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Chapter - 5 Capital Budgeting

5.1 Introduction

An efficient allocation of capital is the most important finance function in the modern times. It involves decision to commit the firm’s funds to the long-term assets. Such decisions are of considerable important to the firm since they tend to determine its value by influencing its growth, profitability and risk.

The first and perhaps the most important decision that any firm has to make is to define the business or businesses that is wants to be in. This decision has a significant bearing on how capital is allocated in the firm. Once the managers of a firm choose the business or businesses they want to be in, they have to develop a plan to invest in building, machineries, equipment, research and development, godowns, showrooms, distribution network, information infrastructure, brands, and other long-lived assets. This is the capital budgeting process. The unit of analysis in capital budgeting is an investment project. Considerable managerial time, attention, and energy is developed to identify, evaluate, and implement investment projects. When you look at an investment project from the financial point of view, you should focus in the magnitude, timing, and riskness of cash flows associated with it. In addition, consider the options embedded in the investment project.

5.2 Meaning

Capital budgeting decisions pertain to fixed/long-term assets which by definition refer to assets which are in operation, and yield a return, over a period of time, usually, exceeding one year. They, therefore, involve a current outlay or series of outlays of cash resources in return for an anticipated flow of future benefits. In other words, the system of capital budgeting is employed to evaluate expenditure decisions which involve current outlays but are likely to produce benefits over a period of time longer than one year. These benefits may be either in the form of increased revenues of reduced costs. Capital expenditure management, therefore, includes addition, disposition, modification and replacement of fixed assets. From the preceding discussion may be deduced the following basic features of capital budgeting: (1) potentially large anticipated benefits; (2) a relatively high degree of risk; and (3) a relatively long time period between the initial outlay and the anticipated returns. The term capital budgeting is used interchangeably with capital expenditure decision, capital expenditure management, long-term investment decision, management of fixed assets and so on.

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5.3 Importance

Capital budgeting decisions are of paramount importance in financial decision making. In the first place, such decisions affect the profitability of a firm. They also have a bearing on the competitive position of the enterprise mainly because of the fact that they relate to fixed assets. They enable the firm to generate finished goods that can ultimately be sold for profit. The current assets are not generally earning assets. Rather, they provide a buffer that allows the firms make sales and extend credit. True, current assets are important to operations, but without fixed assets to generate finished products that can be converted into current assets, the firm would not be able to operate. Further, they are “strategic” investment decisions as against “tactical”-which involve a relatively small amount of funds. Therefore, such capital investment decisions may result in a major departure form what the company has been doing in the past. Acceptance of a strategic investment will involve a significant change in the company’s expected profits and in the risks to which these profits will be subject. These changes are likely to lead stockholders and creditors to revise their evaluation of the company. Thus, the capital budgeting decisions determine the future destiny of the company. An opportune investment decision can yield spectacular returns. On the other hand, an ill- advised and incorrect decisions can endanger very survival even of the large firms. A few wrong decisions and the firm may be forced into bankruptcy.

Secondly, a capital expenditure decisions has its effects over a long time span and inevitably affects the company’s future cost structure. To illustrate, if a particular plant has been purchased by a company to start a new product, the company commits itself to a sizable amount of fixed costs, in terms of labor, supervisors’ salary, insurance, net of building, and so on. If the investment turns out to be unsuccessful in future or yields less profit than anticipated, the firm will have to bear the burden of fixed costs unless it writes off the investment completely. In short, future costs, break-even points, sales and profits will be determined by the selection of assets.

Thirdly, capital investment decisions, once made, are not easily reversible without much financial loss to the firm because there may be no market for second-hand plant and equipment and their conversion to other uses may not be financially viable.

Finally, capital investment involves costs and the majority of the firms have scarce capital resources. This underlines the need for thoughtful, wise and correct investment decisions, as an incorrect decision would not only result in losses but also prevent the firm from earning profits from other investment which could not be undertaken for want of funds.

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5.4 Difficulties

Capital expenditure decisions are of considerable significances as the future success and growth of the firm depends heavily on them. But, they are beset with a number of difficulties.

First, the benefits from investments are received from some future period. The future is uncertain. Therefore, an element is involved. For instance, a decision to acquire an asset that is going to last for 15 years requires 15-years forecasts. A failure to forecast correctly will lead to serious errors which can be corrected only at a considerable expanse. Future revenue involves estimating the size of the market for a product and the expected share of the firm in that. These estimates depends on a variety of factors, including price, advertising and promotion, and sales effort and so on. Adding to the uncertainties are the possibilities of shifts in consumer preference, the actions of competitions, technological developments and changes in the economic or political environment.

Second, costs incurred and benefits received from the capital budgeting decisions occur in different time periods. They are not logically comparable because of the time value of money.

Thirdly, it is not often possible to calculate in strict quantitative terms all the benefits or the costs relating to a particular investment decisions.

5.5 Rationale

The rationale underlying the capital budgeting decision is efficiency. Thus, a firm must replace worm and obsolete plants and machinery, acquire fixed assets for current and new products and make strategic investment decisions. This will enable the firm to achieve its objective of maximizing profits either by way of increased revenues or cost reductions. The quality of these decisions is improved by capital budgeting. Capital budgeting decision can be of tow types: (1) those which expand revenues, and (2) those which reduce costs.

Investment decisions affecting revenues:

Such investment decisions are expected to bring in additional revenues, thereby raising the size of the firm’s total revenue. They can be the result of either expansion of present operations or the development of new product lines. Both types of investment decisions involve acquisition of new fixed assets and are income-expansionary in nature in the case of manufacturing firms.

Investment decisions reducing costs:

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Such decisions, by reducing costs, add to the total earnings of the firm. A classic example of such investment decisions are the replacement proposals when an asset wears out or becomes outdated. The firm must decide whether to continue with the existing assts or replace them. The firm evaluates the benefits from the new machine in terms of lower operating cost and the outlay that would be needed to replace the machine. An expenditure on a new machine may be quite justifiable in the total cost savings that result.

