The investment evaluation process consists of three steps, which are as follows:
• Estimation of cash flows.
• Estimation of the required rate of return (the opportunity cost of capital).
• Application of a decision rule for making the choice.
Investment Decision Rule
For evaluating a capital investment proposal certain factors need to be taken into consideration. Any capital budgeting technique should take into consideration the following factors:
(1) It should consider all cash flows associated with the project.
(2) It should provide for clear and unambiguous way of separating good projects from the bad ones.
(3) It should help in ranking projects according to their profitability.
(4) It should recognise the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones.
Evaluation Criteria
A number of investment criteria (Capital Budgeting Techniques) are used in practice.
They may be grouped under the following two categories:
(1) Non-discounted Cash Flow Criteria
• Pay Back Period (PB)
• Accounting Rate of Return (ARR)
(2) Discounted Cash Flows (DCF) Criteria
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI)
Payback Period Method
In the Payback period, method the payback period is usually expressed in years, the time in which the cash outflows equal cash inflows. This method is focused on liquidity and profitability. This method recognises the original capital invested in a project. The basic element of this method is calculation of recovery time, by accumulation of the cash inflow (including depreciation) year by year until the cash inflows equal the amount of original investment. In simple terms, it may be defined as the number of years required to recover the cost of investments.
Payback period = (Initial investment s - Co)/Annual cashflows - Co
Example
• Estimation of cash flows.
• Estimation of the required rate of return (the opportunity cost of capital).
• Application of a decision rule for making the choice.
Investment Decision Rule
For evaluating a capital investment proposal certain factors need to be taken into consideration. Any capital budgeting technique should take into consideration the following factors:
(1) It should consider all cash flows associated with the project.
(2) It should provide for clear and unambiguous way of separating good projects from the bad ones.
(3) It should help in ranking projects according to their profitability.
(4) It should recognise the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones.
Evaluation Criteria
A number of investment criteria (Capital Budgeting Techniques) are used in practice.
They may be grouped under the following two categories:
(1) Non-discounted Cash Flow Criteria
• Pay Back Period (PB)
• Accounting Rate of Return (ARR)
(2) Discounted Cash Flows (DCF) Criteria
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI)
Payback Period Method
In the Payback period, method the payback period is usually expressed in years, the time in which the cash outflows equal cash inflows. This method is focused on liquidity and profitability. This method recognises the original capital invested in a project. The basic element of this method is calculation of recovery time, by accumulation of the cash inflow (including depreciation) year by year until the cash inflows equal the amount of original investment. In simple terms, it may be defined as the number of years required to recover the cost of investments.
Payback period = (Initial investment s - Co)/Annual cashflows - Co
Example
Solution
In this example project Y would be selected, as its payback period of three years is shorter than the four years payback period of Project X.
Bail out Factor
In the above discussion we have skipped the probability of scrapping the project before the payback period. The salvage value of the project has to be taken into consideration. The bailout payback time is reached when the cumulative cashreceipts plus the salvage value at the end of a particular year equals the initial investment.
Example
In this example project Y would be selected, as its payback period of three years is shorter than the four years payback period of Project X.
Bail out Factor
In the above discussion we have skipped the probability of scrapping the project before the payback period. The salvage value of the project has to be taken into consideration. The bailout payback time is reached when the cumulative cashreceipts plus the salvage value at the end of a particular year equals the initial investment.
Example
Project A costs Rs. 200000 and Project B Costs Rs. 3000000 both have a ten-year life. Uniform cash receipts expected are A Rs. 40,000 p.a. and B Rs. 80,000 p.a. Calculate the payback period.
Solution
Under traditional payback
Project A = Rs. 2,00,000 = 5 years Rs. 40,000
Project B = Rs. 3,00,000 = 3.75 years Rs. 80,000
Merits of Payback Method
(a) It is simple and easy to understand and apply.
