CAPITAL BUDGETING TECHNIQUE

Firms use the relevant cash flows to make decisions about proposed CAPEX. These decision can be expressed in the form of project acceptance or rejection or of project rankings. A number of techniques are used in such decision making; some are more sophisticated than others. We are going to discuss briefly about these techniques.
When firms have developed relevant cash flows,  they analyze them to assess whether a project is acceptable or to rank projects. A number or technique are available for performing such analyses. But the preferred approaches integrate time value procedures, risk and return considerations, and valuation concepts to select capital expenditure that are consistent  with the firm’s goal of maximizing owners’ wealth.

Here we begin with three most popular capital budgeting techniques: Pay back period, NPV (Net Present Value) and IRR (Internal Rate or Return)

1.  Payback Period

Payback periods are commonly used to evaluate proposed investments. The payback period is the amount of time required for the firm to recover its initital investment in a project, as calculated from cash inflows. In case of an annuity, the payback period can be found by dividing the initial investment by the annual cash flow. For mixed stream of cash inflows, the yearly cash inflows must be accumulated until the initial investment is recovered. Although popular, the payback period is generally viewed as an unsophisticated capital budgeting technique, because it does not explicitly consider the TVM (time value of money).

The Decision Criteria

When the payback period is used to make accept-reject decisions, the decision criteria are as follows:

·         If the payback period is less than the maximum acceptable payback period, accept the project.

·         If the payback period is greater than the maximum acceptable payback period, reject the project.

The length of the maximum acceptable payback period is determined by MGT (management). The value is set of subjectively on the basis of a number of factors, including the type of project (expansion, replacement, renewal), the perceived risk of the project and the perceived relationship between the payback period and the share value. It is simply a value that MGT feels, on average, will result in value creating investment decision.

            Weakness of Payback Period technique

1^St weakness is it failure to take fully into account the Time Value Factor.

2^nd Weakness is its failure to recognize cash flow that occur after the payback period.
3^rd one is its subjectivity in determination of numbers. As it is not based on discounting cash flow to determine whether they add to firm’s value. Instead, it just the maximum acceptable period of time over which MGT decides that project’s cash flow must break even.

2.  Net Present Value (NPV) 

NPV is considered as sophisticated capital budgeting technique because it gives explicit consideration to the TVM. This technique in one way or another discount the firm’s cash flows at a specified rate. This rate often called as the discount rate, required return, cost of capital or opportunity cost, is the minimum return or rate that must be achieved on a project to leave the firm’s market value unchanged.

The NPV is calculated by subtracting a project’s initial investment (CF₀) from the PV (present Value) of its cash inflow (CF_t) discount at a rate equal to the firm’s cost of Capita (K_e).
NPV= PV of cash inflow- PV of cash outflow.

When NPV is used, both inflows and outflows are measured in terms of Present Exchange. The PV of project would be founded by subtracting the PV of outflow from PV of inflow.

The Decision Criteria

When NPV is used to make accept-reject decisions, the decision criteria are as follows:

·         If the NPV is greater than Rs. 0, accept the project.

·         If the NPV is less than the Rs0, reject the project.

If the NPV is greater than Rs. 0, the firm will earn a return greater than its cost of capitsl. Such action should enhance the Market value of the firm and therefore the wealth of its owners.

3.  Internal Rate Of Return (IRR)

The IRR is probably the most widely used sophisticated capital budgeting technique. However, it is considerably more difficult than NPV to calculate by hand. The IRR is the discount rate that equates the NPV Of an investment opportunity with Rs. 0 because the PV Of cash inflows equals the initial investment. It is the compound annual rate of return that the firm will earn if it invests in the project and receives the given cash inflows.
Mathematically, the IRR is the value of k that causes NPV to equal Rs.0.
  

The Decision Criteria

When IRR is used to make accept-reject decisions, the decision criteria are as follows:

·                     If the IRR is greater than the K_e, accept the project.

·                     If the IRR is less then the K_e, reject the project.

The criteria guarantee that the firm earns at least its required rate of return. Such an outcome should enhance the market value of the firm and therefore the wealth of its owners.
 

This is the basics of the CAPTIAL BUDGETING TECHNIQUE.   Please continue visiting the blog to know dive deeper into the technique.