A fundamental difference between the above two categories of investment decisions lies in the fact that cost-reduction investment decisions are subject to less uncertainty in comparison to the revenue-affecting investment decisions. This is so because the firm has a better “feel” for potential cost savings as it can examine past production and cost data. However, it is difficult to precisely estimate the revenues and costs resulting from product line, particularly when the firm knows relatively little about the same.

Nature of investment decisions

The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. A capital budgeting decision may be defined as the firm’s decision to invest its current funds most efficiently in the long-term assets in anticipation of an expected flow of benefits over a series of years. The long-term assets are those which affect the firm’s operations beyond the one-year period. The firm’s investment decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. A sale of a division or business (divestment) is also analyzed as an investment decision. Activities such as change in the methods of sales distribution, or undertaking an advertisement campaign or a research and development programme have long-term implications for the firm’s expenditure and benefits, and therefore, they may also be evaluate as investment decision. It is important to note that investment in the long-term assets invariably require funds to be tied up in the current assets such as inventories and receivables. As such, investment in fixed and current assets is one single activity.

The following are the feature of investment decisions:

• The exchange of current funds for future benefits. • The funds are invested in long-term assets. • The future benefits will occur to the firm over a series of year.

It is significant to emphasize that expenditure and benefits of an investment should be measure in cash. In the investment analysis, it is cash flow which is important, not accounting profit. It may also be pointed out that investment decisions affect the firm’s value. The firm’s value will increase if investments are profitable and add to the shareholders’ wealth. Thus, investments should be evaluated on the basis of a

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criterion which is compatible with the objective of the shareholders’ wealth maximization. An investment will add to the shareholders’ wealth if it yields benefits in excess of the minimum benefits as per the opportunity cost of capital.

5.6 Important of Capital Budgeting

A number of factors combine to make capital budgeting perhaps the most important function financial managers and their staffs must perform.

� First, since the results of capital budgeting decision continue for many years, the firm loses some of its flexibility.

� Second, assets expansion is based on expected future sales, a decision to buy an assets that is expected to least 10 years require a 10-years sales forecast.

� Finally, a firm’s capital budgeting decisions define its strategic direction, because moves into new product, service, or markets must be preceded by capital expenditures.

An erroneous forecast of asserts requirements can have serious consequences. If the firm invests too much, it will incur unnecessarily high depreciation and other expanses. On the other hand, if it does not invest enough, two problems may arise.

1. First, its equipment and computer software may not be sufficiently modern to enable it to produce competitively.

2. Second, if it has inadequate capacity, it may lose market share to rival firms, and regaining lost customers requires heavy selling expanses, price reductions, or product improvement, all of which are costly.

Timing is also important – capital assets must be available when they are needed.

Effective capital budgeting can improve both the timing and the quality of assets acquisitions. If a firm forecasts its needs for capital assets in advances, it can purchase and install the assets before they are needed. Unfortunately, many firms do not order capital goods until existing assets are approaching full-capacity usages. If sales increase because of an increase in general market demand, all firms in the industry will tend to order capital goods at about the same time. This results in backlogs, long waiting times for machinery, a deterioration in the quality of the capital equipment, and an increase in costs. The firm that foresees its needs and purchases capital assets during slack period can avoid these problems. Note, though, that if s firm forecasts an increase in demand and then expands to meet the anticipated demand, but sales do not increase, it will be saddled with excess capacity and high costs, which can lead to losses or even bankruptcy. Thus, an accurate sales forecast is critical.

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Capital budgeting typically involves substantial expenditure, and before a firm can spend a large amount of money, it must have funds lined up – large amounts of money are not available automatically. Therefore, a firm contemplating a major capital expenditure program should plan its financing far enough in advance to be sure funds are available.

In this chapter, we assume that the investment project’s opportunity cost of capital is known. We also assume that the expenditures and investment are known with certainty.

Investment decisions require special attention because of the following reasons:

• They influence the firm’s growth in the long run • They affect the risk of the firm • They involve commitment of large amount of funds • They are irreversible, or reversible at substantial loss • They are among the most difficulties decision to make

Growth: - The effects of investment decisions extend into the future and have to be endured for a longer period than the consequences of the current operating expenditure. A firm’s decision to invest in long-term assets has a decision influence on the rate and direction of its growth. A wrong decision can prove terrible for the continued survival of the firm; unwanted or unprofitable expansion of assets will result in heavy operating costs to the firm. On the other hand, inadequate investment in assets would make it difficult for the firm to compete successfully and maintain its market share.

Risk: - A long-term commitment of funds may also change the risk complexity of the firm. If the adoption of an investment increases average gain but causes frequent fluctuations in its earnings, the firm will become more risky. Thus, investment decisions shape the basic character of a firm.

Funding: - Investment decision generally involve large amount of funds which make it imperative for the firm to plan its investment programmes very carefully and make an advance arrangement for procuring finances internally or externally.

Irreversibility: - Most investment decisions are irreversible. It is difficult to find a market for such capital items once they have been acquired. The firms incur heavy losses if such assets are scrapped.

Complexity: - Investment decisions are among the firm’s most difficult decisions. They are an assessment of future events which are difficult to predict. It is really a complex problem to correctly estimate the future cash flow of an investment. The

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uncertainty in cash flow is caused by economic, political, social and technology forces.

5.7 Capital Budgeting

Investment decisions of any given business organizations are of two types:

1. Long term investment decisions – Where funds are invested for a long time period usually more than three years.

2. Short term investment decisions – where funds are invested for a invested for a short term period usually for a year or less.

Long term investment decisions are called capital budgeting decisions/ capital expenditure decisions. For example, launching a new product, Improvisation, Modernization, Expansion, Replacement of Fixed Assets, Research & Development, Purchasing, new fixed Assets, Acquisition, Takeover, Merger, Alliances etc.

