Published by: Nuru
Published date: 28 Feb 2022
Capital Budgeting Techniques
It refers to the expected number of years required to recover the investment of the project.
a. For the same or even annual cash flow generated over the years in projects,
Payback period(PBP) = (Net Cash Outlay or Initial Investment) / (Annual Cash flow after-tax)
b. For the uneven cash flow generated over the years in projects,
Payback period (PBP) = Minimum year to recover + (Cumulative cash flow after tax / Next year cash flow after-tax)
Merits of PBP method:
It is a very simple project evaluation technique, so it is very popular. Also, it views threats of technological obsolescence of projects, an economic downturn, investors paying more attention to the payback criterion.
Demerits of PBP method:
It does not consider the cash flows generated after the recovery period.
Discounted Payback Period:
The time required to recover the original investment of the project from the discounted cash flow.
PBP = Minimum year to recover + (Unrecovered cost at the beginning of the year of full recovery of the original investment / total discounted cash flow during the year of full recovery of original investment)
Merits of Discounted PBP method:
It considers the time value of money and the cost of capital. There is no chance of accepting a project with a negative net present value like in the case of the payback period method. It accepts only projects with zero or more than zero net present value.
Decision:
In case of independent decision: If the project has a PBP less than the life of the project, they are accepted.
In case of mutually exclusive decision: Lesser the PBP of the project, it will be preferred more, and vice versa on the other hand i.e. higher the PBP it is not preferred.
Demerits of Discounted PBP method:
It also does not consider all cash flows of the project as it ignores the cash flows beyond the cutoff time.
Net Present Value:
It refers to the amount difference between the present value of cash inflows (total present value) and the outflow of the projects (Net Cash Outlay).
NPV = Total Present Value of inflows - Net Cash Outlay
= TPV - NCO
a. In case of projects with even or same cash flows generated over the years,
NPV = TPV - NCO
= Annual cash flow * PVIFA (i, n) - Net Cash Outlay
where, PVIFA (i, n) = Present value interest factor annuity at the interest 'i' and number of years 'n'
b. In case of projects with uneven cash flows generated over the years,
NPV = TPV - NCO
where TPV is calculated by using the formula: TPV = summation of [cash flow of particular year * PVIF(i, n)]
here, n = respective year of the respective cash flow generated i.e. for 1st year TPV we use cash flows of first-year multiplied by the PVIF at 'i' interest and year '1'.
Decision:
In case of independent decision: Projects with NPV greater than zero are accepted.
In case of mutually exclusive decision: Higher the NPV of the project, it will be preferred more, and vice versa on the other hand i.e. lower the NPV it is not preferred.
IRR (Internal rate of return):
The internal rate of return is the discount rate that makes the present value of the cash inflows equal to the present value of the cash outflows of the project.
a. In case of projects with even or same cash flows generated over the years,
fake factor = NCO / annual cash flow after-tax
Referring to the fake factor from the PVIFA table at given 'n' years we find the lower range (LR) and higher range (HR) and their respective values which is the interval of the fake factor calculated.
IRR = LR + (value at LR - fake factor) / (value at LR - value at HR) * (HR-LR)
b. In case of projects with uneven cash flows generated over the years,
First of all, we have to find the NPV with a positive and negative value of the project. If we got the positive value of the project we will look for the PVIF at a higher interest factor to get the negative NPV value. And on the other hand, if we get a negative NPV of the project, we will look for the PVIF at a lower interest factor to get the positive NPV.
After getting them, we will have:
So, LR = lower range , HR = higher range, NPV = net present value
IRR = LR + (NPV at LR / NPV at LR - NPV at HR) * (HR-LR)
Decision:
In case of independent decision: Projects with IRR greater than the cost of capital are accepted.
In case of mutually exclusive decision: Higher the IRR of the project, it will be preferred more, and vice versa on the other hand i.e. lower the IRR it is not preferred.
Profitability Index (PI index):
PI refers to the measurement of the relative profitability of the project. It is also defined as the ratio of the total present value of cash inflows to the net cash outlay of the project.
PI = Total present value of cash inflows / Net Cash Outlay
Decision:
In case of independent decision: Projects with PI greater than one are accepted.
In case of mutually exclusive decision: Higher the PI of the project, it will be preferred more, and vice versa on the other hand i.e. lower the PI it is not preferred.