(b) This method is useful in case of capital rationing and in situations where there is high amount of uncertainty.
(c) Assuming regarding future interest rates are not changing.
(d) Firms facing liquidity constraints can use this technique to rank projects according to their ability to repay quickly.
Demerits of Payback Method
(a) This method does not take into consideration the time value of money.
(b) This method ignores cash generation beyond payback period.
(c) This method does not indicate whether an investment should be accepted or rejected.
(d) This is biased against those investments that yield return after a long period.
Payback Period Reciprocal
An alternative way of expressing payback period is "payback period reciprocal" which is expressed as (1/Payback period)× 100
Thus, if a project has a payback period of 5 years then the payback period reciprocal would be
(1/5) × 100 = 20%
Accounting Rate of Return Method (ARR)
The Accounting Rate of Return uses the accounting information as revealed by financial statements, to measure the profitability of an investment. The accounting rate of return is the ratio of average after tax profit divided by average investment.
APR =Average income/Average investment
n
EBIT (( 1 − T ) /n)/( I 0 + I n ) /2
t = 1
Here average income is adjusted for interest. Of the various accounting rate of return, the highest rate of return is taken to be the best investment proposal.In case the accounting rate of return is less than the cost of capital or the prevailing interest rate than that particular investment proposal is rejected.
Example
A project with a capital expenditure of Rs. 5,00,000 is expected to produce the following profits (after deducting depreciation).
Solution
Average annual profits = (40,000 + 80,000 + 90,000 + 30,000/4) = Rs. 60,000
Average investment assuming no scrap value is the average of the investment at the beginning and the investment at the end.i.e. ,
Rs. (5,00,000 + 0)/2 = Rs. 2,50,000
Note: If the residual value is not zero but say Rs. 60,000 then the average investment would be,
Rs. (5,00,000 + Rs. 60,000)/2 = Rs. 2,80,000
The accounting rates of return = Rs. 60,000 x 100 = 24% = Rs. 2,50,000.
This percentage is compared with those of other projects in order that the investment yielding the highest rate of return can be selected.
Example
Consider the following investment opportunity:
A machine is available for purchase at a cost of Rs. 80,000.We expect it to have a life of five years and to have a scrap value of Rs. 10,000 at the end of the five-year period. We have estimated that it will generate additional profits over its life as follows:
These estimates are of profits before depreciation. You are required to calculate the return on capital employed.
Solution
Total profit before deprecation over the life of the machine = Rs. 1,10,000
Average profit p.a. = Rs. 1,10,000/5 years
= Rs. 22,000
Total depreciation over the life of the machine = Rs. 80,000 – Rs. 10,000 = Rs. 70,000
Average depreciati on p.a. = Rs. 70,000/5 years
= Rs. 14,000
Average annual profit after depreciation
= Rs. 22,000 – Rs. 14,000
= Rs. 8,000
Original investment required = Rs. 80,000
Accounting rate of return =
Rs. (8,000/80,000)× 100 = 10%
Return on average investment:
Average investment = (80,000 + 10,000 )/2= Rs. 45,000
Therefore, accounting rate of return = (8,000/45,000) × 100 = 17.78%
Merits of ARR
• It is easy to calculate
• It is not based on cash flows but on profits
• It takes into consideration all the years involved in the life of the project.
Demerits of ARR
• It does not take into consideration time value of money
• Change in depreciation policy may bring inconsistency in results
• This method fails to distinguish the size of the investment
• It is biased against short term projects
• Acceptance and rejection decisions are based on subjective management targets.
Discounted Cash Flow (DCF) Techniques
(1) Net Present Value (NPV) Method
In this method, all cash flows attributable to a capital investment project are discounted by a chosen percentage e.g., the firms weighted average cost of capital to obtain the present value of the future cash flows. If the present value of the future cash flows is higher than the present value of the investments the proposal is accepted else rejected. In order to arrive at the net present value the present value of the future cash flows is deducted from the initial investment.
where C o = initial investment (cash outflows)
C t = Cash flows occurring at time t
K = discount rate
Example
Solution
Under traditional payback
Project A = Rs. 2,00,000 = 5 years Rs. 40,000
Project B = Rs. 3,00,000 = 3.75 years Rs. 80,000
Merits of Payback Method
(a) It is simple and easy to understand and apply.
