Capital Budgeting Techniques Notes

CAPITAL BUDGETING TECHNIQUES. There are different methods of analyzing the viability of an investment. The preferred technique should consider time value procedures, risk and return considerations and valuation concepts to select capital expenditures that are consistent with the firm’s goals of maximizing owner’s wealth. Capital budgeting techniques are grouped in two: a) Non-discounted cash flow techniques (traditional methods) i. Pay back period method(PBP) ii. Accounting rate of return method(ARR) b) Discounted cash flow techniques (modern methods) iii. Net present value method(NPV) iv. Internal rate of return method(IRR) v. Profitability index method(PI) NON-DISCOUNTED CASH FLOW TECHNIQUES PAY BACK PERIOD METHOD (PBP) Pay back period refers to the number of periods/ years that a project will take to recoup its initial cash outlay. This technique applies cash flows and not accounting profits. I f the project generates constant annual cash inflows, the Pay back period will be given by, PBP=Initial Investment Annual cash flow Advantages of PBP 1. It’s simple to understand and use. 2. It’s ideal under high risk investment as it identifies which project will payback as soon as possible 3. PBP is cost effective as it does not require use of computers and a lot of analysis 4. PBP emphasizes on liquidity hence funds which are released as early as possible can be reinvested elsewhere Weaknesses of PBP 1. It does not consider all the cashflows in the entire life of the project. 2. It does not measure the profitability of a project but rather the time it will take to payback the initial outlay 3. PBP does not take into account the time value of money  

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4. It does not have clear decision criteria as a firm may face difficulty in determining the minimum acceptable payback period 5. It is inconsistent with the shareholders wealth maximization objective. Share values do not depend on the pay back period but on the total cashflows. ACCOUNTING RATE OF RETURN METHOD (ARR) This is the only method that does not use cashflows but instead uses accounting profits as shown in the financial statements of a company. It is also known as return on investment (ROI). The ARR is given by: ARR=

Average annual profit after tax ×100 Average investment

Advantages of ARR. 1. Simple to understand and use. 2. The accounting information used is readily available from the financial statements. 3. All the returns in the entire life of the project are used in determining the project’s profitability. Weaknesses of ARR. 1. Ignores time value of money. 2. Uses accounting profits instead of cashflows which could have been arbitrarily determined. 3. Growth companies earning very high rates of return on the existing assets may reject profitable projects as they have set a higher minimum acceptable ARR, the less profitable companies may set a very low acceptable ARR and may end up accepting bad projects. 4. Does not allow for the fact that profits can be reinvested. DISCOUNTED CASHFLOW TECHNIQUES NET PRESENT VALUE (NPV) This is the difference between the present value of cash inflows and the present value of cash outflows of a project. To get the present values a discount rate is used which is the rate of return or the opportunity cost of capital. The opportunity cost of capital is the expected rate of return that an investor could earn if the money would have been invested in financial assets of equivalent risk. Hence it’s the return that an investor would expect to earn.

 

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When calculating the NPV the cashflows are used and this implies that any non-cash item such as depreciation if included in the cashflows should be adjusted for. In computing NPV the following steps should be followed: Cashflows of the investment should be forecasted based on realistic assumptions. If sufficient information is given one should make the appropriate adjustments for non-cash items Identify the appropriate discount rate. (It is usually provided) Compute the present value of cashflows identified in step 1 using the discount rate in step2 The NPV is found by subtracting the present value of cash out flows from present value of cash inflows.

⎡ C C3 Cn ⎤ C2 − C0 NPV = ⎢ 1 + + + + L 2 3 n ⎥ (1 + k ) ⎦ ⎣ (1 + k ) (1 + k ) (1 + k ) n Ct NPV = ∑ − C0 t t =1 (1 + k ) CO

Initial investment

NPV= PV (inflows) –PV (outflows) INTERNAL RATE OF RETURN.(IRR) This is the discounting rate that equates present value of expected future cashflows to the cost of the investment .It is therefore the discounting rate that equates NPV to zero.

C0 =

C3 Cn C1 C2 + + + + L (1 + r ) (1 + r ) 2 (1 + r )3 (1 + r ) n n

C0 = ∑ t =1 n

∑ t =1

Ct (1 + r )t Ct − C0 = 0 (1 + r )t

Where: Co=initial investment  

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C1/C2/C3/Cn=cashflow in year1, 2, 3… up to year n L =cash flows from period 3 to year n r = is the rate that equates the initial investment to the present value of cash inflows over the life of the project.(IRR) PROFITABILITY INDEX It is defined as the ratio of the present value of the cashflows at the required rate of return to the initial cashout flow on the investment. PI= Present value of cash inflow Initial cash outflow. It is also called the benefit –cost ratio because it shows the present value of benefits per shilling of t he cost. It is therefore a relative means of measuring a project’s return. It thus can be used to compare projects of different sizes. Advantages of PI. 1. It considers time value of money. 2. It considers all cash flows yielded by the project. 3. It ranks projects in order of the economic desirer ability. 4. It gives a unique decision criterion. 5. It is a relative measure of profitability and therefore can be used to compare projects of different sizes. Weaknesses of PI 1. It is not consistent with maximizing shareholders wealth. 2. It assumes the discount rate is known and consistency which might not be the case. Advantages of PI. 1. It considers time value of money. 2. It considers all cash flows yielded by the project. 3. It ranks projects in order of the economic desirer ability. 4. It gives a unique decision criterion. 5. It is a relative measure of profitability and therefore can be used to compare projects of different sizes. Weaknesses of PI. 1. It is not consistent with maximizing shareholders wealth. 2. It assumes the discount rate is known and consistency which might not be the case.  

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