In our previous blog post, we have talked about the basics of capital budgeting which includes its meaning, need and importance- read here. In this blog post, we will talk about the various methods of capital budgeting along with their advantages and disadvantages.
Techniques/ Methods of Capital Budgeting
Methods of capital budgeting are mainly divided into two categories- traditional and modern methods. Along with the methods, we will also talk about the capital budgeting techniques advantages and disadvantages.
Traditional Methods of Capital Budgeting
Traditional Methods of Capital Budgeting are Payback Period Method, Post Payback Period Method and Average Rate of Return Method.
So, let’s talk about each in detail.
Payback Period Method
The payback period is the time to recover the initial investment in any project. The formula of Payback period method is-
Initial investment/ total cash inflows
Cash outflows/ total cash inflows
Advantages of Payback Period Method:
- Easy to calculate and understand.
Disadvantages of Payback period Method
- Ignores the time value of money and risk factor.
- Ignores the after the payback period.
- Ignores the after payback period profitability.
- Ignores the uncertainty of the market.
Improvement in Payback period method (Post-Payback period method)
This traditional method of capital budgeting overcomes the limitation of the Payback period method by Involving the time after the payback period. In this method, the firm considers the time after the payback period.
The Post Payback period is computed by two methods-
- Post Payback Profitability-
Net Profit after tax and depreciation / Cash inflows (established payback period)
Post Payback Profits/Investment * 100
- Post-Payback Reciprocal Method-
Annual Cash Inflows / Total Investment
Conditions in Post Payback Period Method
- Equal Cashflows are generated every year.
- Project under consideration has a long life which must be at least twice the payback period.
The Post-Payback period method is also known as the surplus life of project method. The project which gives the major post payback period may be accepted.
Rate of Return Method or Accounting ROR Method
It is a financial ratio which helps to determine the profits and revenue potential of a project. This traditional Capital Budgeting Method calculates the return on investment of a project by considering the average income or profit generated by a project.
The formula of Accounting ROR Method is-
Average Return/Average Investment * 100
Average Annual Profit/Net Investment *100
Total Profit (after depreciation and taxes)/(Net Investment * No. of years of profit) *100
Modern Methods of Capital Budgeting
Modern Methods of Capital Budgeting or the discounted cash flow methods comprises of Net Present Value (NPV) Method, Internal Rate of Return (IRR) Method and Profitability Index Method.
Net Present Value Method(NPV)
This Modern Method of Capital Budgeting takes into consideration the time value of money and calculate the return on investment by introducing the factors of the time element.
Under the NPV method, cash inflows and outflows calculate separately for each year by discounting these flows by firms pre-determined discounting rate.
- First of all, determine the appropriate rate of interest. It is the minimum rate of return/cost of capital/cut of rate.
- Compute the present value of total investment outflows. i.e: cash outflows and the determined discounting rate. If You give the total investment in the initial year, then the present value shall be the same as the cost of investment.
- Compute the present value of cash inflows i.e. cash inflows discounted at the pre-determined rate.
- Calculate the NPV of each project by subtracting the present value of cash inflows from the present value of cash outflows of each project.
- If the NPV is positive or zero, the proposal may be accepted.
- If the NPV is -ve, the proposal will be rejected.
- To select the mutually exclusive project, the project should be ranked in order of the NPV.
An= Annual cash inflows over the years.
r= Rate of Interest.
Advantages of NPV
- It considers the time value of money.
- It considers the entire life of the project and its earning.
- It considers the objective of maximum profitability.
Disadvantages of NPV
- More complicated to understand.
- It may not give good result where project is with unequal bias.
- NPV is successful only where cash inflows must be equal and the project lives too.
Internal Rate of Return Method (IRR)
Both NPV and IRR are kinds of similar. Under NPV, the discounting rate is already given. But in IRR, we can calculate the rate of return after the calculations. The other name of this modern method of capital budgeting is the adjustment rate of return method or trial and error method.
Under the IRR approach, cash flows of project discounts at a suitable rate by hit and trial method which equates the NPV.
Since this method uses the discounting rate which calculates internally. That’s why it is known as the IRR.
IRR can be defined as the discounting rate at which the present value of cash inflows are equal to the present value of cash outflows.
The formula of calculating IRR is An/(1+r)n
Process of calculating the IRR
- Determine the future Net Cash flows during the entire life of the project. Here the cash inflows estimates for the future profits before the depreciation but after the tax.
- Determine the rate of discount at which the value of cash inflow is equal to the value of cash outflow.
- Accept the project if IRR is greater or equal to the minimum required rate of return and reject if IRR < Ko.
Determinants of IRR
- Equal Cash Flows-
- When the annual cash flows are equal over the life of the project
PV= Initial Outlay/Annual Cash flows = 5,00,000/12,500 = 4
Computing PV of the annuity table for 5 years period at which PV factor of 4.
IRR= 8%, Initial Outlay=5,00,000 Life of Asset=5 Years Cash flows =12,500
- When annual cash flows are unequal over the life of the project.
In such a case IRR calculates by hit and trial method. We may start with any assumed discounting rate and find out the total PV (present value) of cash outflows which is equal to the cost of the initial investment. The rate at which the total PV of cash inflows is equal to the value of cash outflows is the IRR.
Several rates are tried until the appropriate rate is found.
- Prepare the cash flows table using an arbitrary assumed discounting rate to discount the net cash flows to the present value.
- Find out the NPV by deducting the present value of total cash flows calculated in above initial cost of investment.
- If NPV is +ve, apply a higher rate of return.
- If the higher discounting rate still gives the +ve NPV, increase the discounting rate further until NPV becomes equal or -ve.
- If the NPV is -ve at the higher rate, the IRR must be between these two rates.
Advantages of IRR
- Consider the time value of money.
- It can necessarily use in those situations where equal or uneven cash flows at a different time.
- It considers the profitability of the project for the entire life.
- It takes the objective of maximum profitability.
Disadvantages of IRR
- Difficult to understand.
- It is based upon the assumption that earning reinvests at the IRR for the remaining years of the project which is not justified.
- The result of NPV and IRR may differ when project under evaluation differ in size, life and timing of the cash flows.
Difference between NPV and IRR
|Basis of Difference||NPV||IRR|
|Interest Rate||Known factor||Unknown factor|
|Rate of Interest (Market)||It recognizes the market rate of interest or Ko.||It doesn’t consider the market rate of interest.|
|Re-investment||Intermediate cash flows are re-invested at the Ko or cut off rate.||Re-invested at the IRR rate.|
Similarities between NPV and IRR
Both the modern capital budgeting methods- NPV and IRR shows the same result in terms of accept and reject decision in the following cases:
- Independent Proposal
- Where the investment made in the initial year but cash inflows in the series of years.
Both NPV and IRR are not similar when projects are mutually exclusive.
Profitability Index Method
This modern method of capital budgeting ranks the projects based on profitability. It calculates by dividing the present value of all cash inflows by the cash outflows.
The formula of profitability index method is the Present Value of Cash Inflows/ Present Value of Cash Outflows.
So, this was about the various methods of capital budgeting-traditional, modern methods and along with the advantages, disadvantages.
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