Techniques used in Capital Budgeting (with advantages and limitations)

Techniques used in Capital Budgeting (with advantages and limitations)

Capital Budgeting:

Capital budgeting can be defined as a process of identifying, evaluating, determining & selecting  long term investment proposal where return are expected over the one year.

Capital budgeting consists of various techniques used by managers such as:

1. Net present value method:

The net present value (NPV) method is a process of calculating the present value of cash flows (inflows and outflows) of an investment proposal, using the cost of capital as the appropriate discounting rate, and finding out the net profit value, by subtracting the present value of cash outflows from the present value of cash inflows.

Decision making criteria:

NPV greater than 0 = Accept

NPV less than 0 = Reject

NPV equal 0 = indifferent position

Advantages:

1. It recognizes the time value of money

2. It considers all cash flows over the entire life of the project in its calculations.

3. It is consistent with the objective of maximizing the welfare of the owners.

Limitations:

1. It is difficult to use

2. It presupposes that the discount rate which is usually the firm’s cost of capital is known. But in practice, to understand cost of capital is quite a difficult concept.

3. It may not give satisfactory answer when the projects being compared involve different amounts of investment.

2. Internal Rate of Return Method:

The internal rate of return (IRR) equates the present value cash inflows with the present value of cash outflows of an investment. 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

Decision making criteria:

IRR greater than cost of capital = Accept

IRR less than cost of capital = Reject

IRR equal to cost of capital = indifferent position

Advantages:

1. Like the NPV method, it considers the time value of money.

2. It considers cash flows over the entire life of the project.

3. It satisfies the users in terms of the rate of return on capital.

4. Unlike the NPV method, the calculation of the cost of capital is not a precondition.

5. It is compatible with the firm’s maximizing owners’ welfare.

Limitations:

1. It involves complicated computation problems.

2. It may not give unique answer in all situations. It may yield negative rate or multiple rates under certain circumstances.

3. It implies that the intermediate cash inflows generated by the project are reinvested at the internal rate unlike at the firm’s cost of capital under NPV method. The latter assumption seems to be more appropriate.

3. Profitability index:                                                                                                                              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.

Decision making criteria:

PI greater than 1= Accept

PI less than 1= Accept

Advantages:

1. It gives due consideration to the time value of money.

2. It requires more computation than the traditional method but less than the IRR method.

3. It can also be used to choose between mutually exclusive projects by calculating the incremental benefit cost ratio.

Limitations:

1. It depends on NPV

4. Payback period:

The payback (or payout) period is one of the most popular and widely recognized traditional methods of evaluating investment proposals, it is defined as the number of years required to recover the original cash outlay invested in a project.

Decision making criteria:

PBP less than target PBP= Accept

PBP greater than target= Reject

Advantages:

1. A company can have more favorable short-run effects on earnings per share by setting up a shorter payback period.

2. The riskiness of the project can be tackled by having a shorter payback period as it may ensure guarantee against loss.

3. As the emphasis in pay back is on the early recovery of investment, it gives an insight to the liquidity of the project.

Limitations:

1. It fails to take account of the cash inflows earned after the payback period.

2. It is not an appropriate method of measuring the profitability of an investment project, as it does not consider the entire cash inflows yielded by the project.

3. It fails to consider the pattern of cash inflows, i.e., magnitude and timing of cash inflows.

4. Administrative difficulties may be faced in determining the maximum acceptable payback period.

5. Accounting Rate of Return method:

The Accounting rate of return (ARR) method uses accounting information, as revealed by financial statements, to measure the profit abilities of the investment proposals. The accounting rate of return is found out by dividing the average income after taxes by the average investment.

ARR= Average income/Average Investment

Decision making criteria:

ARR greater than target ARR = Accept

ARR less than target ARR= Reject

Advantages:

1. It is very simple to understand and use.

2. It can be readily calculated using the accounting data.

3. It uses the entire stream of incomes in calculating the accounting rate.

Limitations:

1. It uses accounting, profits, not cash flows in appraising the projects.

2. It ignores the time value of money; profits occurring in different periods are valued equally.

3. It does not consider the lengths of projects lives.

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Mohiuddin

Dept. of Accounting & Information Systems

University of Barishal.