Explain 5 Techniques of Capital Budgeting
Now that we have understood CapitalBudgeting and Capital Budgeting process the next stage is understanding thetechniques of Capital Budgeting for making investment decision. Investment decision techniques are broadlyclassified into two categories Discounting and Non-Discounting criteria. Indiscounting criteria the time value of money is considered whereas inNon-Discounting criteria Time Value of Money is ignored.
Techniquesof Capital Budgeting
The Various techniques ofCapital Budgeting are as follows
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Net Present Value (NPV)
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Benefit Cost Ratio (PI)
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Internal Rate of Return (IRR)
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Pay Back Period (PBP)
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Accounting Rate of Return (ARR)
Now let usunderstand each evaluation criteria in-depth and know its advantages andlimitations
§ Net Present Value:
It is one ofthe most important concept in finance when it comes to evaluate investments,making financial decisions involving cash flows in multiple periods. It is thesum of the present values of all the cash flows over the life of the project.The NPV represents the net benefit with respect to time and risk associated.Therefore the criteria for accepting a project is that cash flow should bepositive, while reject if the cash flow is negative. NPV can be mathematicalrepresented as
NPV = Ʃ Ct - Initial Investment
(1+r) t
Properties of NPV
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Valueof business can be expressed in terms of sum of present values of the cashflows of project.
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Businessvalue increases when a negative NPV based on future expected cash flow projectis rejected and decreases when a business undertakes negative NPV new project.
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Whena business divests from existing project, the value at which the project iswithdrawn affects the value of the firm.
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Whenacquisition is made and price is paid excessive then the expected present valueof the cash flows it like taking negative NPV and diminish the value of thefirm.
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Thevalue of the firm is affected depending upon the expected NPV when a newproject is taken up.
Limitations
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NPVis expressed in absolute terms and not in relative terms and doesn’t take intoaccount the investment required for the project.
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NPVdoesn’t consider the life of the project.
§ Benefit Cost Ratio :
Itis also known as Profitability Index. It is the ratio between present valuebenefit and initial investment. Net benefit Cost ratio is the ratio betweenPresent Value of Benefit – initial Investment to Initial Investment. The evaluating or decision making criteriafor
BCR | NBCR | Accept / Reject |
>1 | >0 | Accept |
=1 | =0 | Indifferent |
<1 | <0 | Reject |
Whilethis method has an argument and is negatively criticized under certainconditions. It is calculated by the mathematical formula
PI =Total Present Value
Initial Investment
§ Internal Rate of Return:
It is adiscounting technique which makes the project NPV equal to zero. The differencebetween NPV and IRR is that in IRR we determine discount rate (cost of capital)i.e. “r” by set it to zero while in NPV discount rate (Cost of Capital) isknown.
It iscalculated by the mathematical formula
IRR = LDF + DF* {PV of LDF – Initial Investment}
PV of LDF – PV of HDF
§ Modified Internal Rate of Return(MIRR):
MIRR issuperior when compared regular IRR. MIRR is superior to IRR because MIRRconsiders project cash flows are reinvested at cost of capital whereas IRRconsiders cash flows reinvested at the project’s own IRR. MIRR shows the trueprofitability of profit.
It iscalculated by the mathematical formula
MIRR = TotalPresent Value
(1 + MIRR)1/n
§ Pay Back Period:
This is atraditional method which is based on how quickly the investment is recovered.As per PBP criteria the shorter the recovery period for the investment is to beranked 1st. It is simple and easy to calculate. It favors thoseprojects that generate high cash flows in early stage of project. It is a goodcriteria when a business is facing the problem of liquidity of cash. Thismethod measures the capital recovery not the profitability of project. Itreflects projects liquidity and not the business liquidity has a whole.
It iscalculated by the mathematical formula as shown below
PBP = InitialInvestment – Preceding cash flow
§ Accounting Rate of Return:
It is alsoknown as Average Rate of Return. It is the ratio of the Profit after tax andbook value of investment. The selection criterion is high ARR. It is simple in calculation and theinformation is readily available. It has shortcomings like it is based onaccounting profit and not on cash flows; it does not consider Time Value ofMoney. It is calculated by the mathematical formula as shown below
ARR = AverageReturn * 100
AverageInvestment