(b) This method is useful in case of capital rationing and in situations where there is high amount of uncertainty.
(c) Assuming regarding future interest rates are not changing.
(d) Firms facing liquidity constraints can use this technique to rank projects according to their ability to repay quickly.
Demerits of Payback Method
(a) This method does not take into consideration the time value of money.
(b) This method ignores cash generation beyond payback period.
(c) This method does not indicate whether an investment should be accepted or rejected.
(d) This is biased against those investments that yield return after a long period.
Payback Period Reciprocal
An alternative way of expressing payback period is "payback period reciprocal" which is expressed as (1/Payback period)× 100
Thus, if a project has a payback period of 5 years then the payback period reciprocal would be
(1/5) × 100 = 20%
Accounting Rate of Return Method (ARR)
The Accounting Rate of Return uses the accounting information as revealed by financial statements, to measure the profitability of an investment. The accounting rate of return is the ratio of average after tax profit divided by average investment.
APR =Average income/Average investment
n
EBIT (( 1 − T ) /n)/( I 0 + I n ) /2
t = 1
Here average income is adjusted for interest. Of the various accounting rate of return, the highest rate of return is taken to be the best investment proposal.In case the accounting rate of return is less than the cost of capital or the prevailing interest rate than that particular investment proposal is rejected.
Example
A project with a capital expenditure of Rs. 5,00,000 is expected to produce the following profits (after deducting depreciation).
Solution
Average annual profits = (40,000 + 80,000 + 90,000 + 30,000/4) = Rs. 60,000
Average investment assuming no scrap value is the average of the investment at the beginning and the investment at the end.i.e. ,
Rs. (5,00,000 + 0)/2 = Rs. 2,50,000
Note: If the residual value is not zero but say Rs. 60,000 then the average investment would be,
Rs. (5,00,000 + Rs. 60,000)/2 = Rs. 2,80,000
The accounting rates of return = Rs. 60,000 x 100 = 24% = Rs. 2,50,000.
This percentage is compared with those of other projects in order that the investment yielding the highest rate of return can be selected.
Example
Consider the following investment opportunity:
A machine is available for purchase at a cost of Rs. 80,000.We expect it to have a life of five years and to have a scrap value of Rs. 10,000 at the end of the five-year period. We have estimated that it will generate additional profits over its life as follows:
These estimates are of profits before depreciation. You are required to calculate the return on capital employed.
Solution
Total profit before deprecation over the life of the machine = Rs. 1,10,000
Average profit p.a. = Rs. 1,10,000/5 years
= Rs. 22,000
Total depreciation over the life of the machine = Rs. 80,000 – Rs. 10,000 = Rs. 70,000
Average depreciati on p.a. = Rs. 70,000/5 years
= Rs. 14,000
Average annual profit after depreciation
= Rs. 22,000 – Rs. 14,000
= Rs. 8,000
Original investment required = Rs. 80,000
Accounting rate of return =
Rs. (8,000/80,000)× 100 = 10%
Return on average investment:
Average investment = (80,000 + 10,000 )/2= Rs. 45,000
Therefore, accounting rate of return = (8,000/45,000) × 100 = 17.78%
Merits of ARR
• It is easy to calculate
• It is not based on cash flows but on profits
• It takes into consideration all the years involved in the life of the project.
Demerits of ARR
• It does not take into consideration time value of money
• Change in depreciation policy may bring inconsistency in results
• This method fails to distinguish the size of the investment
• It is biased against short term projects
• Acceptance and rejection decisions are based on subjective management targets.