C.B decisions are made when the firm is interested in acquisition, investment in long lived/fixed assets and for such purpose the firm has to make long range planning where realistic and flexible plans are made taking into accounts the financing, producing, marketing, research etc. components of the project.

The given investment proposals (Projects) are evaluated and selected by the firm on basis of their merit and finally implemented. On-line projects are continuously monitored, measured, and controlled. Thus feed back helps the firm to improve upon its investment and financing decisions.

Whenever a firm opts for investing in long term projects (F.A) it incurs a present cash outlay which is very high. It invests heavily in order to generate future cash inflow for a long time to cover its cost and add value to its investments, e,g. investment in new product/service generation, new advertising campaign, new distribution system, setting up a new plant, branch expansion, machine replacement etc.

These long-term investment or capital budgeting decisions give rise to fixed assets. Investment in F.A. includes both tangible assets like plants, machinery, etc. and intangible assets like patents, management contracts, goodwill.

5.8 CHARACTERISTICS OF CAPITAL BUDGETING DECISIONS

1. Long term consequences/results: The benefits/losses associations with such decisions arise in future due to high set up or initial cost and long gestation period involved. Due to high costs involved, in case of losses such firms face serious long term impacts which affect its profitability. Profitability will be reduced by all such costs and losses incurred.

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2. Initial investment in C.B decisions are large: The funds invested ate into projects whose nature is such that large investment are required like purchase of fixed assets, Branch expansion, replacements, Acquisition etc.

3. Usually C.B decisions are irreversible decisions: There are various reasons to support this view

• Resale value of any input/purchases done as a part of C.B decisions is very low.

• The initial costs involved in setting up costs cannot be recovered if the project generates losses. As large time periods are involved in setting up the project and finally implementing it, the value of money with time changes drastically. Future value of same money increases as time passes by and so expected returns are also high. In case of low profits/zero profits cost of projects increases manifold with time.

4. Capital investment of any form reveals its growth potential: The long term investments are made to generate future revenues/profits which add to the value of the firm. Thus investments grow with time if profitable investment plans are implemented.

“We know that growth of any company is measured by the expected return multiplied by the amount of funds invested by the firm i.e., rbg ×= ”

Where g is growth of the firm

b is the funds retained by the firm only for investment purpose

r is required/expected rate of return and kr > (cost of capital).

When b is high i.e. funds invested by the firm are large then g will also be large even if r remains constant. Hence once the company decides to go for profitable investment the company will grow. Provide that kr > (cost of capital).

As already discussed above we realize that all the departments of a given firm i.e production, marketing, purchase, personnel etc. are involved and affected by Capital Budgeting decisions of the firm as a whole. So all managers irrespective of their responsibly and expertise and task objectives should have adequate knowledge of firm’s C.B. decisions.

5.9 LIMITATIONS OF CAPITAL BUDGETING DECISIONS

1. Huge investment costs involved in capital budgeting decisions. Capital budgeting decisions involve large investments due to the nature of investment plans like purchasing of any fixed assets, launching a new product, product line, product improvisation, branch expansion etc.

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2. If funds availability is critical and uncertain then effectiveness of C.B. is hampered. We know that C.B. decisions require huge outlay hence funds are required in large amount. If these funds are not available freely and at low cost, then C.B. decisions lose their importance. The growth of the firm is delayed and slowed down.

3. Due to long term investment nature C.B. decisions are very rigid. They do not have the component of flexibility. Everything from zero to final results is decided beforehand, thus leaving no scope for contingencies.

4. Investment for a long time period is usually based on forecasting of opportunities, cost involved and future benefits arising. Inaccurate forecasting, may lead to unbalanced investment in F.A. All related decisions like financing decisions, timing of financing and implementation, benefits/loss arising etc. may all deviate from their actual figure and thus even a bad investment may be taken up as a good investment decisions and finally the firm would face a failure after putting in lots of efforts, time, and cost.

5. Long term serious implications of a wrong C.B decisions are very detrimental for any firm like its

• Liquidity • Profitability • Risk Structure • Competitive and technology edge • Manufacturing Capacity • Existing and potential customers etc.

Thus any firm can be badly affected by wrong and a non-profitability investment decision.

5.10 CAPITAL BUDGETING PROCESS

The C.B. process involves the following steps:

1. Tapping the environment to generate the investment proposals with firm’s strategic objective. Projects do not appear from air. One has to do hard thinking, screening, intense research and careful planning to fund one or two good investment opportunities for the firm.

2. Planning and preparations of capital budget. Capital budget is the investment proposal (s) the firm will adopt after careful evaluation and selection.

3. Estimation and calculation of future expected net cash flow (after various adjustments like depreciation and taxes) of different C.B. opportunities. Hence costs and benefits of each investment proposal are determined to ascertain the net cash generated from each proposal respectively.

4. Selecting the favorable (one or more projects depending on the fund availability with the firm) project proposal by using capital budgeting techniques.

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5. Implementation of project proposal. Continuous monitoring and control of the online-project, to measure its performance and check any deviations from the forecasted standards.

6. Post audit control. Auditing is determining whether all the economic transaction carried out by the firm are correct or not. Any deviations are noted and proper action is then taken. Auditing the project (s) helps to control and economize the investments.

Let us now discuss the capital budgeting process in detail.

TAPPING AND GENERATING INVESTMENT PROPOSAL (s):

The firm has to keep itself completely aware of the external environmental changes and the various investment opportunities in the surrounding scenario. Firm can also generate investment opportunities from various internal sources too.

Broadly, we can have following main types of investment opportunities.

• Launching a new product/service/product line. • Improvisation of existing product/services. • Branch/unit expansion. • Replacement (of plant/machinery etc.) decisions. • Research and development etc. All investment proposals have to be consistent with the overall strategic corporate goal.

