What are the best techniques of evaluation of a projects in capital budgeting?

Companies use several techniques to determine if it makes sense to invest funds in a capital expenditure project. The attractiveness of a capital investment should consider the time value of money, the future cash flows expected from the investment, the uncertainty related to those cash flows and the performance metric used to select a project.

Tip

The most commonly used methods for capital budgeting are the payback period, the net present value and an evaluation of the internal rate of return.

Payback Period

The payback period method is popular because it's easy to calculate. Quite simply, the payback period is a calculation of how long it takes to get your original investment back.

Let's suppose you spent $24,000 to buy a machine that made blue widgets, and the profits from selling these widgets would amount to $8,000 per year. Your payback period would be $24,000 divided by $8,000 or three years. Is that acceptable? It depends on your criteria for a required payback period.

What About the Time Value of Money? 

The payback method has a flaw in that it does not consider the time value of money. Suppose you're considering two projects and both have the same payback period of three years. However, Project A returns most of your investment in the first one and one-half years whereas Project B returns most of its cash flow return in years two and three.

They both have the same payback period of three years, so which one would you choose? You would select Project A, because you would get most of your money back in the early years, as opposed to Project B, which has returns concentrated in the later years.

Note that the payback method only considers the time required to return the original investment. But suppose that Project A had zero cash flow beyond the third year, whereas the cash flow from Project B continued to generate $10,000 per year in years four, five, six and beyond. Now, which project would you choose?

Net Present Value

Unlike the payback method, the net present value approach does consider the time value of money for as long as the projects generate cash flow. The net present value method uses the investor's required rate of return to calculate the present value of future cash flow from the project.

The rate of return used in these calculations depends on how much it cost for the investor to borrow money or the return that the investor wants for his own money. The evaluation of projects depends on whatever return the investor says it has to be. If the present value of discounted future cash flows exceeds the initial investment, then the project is acceptable. If the present value of future cash flows is less than the initial outlay, the project is rejected.

The net present value method considers the differences in the timing of future cash flows over the years. Getting your money back in the early years is preferable to receiving it 20 years from now. Inflation makes money worth less in future years than it is worth today.

Internal Rate of Return

The internal rate of return method is a simpler variation of the net present value method. The internal rate of return method uses a discount rate that makes the present value of future cash flows equal to zero. This approach gives a method of comparing the attractiveness of several projects.

The project with the highest rate of return wins the contest. However, the rate of return of the winning project must also be higher than the investor's required rate of return. If the investor says he wants to receive a 12 percent return on his money, and the winning project only has a return of 9 percent, then the project would be rejected. The investor's cost of capital is the minimum return acceptable, when using the internal rate of return method.

No Method is Foolproof

As you can see, none of these methods are completely reliable by themselves. They all have their flaws for making an intelligent analysis, when evaluating the worth of several projects.

A project that has the highest internal rate of return may not have the best net present value of future cash flows. Another project could have a short payback period, but it continues to produce cash flows after the payback period ends. This means that all these methods of analysis should be used, and investment decisions made with good business judgement.

In our last article, we talked about the Basics of Capital Budgeting, which covered the meaning, features and Capital Budgeting Decisions. In this article let us talk about the important techniques adopted for capital budgeting along with its importance and example.

CAPITAL BUDGETING TECHNIQUES / METHODS

There are different methods adopted for capital budgeting. The traditional methods or non discount methods include: Payback period and Accounting rate of return method. The discounted cash flow method includes the NPV method, profitability index method and IRR.

• Payback period method:

As the name suggests, this method refers to the period in which the proposal will generate cash to recover the initial investment made. It purely emphasizes on the cash inflows, economic life of the project and the investment made in the project, with no consideration to time value of money. Through this method selection of a proposal is based on the earning capacity of the project. With simple calculations, selection or rejection of the project can be done, with results that will help gauge the risks involved. However, as the method is based on thumb rule, it does not consider the importance of time value of money and so the relevant dimensions of profitability.

Payback period = Cash outlay (investment) / Annual cash inflow

Example

Payback period of project B is shorter than A, but project A provides higher returns. Hence, project A is superior to B.

• Accounting rate of return method (ARR):

This method helps to overcome the disadvantages of the payback period method. The rate of return is expressed as a percentage of the earnings of the investment in a particular project. It works on the criteria that any project having ARR higher than the minimum rate established by the management will be considered and those below the predetermined rate are rejected.

This method takes into account the entire economic life of a project providing a better means of comparison. It also ensures compensation of expected profitability of projects through the concept of net earnings. However, this method also ignores time value of money and doesn’t consider the length of life of the projects. Also it is not consistent with the firm’s objective of maximizing the market value of shares.

ARR= Average income/Average Investment

• Discounted cash flow method:

The discounted cash flow technique calculates the cash inflow and outflow through the life of an asset. These are then discounted through a discounting factor. The discounted cash inflows and outflows are then compared. This technique takes into account the interest factor and the return after the payback period.