Discounted Cash Flow (DCF) Techniques
(1) Net Present Value (NPV) Method
In this method, all cash flows attributable to a capital investment project are discounted by a chosen percentage e.g., the firms weighted average cost of capital to obtain the present value of the future cash flows. If the present value of the future cash flows is higher than the present value of the investments the proposal is accepted else rejected. In order to arrive at the net present value the present value of the future cash flows is deducted from the initial investment.
where C o = initial investment (cash outflows)
C t = Cash flows occurring at time t
K = discount rate
Example
A firm can invest Rs. 10,000 in a project with a life of three years.
The cost of capital is 10% p.a., should the investment be made?
Solution
Firstly, the discount factors can be calculated based on Rs. I received in with r rate of interest in 3 year.
1/(1 + r) n
In this chapter, the tables given at the end of the block are used wherever possible. Obviously, where a particular year or rate of interest is not given in the tables it will be necessary to resort to the basic discounting formula.
Since the present value is positive, investment in the project can be made.
Example
Machine A costs Rs. 1,00,000 payable immediately. Machine B costs Rs. 1,20,000 half payable immediately and half payable in one year'
s time.The cash receipts expected are as follows:
With 7% interest, which machine should be selected?
Solution
Machine A:
Machine B:
Since Machine B has the higher NPV, our decision should be to select
Machine B.
Merits of NPV Method:
• It recognises the time value of money.
• It considers the total benefits arising out of the proposal over its lifetime.
• This method is particularly useful for selection of mutually exclusive projects.
Demerits of NPV Method:
• It is difficult to calculate as well as understand.
• Calculating the discount rate is complicated.
• This method is an absolute measure. When two projects are considered this method will favour the project with the higher NPV.
• If two projects with different life spans are evaluated using this method,this method may not yield satisfactory result.
Machine A costs Rs. 1,00,000 payable immediately. Machine B costs Rs. 1,20,000 half payable immediately and half payable in one year'
s time.The cash receipts expected are as follows:
With 7% interest, which machine should be selected?
Solution
Machine A:
Machine B:Since Machine B has the higher NPV, our decision should be to select
Machine B.
Merits of NPV Method:
• It recognises the time value of money.
• It considers the total benefits arising out of the proposal over its lifetime.
• This method is particularly useful for selection of mutually exclusive projects.
Demerits of NPV Method:
• It is difficult to calculate as well as understand.
• Calculating the discount rate is complicated.
• This method is an absolute measure. When two projects are considered this method will favour the project with the higher NPV.
• If two projects with different life spans are evaluated using this method,this method may not yield satisfactory result.
(2) Internal Rate of Return (IRR) Method
Internal rate of return is a percentage discount rate used in capital investment appraisals which makes the present value of the cost of the project equal to the future cash flows of the project. It is the rate of return which equates the present value of the cost of the project equal to the future cash flows of the project. It is the rate of return which equates the present value of anticipated net cash flows with the initial outlay. The IRR is also defined as the rate at which the net present value is Zero. The test of profitability of a project is the relationship between the internal rate of return (%) of the project and the minimum acceptable rate of return. The IRR can be determined by solving the following equation for r :
Internal rate of return is a percentage discount rate used in capital investment appraisals which makes the present value of the cost of the project equal to the future cash flows of the project. It is the rate of return which equates the present value of the cost of the project equal to the future cash flows of the project. It is the rate of return which equates the present value of anticipated net cash flows with the initial outlay. The IRR is also defined as the rate at which the net present value is Zero. The test of profitability of a project is the relationship between the internal rate of return (%) of the project and the minimum acceptable rate of return. The IRR can be determined by solving the following equation for r :
The IRR equation is the same as the one used for the NPV method. The only difference is that in the NPV method, the required rate of return k is known while in the IRR method the value of r has to be determined at which the net present value becomes zero.A project is accepted if the internal rate of return is higher than the cost of capital.
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