Thus all those project, which do not comply the above requirement, are excluded at preliminary screening. These proposals are scrutinizing and analyzed at all corporate levels to filter out the nonviable ones. Out of all decisions, usually replacement decisions are easy and simple to make. Replacement decisions increase the production efficiency as old, absolute assets are done away with.

1. CAPITAL BUDGET: Capital budget is a list of all investment proposals to be undertaken for final evaluation by the firm. After the initial screening, the firm prepares the capital budget which include all the investment proposals which are compatible with the firm’s objective, feasible to implement, creates positive NPV (Net Present Value) for the firm. With each investment proposal a budget (investment plan) is planned and reviewed by the top management and the expertise in related field for final selection. Once the C.B. is ascertained for the firm, funds are arranged by the finance department, according to the budget outlay (already planned) and other forecasted costs.

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2. ESTIMATING AND EVALUATING CASH FLOWS Cash flow is a simple concept.

It is difference between the rupee received and the rupee paid.

However, estimation of future cash flow for a project is one of the most important and difficult steps in Capital Budgeting. If future cash flows are not determine and estimated correctly then the profitability of the project proposal (s) cannot be estimated correctly.

Now We Will Study How Cash Flows Are Determined For C.B. Investment Decisions:

The first and foremost point to understand is that Cash Flows are determined on an incremental basis. This means that only the difference between the cash flow of firm with or without the decision (investment proposal) is estimated and analyzed. Thus incremental cash flows are that CFs which affects directly the investment decisions thus ignoring those cash flows which remain fixed/constant.

For example, a firm thinks of purchasing a machine costing Rs.50, 000. If finds out that old machine is no longer in use by it can be sold for Rs. 12, 000.

So the total funds require for purchasing the machine is not Rs. 50, 000 but (50, 000 – 12, 000) = 38, 000 /-. Rs 38, 000 is the net incremental cash outflow and not Rs 50, 000/- as many of us would say taking into account the total investment in the new machinery. The value of the project will be determined by net cash inflow (cash inflow_ cash out flow) that will be generated if project is accepted.

For determining incremental CFs we consider the following points.

1. Sunk Cost : (Sunk costs are unrecoverable past expenditures) Sunk costs are not considered while determining the incremental cash flows. They are considered irrelevant, as they are unrecoverable past investment proposal. Hence sunk costs are not considered when calculating the cash flows.

2. Opportunities Cost: (The true cost of something is what you give up to get it. This includes not only the money spent in buying (or doing) the something, but also the economic benefits (UTILITY) that you did without because you bought (or did) that particular something and thus can no longer buy (or do) something else).

Opportunity costs are considered while determining the incremental cash flows. An opportunities costs is the associated with the next best alternative foregone to undertake present alternative e.g production plant uses a machinery which could otherwise be sold for 50, 000/-. The opportunity cost

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of machinery is the cash it would generate for the company if the project is not undertaken. Here firm gives up 50, 000/- for undertaking the project (by using that machinery).

3. Time Value of Money & Inflation : As C.B. investment decisions involve long period of time, hence any given business unit has to consider affects of time and inflation on its C.B. When we talk about future flows we take the actual figure without any adjustment. Suppose we receive Rs 100 after 2 years, a layman would say that the value of money earned after two years is Rs 100/-. Here the real future value of cash flow is not determined because one has not considered the effects of time & inflation rate of the country while determining the value of future earnings (cash inflow).

Real value of future cash flows (inflows & outflows) is determine by

• Time factor • Inflation rate of the country in which the firm operates.

Without inflation we simply discount (adjust) the future CFs by the time value of money.

4. Working Capital: Working capital is the investment in C.A. of a firm e.g. inventory, accounts receivable, cash etc. C.A. are financed by current liabilities e.g bills payable, bank borrowing etc. Any change in working capital of the due to with or without affect of the investment decision of the firm is included in the cash Flow estimates of the project proposal. e.g. change in inventory, change in receivable/payables.

5. Depreciation : Depreciation is a non-cash expanse but still is very important consideration while determining the incremental cash flow of the project proposal. It increase the tax incident on the net income of the firm i.e. cash outflow.

TOTAL INCOME – DEPRECIATION = NET INCOME

EBDIT – DEPRECIATION = EBIT

EBIT – TAX = PAT

(Depreciation provides a tax shield as tax is charged on net income at a fixed rate after deducting tax).

Tax shield provided by depreciation rate = Depreciation * Tax

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The greater is the depreciation charged, lesser is the tax paid as net income decreased/reduced by the amount of depreciation.

Thus, inspite of being a non-cash outflow, depreciation affects the firm’s cash flow by affecting the tax payments/cash outflows of the firm.

6. Capital Expenditure: The balance sheet of every business unit shows the capital expenditure i.e. the assets bought by the business. The profit and loss account takes into account only the non-capital expenditure hence it does not reveal the true income statement. We can say that income statement is overestimated by capital expenditure. Profits thus shown by the profit and loss account should be reduced by the capital expenditure. Profits thus shown by the P/L account should be reduced by the capital expenditure made by the business unit.

Equation For Incremental Cash Flow Can Be Determine As Shown Below

EBDIT – DEPRECIATION = EBIT

EBIT – INTEREST = EBT

EBT – TAX = PAT/EAT

PAT/EAT + DEPRECIATION – CAPEX = NET CASH FLOW

NET OPERATING PROFITS (N.O.P.) = OPERATING REVENUES – TAX LIABILITY

N.O.P. = EBIT – TAX

TAX = T (EBIT)

EBIT = SALES REVENUES – EXPANSES – DEPRECIATION

Hence N.O.P. = EBIT – EBIT (T)

N.O.P = EBIT (1-T)

Where EBIT = Earning Before Interest and Tax

T = Tax

For determining the NET CASH FLOW (N.C.F) we make the following adjustment for depreciation, working capital, capital expenditure.

N.C.F. = EBIT (1-T) + depreciation – net working capital – capexpt.

