Briefly explain the traditional and modern methods of capital budgeting?

Briefly explain the traditional and modern methods of capital budgeting?

At each point of time a business firm has a number of proposals regarding various projects in which it can invest funds. But the funds available with the firm are always limited and it is not possible to invest funds in all the proposals at a time. Hence, it is very essential to select from amongst the various competing proposals, those which give the highest benefits. The crux of the capital budgeting is the allocation of available resources to various proposals.

There are many methods of evaluating profitability of capital investment proposals.  The various commonly used methods are as follows:

(A)    Traditional methods:

(1)     Pay-back Period Method or Pay out or Pay off Method.

(2)       Improvement of Traditional Approach to pay back Period Method.(post payback method)

(3)       Accounting or Average Rate of Return Method.

(B)    Time-adjusted method or discounted methods:

(4)     Net Present Value Method.

(5)     Internal Rate of Return Method.

(6)     Profitability Index Method.

(A)    TRADITIONAL METHODS:

1. PAY-BACK PERIOD METHOD

The ‘pay back’ sometimes called as pay out or pay off period method represents the period in which the total investment in permanent assets pays back itself. This method is based on the principle that every capital expenditure pays itself back within a certain period out of the additional earnings generated from the capital assets.Under this method, various investments are ranked according to the length of their payback period in such a manner that the investment within a shorter payback period is preferred to the one which has longer pay back period. (It is one of the non- discounted cash flow methods of capital budgeting).

MERITS

The following are the important merits of the pay-back method:

1.   It is easy to calculate and simple to understand.

2.  Pay-back method provides further improvement over the accounting rate return.

3.  Pay-back method reduces the possibility of loss on account of obsolescence.

DEMERITS

1.   It ignores the time value of money.

2.   It ignores all cash inflows after the pay-back period.

3.   It is one of the misleading evaluations of capital budgeting.

ACCEPT /REJECT CRITERIA

If the actual pay-back period is less than the predetermined pay-back period, the project would be accepted. If not, it would be rejected.

2.   POST PAY-BACK PROFITABILITY METHOD:

One of the serious limitations of Pay-back period method is that it does not take into account the cash inflows earned after pay-back period and hence the true profitability of the project cannot be assessed. Hence, an, improvement  over  this method can be made by taking into account the return receivable beyond the pay-back period.

Post pay-back profitability      =Cash inflow (Estimated life – Pay-back period) Post pay-back profitability index= Post pay-back profitability/original investment

3.   AVERAGE RATE OF RETURN:

This method takes into account the earnings expected from the investment over their whole life. It is known as accounting rate of return method for the reason that under this method, the Accounting concept of profit (net profit after tax and depreciation) is used rather than cash inflows. According to this method, various projects are ranked in order of the rate of earnings or rate of return. The project with the higher rate of return is selected as compared to the one with lower rate of return.  This method can also be  used to make decision as to accepting or rejecting a proposal. Average rate of return means the average rate of return or profit taken for considering

(a)   Average Rate of Return Method (ARR):

Under this method average profit after tax and depreciation is calculated and then it is divided by the total capital outlay or total investment in the project. The project evaluation. This method is one of the traditional methods for evaluating

The project proposals

ARR = (Total profits (after dep & taxes))/ (Net Investment in the project X No. of years of profits) x 100

OR

ARR = (Average Annual profits)/ (Net investment in the project) x 100

(b)   Average Return on Average Investment Method:

This is the most appropriate method of rate of return on investment Under this method, average profit after depreciation and taxes is divided by the average amount of investment; thus:

Average Return on Average Investment = (Average Annual Profit after depreciation and taxes)/ (Average Investment) x 100

Merits

1.   It is easy to calculate and simple to understand.

2.   It is based on the accounting information rather than cash inflow.

3.   It is not based on the time value of money.

4.   It considers the total benefits associated with the project.

Demerits

1.   It ignores the time value of money.

2.   It ignores the reinvestment potential of a project.

3.   Different methods are used for accounting profit. So, it leads to some difficulties in the calculation of the project.

Accept/Reject criteria

If the actual accounting rate of return is more than the predetermined required rate of return, the project would be accepted. If not it would be rejected.

(B)      TIME – ADJUSTED OR DISCOUNTED CASH FLOW METHODS: or MODERN METHOD

The traditional methods of capital budgeting i.e. pay-back method as well as accounting rate of return method, suffer from the serious limitations that give equal weight to present and future flow of incomes. These methods do not take into consideration the time value of money, the fact that a rupee earned today has more value than a rupee earned after five years.

1.       NET PRESENT VALUE

Net present value method is one of the modern methods for evaluating the project proposals. In this method cash inflows are considered with the time value of the money. Net present value describes as the summation of the present value of cash inflow and present value of cash outflow. Net present value is the difference between the total present values of future cash inflows and the total present value of future cash outflows.

NPV = Total Present value of cash inflows – Net Investment

If offered an investment that costs $5,000 today and promises to pay you $7,000 two years from today and if your opportunity cost for projects of similar risk is 10%, would you make this investment? You Need to compare your $5,000 investment with the $7,000 cash flow you expect in two years. Because you feel that a discount rate of 10% reflects the degree of uncertainty associated with the $7,000 expected in two years, today it is worth: 

By investing $5,000 today, you are getting in return a promise of a cash flow in the future that is worth $5,785.12 today. You increase your wealth by $785.12 when you make this investment.

Merits

1.   It recognizes the time value of money.

2.   It considers the total benefits arising out of the proposal.

3.   It is the best method for the selection of mutually exclusive projects.

4.   It helps to achieve the maximization of shareholders’ wealth.

Demerits

1.   It is difficult to understand and calculate.

2.   It needs the discount factors for calculation of present values.

3.   It is not suitable for the projects having different effective lives.

Accept/Reject criteria

If the present value of cash inflows is more than the present value of cash outflows, it would be accepted. If not, it would be rejected.

