Capital Budgetting Decision

Introduction

Capital budgeting is primarily concerned with sizable investments in long-term assets. These assets may be tangible items such as property, plant, or equipment or intangible ones such as new technology, patents, or trademarks. Capital Budgeting can be defined the planning and management of expenditures on long-term assets. It is the decision making process for investing the capital into various sizable or long-term assets.

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. 

Basically there are six different types or natures of capital projects include independent projects, contingent projects, mutually exclusive projects, replacement projects, expansion of the business projects and diversification projects.

The capital budgeting decision is important (significance) for the various purpose such as growth, large amount of funds, risk, complex, national importance etc.

Tools for Project Evaluation

The project evaluation tools help to make the proper decision regarding the investment in the project based on the performance measurement of the project. Basically there are broadly two types of techniques to evaluate the project based on the future cash flow. The following diagram can be illustrated as below:

Fig: Tools for Investment Project Evaluation

  • Payback Period (PBP): Payback period (PBP) is a number of years represents that your entire investment amount will be recovered based on the annual cash flow streams. It is one of the type of capital budgeting techniques under non-discounted cash flow method.  It is also known as the tool under traditional method of capital budgeting techniques. The payback period can be calculated as follows:

Payback Period (PBP)= Minimum Year+ (Remaining Amount to be Recovered /Cash Flow During the current year)

Decision rule: Longest payback period places in the last priority, shortest payback period places in the first priority. 

  • Accounting Rate of Return (ARR): Accounting Rate of Return (ARR) is one of the project evaluation tools under non-discounted techniques of capital budgeting. It is also known as Average Accounting Rate of Return/ Return on Investment/Return on Capital Employed. It is a financial ratio used in capital budgeting. It can be defined as the annualized net income earned on the average funds invested in a project. The accounting rate of return can be calculated as follows:

Accounting Rate of Return(ARR)= Average EADT /(NCO + Salvage Value)/2))

Where EADT stands for Earning after Depreciation and Tax, NCO stands for Net Cash Outlay or Initial Investment and ‘k’ represents for required rate of return.

Decision rule: If ARR > k, ARR < k and ARR = k then the project should be accepted, rejected and indifference respectively.

Note: The ARR can also be used to rank various mutually exclusive projects. The project with higher ARR will have the first priority while the project with lowest ARR will have the lowest priority.

  •  Discounted Payback Period (DPBP): The Discounted Payback Period is the number of years required by an investment project to recover present value of cost by present value of benefits. In other words, it is the amount of time that it takes (in years) for the initial cost of a project to equal to discounted value of expected cash flows (CFAT). The discounted payback period can be calculated as follows:

Discounted Payback Period(DPBP)= Minimum Year+ (Cumulative PV During Minimum Year/ PV after Minimum Year)

Decision rule: Longest discounted payback period places in the last priority, shortest discounted payback period places in the first priority.

  • Net Present Value (NPV): Net present value is popular and widely used discounted cash flow technique. The net present value can be defined as the sum of the present values of all the cash inflows less the sum of the present values of all of the cash outflows associated with the project. In this case, the cash outflows mean investment project cost which always occur in the beginning at time zero. The net present value can be calculated as follows:

Net Present Value(NPV)= Total Present Value - Net Cash Outlay

Decision rule: If NPV > 0, NPV < 0 and NPV = 0 then the project should be accepted, rejected and indifference respectively.

Note: (1) Higher the discount rate Lower the NPV; there is inverses relationship between discounting rate and NPV. (2) In case of mutually exclusive projects, the project with higher NPV should be chosen.

  • Internal Rate of Return (IRR): The IRR is the interest rate that equates the present value of the expected future cash flows or receipts to the initial cash outlay. The IRR formula is the same as NPV formula, except it sets the NPV equal to zero and solves for discount rate. The IRR is ascertained by the trial and error procedure. The internal rate of return can be calculated as follows:

Internal Rate of Return (IRR)= (CF / ( 1+IRR ))-NCO = 0

The value of IRR implies finding out the net present value of the proposal at two assumed values of IRR which the IRR is expected to lie. Thereafter the two rates are interpolated to make the NPV equal to zero. The formula of interpolation for IRR is:

Interpolation Formula for IRR = LR+(NPV_LR / (NPV_LR - NPV_HR)*( HR-LR)

Decision rule: If IRR > k, IRR < k and IRR = k then the project should be accepted, rejected and indifference respectively.

Note: ‘k’ represents the required rate of return.

  • Modified Internal Rate of Return (MIRR): Modified Internal Rate of Return (MIRR) is one of the tools of project evaluation techniques under discounted cash flow method. It solves the issues of IRR (Internal Rate of Return). IRR can only solve the problem of two IRR while MIRR solves the problem of multiple IRR. The multiple IRR assumes that cash flows from all projects are reinvested at the cost of capital as opposed to the project's own IRR. The rate of return which equates that initial investment with a project terminal value, where the terminal value is the future value of the cash inflows compounded at the required rate of return. The modified internal rate of return can be calculated as follows:

Modified Internal Rate of Return (MIRR)= ((TPV/NCO)^(1/n)-1)

Where TPV stands for total present value, NCO stands for net cash outlay, ‘n’ represents the number of project years

Decision rule: If MIRR > k, MIRR < k and MIRR = k then the project should be accepted, rejected and indifference respectively.

Note: ‘k’ represents the required rate of return.

  • Profitability Index (PI): The profitability index can be defined as the ratio of present value of future cash flows to the initial outlay. It is also known as benefit cost (B/C) ratio. The profitability index can be calculated as follows:

Profitability Index (PI)= TPV / NCO

Where TPV stands for total present value and NCO stands for net cash outlay

Decision rule: If PI > 1, PI < 1 and PI = 1 then the project should be accepted, rejected and indifference respectively.

Note: (1) The NPV and PI methods provide us with the same accept reject decision; they may rank two or more projects differently. The difference occurs because the NPV criteria measure the rupee value of the project, while the PI measures its value relative to project cost. (2) Lower the NPV Higher the PI; there is inverse relationship between NPV and PI.

Conclusion

Decision Rule for Accepting the Project based on its Parameters

Table: Decision Making Matrix

Capital Budgeting Decision Making Matrix

Note: The ‘k’ represents required rate of return.

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