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For making adjustment for (a) time value, (b) inflation, we adjust the cash flows by discounting them with the respective opportunities cost & inflation rate as discussed before.

Incremental Cash Flow = Change in N.C.F (∆ N.C.F.)

∆ N.C.F. = ∆ EBIT (1-T) + ∆ DEPRECIATION - ∆ NET WORKING CAPITAL - ∆ CAPEXPT

Timing Of Incremental Cash Flow (ICF)

We calculate the I.C.F. of the investment proposal in three phases:

• Initial cash outflow/initial investment: we determine I.C.F. by adjusting installation costs, tax, sales proceeds from sale of old assets etc. from gross cash outflow.

• Interim incremental cash Flow: After the initial investment, subsequent cash flows arise which are benefits & costs generated by the project. These consist of periodic incremental after tax operating cash flows generated by the project over its life. e.g. incremental changes in operating revenues, incremental changes in taxes.

• Terminal year incremental cash flow: Terminal year is the final year existence of the project undertaken. It is also said to be last year of the useful of the F.A. e.g. salvage value of the disposal assets, tax savings due to asset disposal etc. Thus in the entire C.B. process, special emphasis is laid on real estimates of the cost saving/revenue incurred due to investment decisions.

3. SELECTING THE PROJECT PROPOSAL After determining the estimated costs and benefits of different investment proposal under consideration we pick out from amongst these investment proposals, the best project(s)/investment(s). For this we require technique known as C.B. techniques to evaluate and rank the given projects. The projects proposal(s) with the highest ranking is selected.

4. IMPLEMENTING AND MEASURE THE PERFORMANCE OF PROJECT(S)

After proper analysis of selected project a rough plan is made regarding its implementation and then after judging the capital efficiency, financing mix of the firm the project is implemented. As the project goes on-line it is extremely essential that its performance is measured continuously to check its feasibility and deviations (actual returns are compared with estimated returns) in time. We know that capital budgeting decisions are long term decisions hence the unproductive project if undertaken may yield increased losses over time. If any

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weakness/limitation is measured in time, proper action(s) can be taken to rectify the errors and put the project in the right directions or do away with the project(s). There are many financial indicators & ratio analysis methods by which the business organizations can easily perform the financial analysis and final selection of its project proposal(s).

5. POST AUDITS Auditing means that all economic transaction related to the project proposal are evaluated in terms of their correctness, financial viability, and feasibility of the whole project. Relative failures are judged and their causes estimated so that no failures may arise due to the same. The failure is estimated to their roots and all possible measures are worked upon to rectify the same for the present or for future reference.

5.11 Project classification

Project analysis entails time and effort. The costs incurred in this exercise must be justified by the benefits from it. Certain projects, given their complexity and magnitude, may warrant a details analysis while others may call for a relatively simple analysis. Hence firms normally classify projects into different categories. Each category is then analyzed somewhat differently.

While the system of classification may vary from one firm to another, the flowing categories are found is most classifications.

1. Mandatory Investment: These are expenditure required to complex with statutory requirements. Examples of such investments are pollution control, medical dispensary, fire fitting equipments, crèche in factory premises, and so on. These are often non-revenue producing investments. In analyzing such investment the focus is mainly on finding the most cost-effectively way of fulfilling a given statutory need.

2. Replacement Projects: Firms routinely invest in equipment meant to replace obsolete and inefficient equipments, even though they may be in a serviceable condition. The objective of such investments is to reduce costs (of labour, raw material, and power), increase yield, and improve quality. Replacement can be evaluated in a fairly straight forwards manner, though at times the analysis may be quite detailed.

3. Expansion Projects: These investments are meant to increase capacity and/or widen the distribution network. Such investment call for an explicit forecast of growth. Since this can be risky and complex, expansion project normally warrant more careful analysis than replacement projects. Decisions relating to such projects taken by the top management.

4. Diversifications Projects: These investments are aimed at producing new products or services or entering into entirely new geographical areas. Often diversification projects entail substantial risks, involve large outlays, and

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require considerable managerial effort and attention. Given their strategic importance, such projects call for a very through evaluation, both quantitative and qualitative. Further, they require a significant involvement of the board of directions.

5. Research and Development Projects: Traditionally, R & D absorbed a very small proportion of capital budget in most Indian companies. Things, however, are changing. Companies are now allocating more funds to R & D projects, more so in knowledge-intensive industries. R & D projects characteristic by numerous uncertainties and typically involve sequential decision making.

6. Miscellaneous Projects: This is a catch-all category that items like interior decoration, recreational facilities, executive aircrafts, landscaped gardens, and so on. There is no standard approach for evaluating these projects regarding them are based on personal preference of top management.

5.12 TECHNIQUES OF CAPITAL BUDGETING

A truck manufacturing is considering investment in a new plant; an airliner is planning to buy a fleet of jet aircrafts; a commercial bank is thinking of an ambitions computerization programme; a pharmaceutical firm is evaluating s major R & D programme. All these situations involve a capital expenditure decision. Essentially each of them represents a scheme for investing resources which can be analyzed and appraised reasonably independently. The basic characteristic of a capital expenditure (also referred to as capital investment or capital project or just project) is that it typically involve a current outlay (or current and future outlays) of funds in the expectations of a stream of benefits extending far into the future.

Capital expenditures represent the growing edge of a business. Capital expenditures have three distinct features:

i. They have long-term consequences; ii. They often involve substantial outlays;

iii. They may be difficult or expensive to reserve. Due to these characteristic, capital budgeting is perhaps the most important issue in corporate finance. How a firm finances its investment (the capital structure decision) and how it managers its short-term operations (the working capital decision) are definitely issues of concern but how it allocates its capital (the capital budgeting decision) really reflects its strategy and its business. That is why the process of capital budgeting is also referred to as strategic asset allocation.

