its payback period.

b) This method becomes an inadequate measure of evaluating 2 projects where the cash inflows are uneven.

c) This method does not give any consideration to time value of money, cash flows occurring at all points of time are simply added.

d) Post-payback period profitability is ignored totally.

2) Accounting rate of return (Average rate of return – ARR): 

ARR is a financial ratio used in capital budgeting. The 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. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested. If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects. It is calculated with the help of the following formula:

ARR=Average Profit / Investment

Merits of ARR

a)      It is simple, common sense oriented method.

b)      Profits of all years taken into account.

c)       It considers actual net profit of the project.

Demerits of ARR

a)      Time value of-money is not considered

b)      Risk involved in the project is not considered

c)       Annual average profits might be same for different projects but accrual of profits might differ having significant implications on risk and liquidity

d)      The ARR has several variants and that it lacks uniform understanding.

3) Net present value (NPV) method: 

The best method for evaluation of investment proposal is net present value method or discounted cash flow technique. This method takes into account the time value of money. The net present value of investment proposal may be defined as sum of the present values of all cash inflows as reduced by the  present values of all cash outflows associated with the proposal. Each project involves certain investments and commitment of cash at certain point of time. This is known as cash outflows. Cash inflows can be calculated by adding depreciation to profit after tax arising out of that particular project.

Merits of NPV method:

1) NPV method takes into account the time value of money.

2) The whole stream of cash flows is considered.

3) NPV can be seen as addition to the wealth of shareholders. The criterion of NPV is thus in conformity with basic financial objectives.

4) NPV uses discounted cash flows i.e. expresses cash flows in terms of current rupees. NPV's of different projects therefore can be compared. It implies that each project can be evaluated independent of others on its own merits.

Limitations of NPV method:

1) It involves different calculations.

2) The application of this method necessitates forecasting cash flows and the discount rate. Thus accuracy of NPV depends on accurate estimation of these 2 factors that may be quite difficult in reality.

3) The ranking of projects depends on the discount rate.

4) Internal rate of return (IRR): 

The internal rate of return method is also a modern technique of capital budgeting that takes into account the time value of money. It is also known as ‘time adjusted rate of return’ discounted cash flow’ ‘discounted rate of return,’ ‘yield method,’ and ‘trial and error yield method’. In the net present value method the net present value is determined by discounting the future cash flows of a project at a predetermined or specified rate called the cut-off rate. But under the internal rate of return method, the cash flows of a project are discounted at a suitable rate by hit and trial method, which equates the net present value so calculated to the amount of the investment. Under this method, since the discount rate is determined internally, this method is called as the internal rate of return method. The internal rate of return can be defined as that rate of discount at which the present value of cash-inflows is equal to the present value of cash outflows.

Merits of IRR

1.       It considers the time value of money.   

2.       It considers entire cash flows over entire life of the project.

3.       It is consistent with the objective of maximizing the wealth of owners.

4.       It is a measure of profitability since entire cash flows over entire life of the project are considered.

5.       Unlike the NPV, cost of capital is not assumed to be known.

Demerits of IRR

1.       It requires the estimation of cash inflows and cash outflows, which is a difficult task.

2.       It assumes that intermediate cash inflows are reinvested at IRR.

3.       It may yield negative rates under certain circumstances. (e.g. when Cash Outflows are more than Cash Inflows).

4.       It may yield multiple rates under certain circumstances (e.g. when cash flows reverse their signs during the project.

5.       It is relatively difficult to compute.

5) Profitability Index (PI): 

It is also a time-adjusted method of evaluating the investment proposals. Profitability index also called as Benefit-Cost Ratio (B/C) or ‘Desirability factor’ is the relationship between present value of cash inflows and the present value of cash outflows.

Merits of PI

1.       It considers the time value of money.

2.       It considers entire cash flows over entire life of the project.

3.       It is a relative measure of profitability since the ratio of cash inflows to cash outflows is considered.

4.       It guides in resolving capital rationing where projects are divisible.

5.       It guides the selection of Mutually Exclusive Projects having same Net Present Value.

Demerits of PI

1.       It requires the estimation of cash inflows and cash outflows, which is a difficult task.

2.       It requires the computation of the cost of capital to be used as discount rate.

3.       The ranking of projects depends upon the discount rate.

4.       It ignores the difference in initial cash outflows, size of different projects, etc. while evaluating mutually exclusive projects.

5.       It fails to guide in resolving capital rationing where projects are indivisible.

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