2.       PROFITABILITY INDEX METHOD

The profitability index (PI) is the ratio of the present value of change in operating cash inflows to the present value of investment cash outflows:

Instead of the difference between the two present values, as in equation PI is the ratio of the two present values. Hence, PI is a variation of NPV. By construction, if the NPV is zero, PI is one.

3.       INTERNAL RATE OF RETURN METHOD

This method is popularly known as time adjusted rate of return method/discounted rate of return method also. The internal rate of return is defined as the interest rate that equates the present value of expected future receipts to the cost of the investment outlay. This internal rate of return is found by trial and error. First we compute the present value of the cash-flows from an investment, using an arbitrarily elected interest rate. Then we compare the present value so obtained with the investment cost. If the present value is higher than the cost figure, we try a higher rate of interest and go through the procedure again. Conversely, if the present value is lower than the cost, lower the interest rate and repeat the process. The interest rate that brings about this equality is defined as the internal rate of return. This rate of return is compared to the cost of capital and the project having higher difference, if they are mutually exclusive, is adopted and other one is rejected. As the determination of internal rate of return involves a number of attempts to make the present value of earnings equal to the investment, this approach is also called the Trial and Error Method. Internal rate of return is time adjusted technique and covers the disadvantages of the Traditional techniques. In other words it is a rate at which discount cash flows to zero. It is expected by the following ratio

Steps to be followed:

Step1. Find out factor Factor is calculated as follows:

Step 2. Find out positive net present value Step 3. Find out negative net present value

 Step 4. Find out formula net present value

Base factor = Positive discount rate DP = Difference in percentage Merits

1.   It considers the time value of money.

2.   It takes into account the total cash inflow and outflow.

3.   It does not use the concept of the required rate of return.

4.   It gives the approximate/nearest rate of return.

Demerits

1.   It involves complicated computational method.

2.   It produces multiple rates which may be confusing for taking decisions.

3.    It is assume that all intermediate cash flows are reinvested at the internal rate of return.

Accept/Reject criteria

If the present value of the sum total of the compounded reinvested cash flows is greater than the present value of the outflows, the proposed project is accepted. If not it would be rejected.

NPV vs. IRR Methods¶

Key differences between the most popular methods, the NPV (Net Present Value) Method and IRR (Internal Rate of Return) Method, include:

•   NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return a firm expects the capital project to return;

•   Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not;

•   The IRR Method cannot be used to evaluate projects where there are changing cash flows (e.g., an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm);

•   However, the IRR Method does have one significant advantage -- managers tend to better understand the concept of returns stated in percentages and find it easy to compare to the required cost of capital; and, finally,

•   While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows, is preferable to a larger project that will generate more cash.

•   Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation.

Recent variations of these methods include:

•   The Adjusted Present Value (APV) Method is a flexible DCF method that takes into account interest related tax shields; it is designed for firms with active debt and a consistent market value leverage ratio;

•   The Profitability Index (PI) Method, which is modeled after the NPV Method, is measured as the total present value of future net cash inflows divided by the initial investment; this method tends to favor smaller projects and is best used by firms with limited resources and high costs of capital;

•   The Bailout Payback Method, which is a variation of the Payback Method, includes the salvage value of any equipment purchased in its calculations;

  

•   The Real Options Approach allows for flexibility, encourages constant reassessment based on the riskiness of the project's cash flows and is based on the concept of creating a list of value-maximizing options to choose projects from; management can, and is encouraged, to react to changes that might affect the assumptions that were made about each project being considered prior to its commencement, including postponing the project if necessary; it is noteworthy that there is not a lot of support for this method among financial managers at this time.

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BASIS FOR COMPARISON	NPV	IRR
Meaning	The total of all the present values of cash flows (both positive and negative) of a project is known as Net Present Value or NPV.	IRR is described as a rate at which the sum of discounted cash inflows equates discounted cash outflows.
Expressed in	Absolute terms	Percentage terms
What it represents?	Surplus from the project	Point of no profit no loss (Break even point)
Decision Making	It makes decision making easy.	It does not help in decision making
Rate for reinvestment of intermediate cash flows	Cost of capital rate	Internal rate of return
Variation in the cash outflow timing	Will not affect NPV	Will show negative or multiple IRR

Key Differences Between NPV and IRR

The basic differences between NPV and IRR are presented below:

The aggregate of all present value of the cash flows of an asset, immaterial of positive or negative is known as Net Present Value. Internal Rate of Return is the discount rate at which NPV = 0.

The calculation of NPV is made in absolute terms as compared to IRR which is computed in percentage terms.

The purpose of calculation of NPV is to determine the surplus from the project, whereas IRR represents the state of no profit no loss.

Decision making is easy in NPV but not in the IRR. An example can explain this, In the case of positive NPV, the project is recommended. However, IRR = 15%, Cost of Capital < 15%, the project can be accepted, but if the Cost of Capital is equal to 19%, which is higher than 15%, the project will be subject to rejection.

Intermediate cash flows are reinvested at cut off rate in NPV whereas in IRR such an investment is made at the rate of IRR.

When the timing of cash flows differs, the IRR will be negative, or it will show multiple IRR which will cause confusion. This is not in the case of NPV.

When the amount of initial investment is high, the NPV will always show large cash inflows while IRR will represent the profitability of the project irrespective of the initial invest. So, the IRR will show better results.

Similarities

• Both uses Discounted Cash Flow Method.
• Both takes into consideration the cash flow throughout the life of the project.
• Both recognize time value of money.