Given the crucial significance of capital budgeting decisions, it is not surprising that firms spend considerable time in planning these decisions and involve top executives from production, engineering, marketing, and so on, in evaluating capital

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expenditure proposals – these decisions are too important to be left to financial manager alone.

Most firms have numerous investment opportunities before them. Some are valuable while others are not. The essence of financial management is to identify which are which.

The primary goal of this chapter is to introduce you to techniques of capital budgeting which are helpful in identifying valuable investment opportunities.

• Net Present Value (NPV). • Benefit Cost Ratio (BCR) • Internal Rate of Return (IRR) • Modified Internal Rate of Return (MIRR) • Payback Period • Accounting rate of Return (ARR) • Profitability Index (PI)

5.13 Investment Criteria

A wide range of criteria has been suggested to judge the worthwhileness of investment project. The important investment criteria, classified into two broad categories –

1. Discounting criteria

a) Net Present Value (NPV) b) Benefit Cost Ratio (BCR) c) Internal Rate of Return (IRR)

2. Non - Discounting criteria

a) Payback Period b) Accounting rate of Return (ARR)

1. Net Present Value (NPV) The net Present Value (NPV) of a project is the sum of the present values of all the cash flows – positive as well as negative – that are expected to occur over the life of the project. The general formula of NPV is:

NPV of project ( )∑=

−+

=n

tt

t InvestmentInitialr

C

1 1

Where Ct = Cash flow at the end of year t.

n = Life of the project

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r = Discount rate (The interest rate used in discounting future cash flows)

To illustrate the calculation of net present value, a project which has the following cash flow stream?

Year Cash Flow in Rs 0 1 2 3 4 5

(1,000,000) 200,000 200,000 300,000 300,000 350,000

The cost of capital, r, for the firm is 10 percent value of the proposal is:

( ) ( ) ( ) ( ) ( ) ( )273,5.

10.1

000,350

10.1

000,300

10.1

000,300

10.1

000,200

10.1

000,200

10.1

000,000,1543210

Rs

NPV

−=

+++++−=

The net present value represents the net benefits over and above the compensation for time and risk. Hence the decision rule association wit the net present value criterion is:

Accept the project if the net present value is positive and reject the project if the net present value is negative. (if the NPV is Zero, it is a matter of indifference).

What NPV tells

With a particular project, if Ct is a positive value, the project is in the status of cash inflow in the time of t. If Ct is a negative value, the project is in the status of cash outflow in the time of t. Appropriately risked projects with a positive NPV should be accepted. This does not necessarily mean that they should be undertaken since NPV at the cost of capital may not account for opportunity cost, i.e. comparison with other available investments. In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the higher NPV should be selected. The following sums up the NPV's various situations.

If... It means... Then...

NPV > 0

the investment would add value to the firm

the project should be accepted

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NPV < 0

the investment would subtract value from the firm

the project should be rejected

NPV = 0

the investment would neither gain nor lose value for the firm

the project could be accepted as shareholders obtain required rate of return

Properties of the NPV Rule

The NPV has certain properties that make it a very attractive decision criterion:

NPVs are Additive The net present value of a package of projects is simply the sum of the net present values of individual projects included in the package. This property has several implications:

• The value of a firm can be expected as the sum of the present value of projects in place as well as the net present value of prospective projects: Value of a firm = Σ Present value of Projects +Σ NPV of Expected future Projects

The firm term on the right hand side of this equation captures the value of assets in place and the second term the value of growth opportunities.

• When a firm terminates an existing project which has a negative NPV based on its expected future cash flows, the value of the firm increases by that amount. Likewise, when a firm undertakes a new project that has a negative NPV, the value of the firm decreases by that amount.

• When a firm divests itself of an existing project, the price at which the project is divested affects the value of the firm. If the price is greater/lesser than the present value of the anticipated cash of the project, the value of the firm will increase/decrease with the divestiture.

• When a firm takes a new project with a positive NPV, its effects on the value of the firm depends on whether its NPV is in line expectations. Hindustan Lever Limited, for example, is expected to take on high positive NPV projects and this expectation is reflected in its value. Even if the new projects taken on by Hindustan Lever Limited have positive NPV, the value of the firm may drop if the NPV is not in line with the high expectation of investors.

• When a firm makes an acquisition and pays a price in excess of the present value of the expected cash flows from the acquisition it is taking on a negative NPV project and hence will diminish the value of the firm.

NPV Calculation Permits Times Varying Discount Rates

So for we assume that the discount rate remains constant over time. This need not always be the case. The NPV can be calculated using time-varying discount rates. The general formula of NPV is as follows:

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( )∑=

−+

=n

tt

t

t InvestmentInitialr

CNPV

1 1

Where Ct = Cash flow at the end of year t

rt = discount rate for the year t

In even more general term, NPV is expected as follows:

( )

∑∏=

=

−+

=n

tt

jj

t InvestmentInitialr

CNPV

1

1

1

Where Ct = Cash flow at the end of year t

rj = one period discount rate

n = life of the project

The discount rate may change over time for the following reasons:

i. The level of interest rates may change over time – the term structure of interest rates light on expected rates in future.

ii. The risk characteristics of the projects may change over time, resulting in changes in the cost of capital.

iii. The financing mix of the project may vary over time, causing changes in the cost of capital.

The cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two).

To illustrate, assume that you are evaluating a 5-year project involving software development. You believe that the technological uncertainty associated with this industry leads to higher discount rates in future.