• Net present Value (NPV) Method:

This is one of the widely used methods for evaluating capital investment proposals. In this technique the cash inflow that is expected at different periods of time is discounted at a particular rate. The present values of the cash inflow are compared to the original investment. If the difference between them is positive (+) then it is accepted or otherwise rejected. This method considers the time value of money and is consistent with the objective of maximizing profits for the owners. However, understanding the concept of cost of capital is not an easy task.

The equation for the net present value, assuming that all cash outflows are made in the initial year (tg), will be:

Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost of the investment proposal and n is the expected life of the proposal. It should be noted that the cost of capital, K, is assumed to be known, otherwise the net present, value cannot be known.

NPV = PVB – PVC

where,

PVB = Present value of benefits

PVC = Present value of Costs

• Internal Rate of Return (IRR):

This is defined as the rate at which the net present value of the investment is zero. The discounted cash inflow is equal to the discounted cash outflow. This method also considers time value of money. It tries to arrive to a rate of interest at which funds invested in the project could be repaid out of the cash inflows. However, computation of IRR is a tedious task.

It is called internal rate because it depends solely on the outlay and proceeds associated with the project and not any rate determined outside the investment.

It can be determined by solving the following equation:

If IRR > WACC then the project is profitable.

If IRR > k = accept

If IR < k = reject

• Profitability Index (PI):

It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one. The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows.

PI = PV cash inflows/Initial cash outlay A,

PI = NPV (benefits) / NPV (Costs)

All projects with PI > 1.0 is accepted.

IMPORTANCE OF CAPITAL BUDGETING

1) Long term investments involve risks: Capital expenditures are long term investments which involve more financial risks. That is why proper planning through capital budgeting is needed.

2) Huge investments and irreversible ones: As the investments are huge but the funds are limited, proper planning through capital expenditure is a pre-requisite. Also, the capital investment decisions are irreversible in nature, i.e. once a permanent asset is purchased its disposal shall incur losses.

3) Long run in the business: Capital budgeting reduces the costs as well as brings changes in the profitability of the company. It helps avoid over or under investments. Proper planning and analysis of the projects helps in the long run.

SIGNIFICANCE OF CAPITAL BUDGETING

• Capital budgeting is an essential tool in financial management
• Capital budgeting provides a wide scope for financial managers to evaluate different projects in terms of their viability to be taken up for investments
• It helps in exposing the risk and uncertainty of different projects
• It helps in keeping a check on over or under investments
• The management is provided with an effective control on cost of capital expenditure projects
• Ultimately the fate of a business is decided on how optimally the available resources are used

Example of Capital Budgeting:

Capital budgeting for a small scale expansion involves three steps: recording the investment’s cost, projecting the investment’s cash flows and comparing the projected earnings with inflation rates and the time value of the investment.

For example, equipment that costs $15,000 and generates a $5,000 annual return would appear to "pay back" on the investment in 3 years. However, if economists expect inflation to rise 30 percent annually, then the estimated return value at the end of the first year ($20,000) is actually worth $15,385 when you account for inflation ($20,000 divided by 1.3 equals $15,385). The investment generates only $385 in real value after the first year.

Capital Budgeting is an interesting concept and a high in demand skill among organizations globally. Learning capital budgeting requires professional guidance to cover the complexities of the topic well. There are courses that are focused on cost accounting and budgeting and cover the topic extensively. Pursuing a course in Management Accounting also trains the candidate on capital budgeting. Below are two courses that can be pursued to learn capital Budgeting in depth: 

US CMA – Certified Management Accountant 

The US CMA course is offered by IMA, an institute based in the United States. US CMA course covers Management Accounting as the major domain in accounting. Management Accounting being different than generic accounting is a specialized domain and requires specialized training.

For details on the US CMA course like US CMA course eligibility, US CMA course scope, US CMA course duration, contact our counsellors. 

ACCA – Chartered Certified Accountants

The ACCA course is offered by an accounting body in the United Kingdom. The ACCA course is a great combination of general accounting and management accounting. That means a candidate gets to learn and excel in every domain of accounting, including financial accounting and management accounting. The ACCA course also defines exemptions for certain exams and levels depending on the academic and work background of the candidate.

For details on the ACCA course like ACCA course eligibility, ACCA course scope, ACCA course duration, contact our counsellors. 

Talk to our expert career counselors who can guide you about right course, career benefits, and preparation.

Conclusion:

According to the definition of Charles T. Hrongreen, “Capital Budgeting is a long-term planning for making and financing proposed capital outlays.”

One can conclude that capital budgeting is the attempt to determine the future.

What is the best method for evaluating capital budgeting projects?

What is the popular technique used in evaluation of capital project?

Which methods can be used for evaluating capital budgeting decisions?

Which of the following methods of evaluating capital investment projects?