Year Investment Cash Flows in Rs

Discount rate (%)

0 1 2 3 4 5

(12000) 4,000 5,000 7,000 6,000 5,000

- 14 15 16 18 20

The present value of the cash flows can be calculated as follows:

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PV of C1 = 4,000/1.14 = 3509

PV of C2 = 5,000/ (1.14*1.15 = 3814

PV of C3 = 7,000/ (1.14*1.15*1.16) = 4603

PV of C4 = 6,000 / (1.14*1.15*1.16*1.18) = 3344

PV of C5 = 5,000 / (1.14*1.15*1.16*1.18*1.20) = 2322

NPV of project = 3509+3814+4603+3344+2322-12000 = Rs 5592

Limitations

Despite its advantage and a direct linkage to the objective of value maximization, the NPV rule has its opponents who points towards some limitations:

• The NPV is expressed in absolute terms rather than relative terms and hence does not factor in the scale of investment. Thus, project A may have an NPV of 5,000 while project B has an NPV of 2,500, but project A may require an investment of 50,000 whereas project B may require an investment of just 10,000. Advocates of NPV, however, argue that what matters is the surplus value, over and above the hurdle rate, irrespective of what the investment outlay is.

• The NPV rule does not consider the life of the project. Hence, when mutually exclusive project with different lives are being considered, the NPV rule is biased in favour of the longer term project.

Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find its net present value (NPV). This valuation requires estimating the size and timing of all of the incremental cash flows from the project. These future cash flows are then discounted to determine their present value. These present values are then summed, to get the NPV. The NPV decision rule is to accept all positive NPV projects in an unconstrained environment, or if projects are mutually exclusive, accept the one with the highest NPV.

The NPV is greatly affected by the discount rate, so selecting the proper rate - sometimes called the hurdle rate - is critical to making the right decision. The hurdle rate is the minimum acceptable return on an investment. It should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix. Managers may use models such as the CAPM or the APT to estimate a discount rate appropriate for each particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply

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a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole.

2. Benefit Cost Ratio (BCR) There are two ways of defining the relationship between benefits and cost:

a) Benefit-Cost Ratio (BCR) = I

PVB

b) Net Benefit – Cost Ratio (NBCR) = 1−=−BCR

I

IPVB

Where PVB = Present Value of Benefits

I = Initial Investment

To illustrate the calculation of these measures, let us consider a project which is being evaluated by a firm that has a cost of capital of 12 percent.

Initial Investment Rs 1, 00,000

Benefits Year 1 25,000

Year 2 40,000

Year 3 40.000

Year 4 50,000

The benefits cost ratio measures for this project reject are:

( ) ( ) ( ) ( )145.1

000,00,112.1

000,25

12.1

000,40

12.1

000,4012.1000,25

432

=+++

=BCR

NBCR = BCR – 1 = 0.145

The two benefits cost ratio measures, because the difference between them is simply unity, give the same signals. The following rules are associated with them.

When BCR Or NBCR Rule is >1 =1 <1

>0 =0 <0

Accept Indifferent Reject

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Evaluation

The proponents of benefits cost ratio argue that since criterion measures net present value per rupee of outlay, it can discriminate better between large and small investments and hence is preferable to the present value criteria.

How valid is this argument? Weingartenr, who examined this criteria theoretically, finds that:

i. Under unconstrained conditions, the benefits-cost ratio criteria will accept and reject the same projects as the net present value criteria

ii. When the capital budget is limited the same in the current period, the benefit-cost ratio criterion may rank projects correctly in the order of decreasingly efficiently use of capital. However, its use is not recommended because it provides no means for aggregating several smaller projects into a package that can be compared with a large project.

iii. When cash outflows occur beyond the current period, the benefits-cost ratio criterion is unsuitable as a selection criterion.

3. Internal Rate of Return (IRR) The internal rate of return (IRR) of a project is the discount rate which makes its NPV equal to zero. Put differently, it is discount rate which equates the present value of future cash flows with the initial investment. It is the value of r in the following equation:

Investment ( )∑

= +=

n

tt

t

r

C

1 1

Where Ct = cash Flow at the end of year t

r = Internal rate of return (IRR)

n = life of the project

In the NPV calculation we assume that the discount rate (cost of capital) is known and determine the NPV. In the IRR calculation, we set the NPV equal to zero and determine the discount rate that satisfies this condition.

To illustrate the calculation of IRR, consider the cash flows of a project being considered by Techtron Limited.

Year 0 1 2 3 4 Cash Flow (100,000) 30,000 30,000 40,000 45,000

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The IRR is the value of r which satisfies the following equation:

( ) ( ) ( ) ( )4321 1

000,45

1

000,40

1

000,30

1

000,30000,100

rrrr ++

++

++

+=

The calculation of r involves a process of trial and error. We try different values of r till we find that the right – hand side of the above equation is equal to 100,000. Let us, to begin with, try r = 15 percent. This makes the right - hand side equal to:

( ) ( ) ( ) ( ) 802,10015.1

000,45

15.1

000,40

15.1

000,30

15.1

000,304321 =+++

This value is slightly higher then our target value, 100,000. So we increase the value of r from 15 percent to 16 percent. (In general, a higher r lowers and a smaller r increases the right – hand side value). The right – hand side becomes:

( ) ( ) ( ) ( ) 641,9816.1

000,45

16.1

000,40

16.1

000,30

16.1

000,304321 =+++

Since this value is now less than 100,000, we conclude that the value of r lies between 15 percent and 16 percent. For most of the purpose this indication suffices.

1) Determine the net present value of the two closest rates of return. (NPV/15%) 802

(NPV/16%) (1,359)

2) Find the sum of the absolute values of the net present values obtained in step 1: 802+1,359 = 2,161

3) Calculate the ratio of the net present values of the smaller discount rate, identified in step 1, to the sum obtained is step 2:

802/2,161 = 0.37

4) Add the number obtained in step 3 to the smaller discount rate: 15+0.37 = 15.37%

The internal rate of return, calculated in this manner, is a very close approximation to the true rate of return.

The decision rule for IRR is as follows:

Accept: if the IRR is greater than the cost of capital

Reject: If the IRR is less than the cost of capital

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The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency.

The IRR method will result in the same decision as the NPV method for independent (non-mutually exclusive) projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR - which is often used - may select a project with a lower NPV.

In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists and is unique if one or more years of net investment (negative cash flow) are followed by years of net revenues. But if the signs of the cash flows change more than once, there may be several IRRs. The IRR equation generally cannot be solved analytically but only via iterations.

One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return is almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is often used.

Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV, although they should be used in concert. In a budget-constrained environment, efficiency measures should be used to maximize the overall NPV of the firm. Some managers find it intuitively more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV.

Accept/reject rule for IRR

IRR thus determine (calculated) for given investment project(s) is compared with the required rate of return (minimum rate accepted by the shareholders) also known as opportunity cost of capital of the firm i.e. ‘k’.

When IRR > k then one ACCEPTs the projects proposal.

IRR < k then one REJECTs the projects proposal.

IRR = k then one is INDIFFERENT to the projects proposal.

1. ADVANTAGES AND DISADVANTAGES OF IRR AND NPV

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A number of surveys have shown that, in practice, the IRR method is more popular than the NPV approach. The reason may be that the IRR is straightforward, but it uses cash flows and recognizes the time value of money, like the NPV. In other words, while the IRR method is easy and understandable, it does not have the drawbacks of the ARR and the payback period, both of which ignore the time value of money.

The main problem with the IRR method is that it often gives unrealistic rates of return. Suppose the cutoff rate is 11% and the IRR is calculated as 40%. Does this mean that the management should immediately accept the project because its IRR is 40%. The answer is no! An IRR of 40% assumes that a firm has the opportunity to reinvest future cash flows at 40%. If past experience and the economy indicate that 40% is an unrealistic rate for future reinvestments, an IRR of 40% is suspect. Simply speaking, an IRR of 40% is too good to be true! So unless the calculated IRR is a reasonable rate for reinvestment of future cash flows, it should not be used as a yardstick to accept or reject a project.

Another problem with the IRR method is that it may give different rates of return. Suppose there are two discount rates (two IRRs) that make the present value equal to the initial investment. In this case, which rate should be used for comparison with the cutoff rate? The purpose of this question is not to resolve the cases where there are different IRRs. The purpose is to let you know that the IRR method, despite its popularity in the business world, entails more problems than a practitioner may think.

2. WHY THE NPV AND IRR SOMETIMES SELECT DIFFERENT PROJECTS When comparing two projects, the use of the NPV and the IRR methods may give different results. A project selected according to the NPV may be rejected if the IRR method is used.

Suppose there are two alternative projects, X and Y. The initial investment in each project is $2,500. Project X will provide annual cash flows of $500 for the next 10 years. Project Y has annual cash flows of $100, $200, $300, $400, $500, $600, $700, $800, $900, and $1,000 in the same period. Using the trial and error method explained before, you find that the IRR of Project X is 17% and the IRR of Project Y is around 13%. If you use the IRR, Project X should be preferred because its IRR is 4% more than the IRR of Project Y. But what happens to your decision if the NPV method is used? The answer is that the decision will change depending on the discount rate you use. For instance, at a 5% discount rate, Project Y has a higher NPV than X does. But at a discount rate of 8%, Project X is preferred because of a higher NPV.

The purpose of this numerical example is to illustrate an important distinction: The use of the IRR always leads to the selection of the same project, whereas project selection using the NPV method depends on the discount rate chosen.

• PROJECT SIZE AND LIFE

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There are reasons why the NPV and the IRR are sometimes in conflict: the size and life of the project being studied are the most common ones. A 10-year project with an initial investment of $100,000 can hardly be compared with a small 3-year project costing $10,000. Actually, the large project could be thought of as ten small projects. So if you insist on using the IRR and the NPV methods to compare a big, long-term project with a small, short-term project, don’t be surprised if you get different selection results. (See the equivalent annual annuity discussed later for a good way to compare projects with unequal lives.)

• DIFFERENT CASH FLOWS Furthermore, even two projects of the same length may have different patterns of cash flow. The cash flow of one project may continuously increase over time, while the cash flows of the other project may increase, decrease, stop, or become negative. These two projects have completely different forms of cash flow, and if the discount rate is changed when using the NPV approach, the result will probably be different orders of ranking. For example, at 10% the NPV of Project A may be higher than that of Project B. As soon as you change the discount rate to 15%, Project B may be more attractive.

� WHEN ARE THE NPV AND IRR RELIABLE? Generally speaking, you can use and rely on both the NPV and the IRR if two conditions are met. First, if projects are compared using the NPV, a discount rate that fairly reflects the risk of each project should be chosen. There is no problem if two projects are discounted at two different rates because one project is riskier than the other. Remember that the result of the NPV is as reliable as the discount rate that is chosen. If the discount rate is unrealistic, the decision to accept or reject the project is baseless and unreliable. Second, if the IRR method is used, the project must not be accepted only because its IRR is very high. Management must ask whether such an impressive IRR is possible to maintain. In other words, management should look into past records, and existing and future business, to see whether an opportunity to reinvest cash flows at such a high IRR really exists. If the firm is convinced that such an IRR is realistic, the project is acceptable. Otherwise, the project must be reevaluated by the NPV method, using a more realistic discount rate.

YOU SHOULD REMEMBER

The internal rate of return (IRR) is a popular method in capital budgeting. The IRR is a discount rate that makes the present value of estimated cash flows equal to the initial investment. However, when using the IRR, you should make sure that the calculated IRR is not very different from a realistic reinvestment rate.

Net present value (NPV) Vs Internal rate of return (IRR)

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By now you may have noticed that the IRR rule is quite similar to the NPV rule. To see the link between them, let us plot the values of NPV for project the project of Techtron Limited for different discount rates. The NPV profile is shown in the following Fig where the NPV is plotted on the vertical or y – axis and the discount rate on the horizontal or x – axis. The NPV profile provides valuables insights:

• The IRR is the point at which the NPV profile crosses the x-Axis. • The slope of the NPV profile reflects how sensitive the project is to discount

rate changes.

Do the IRR and the NPV rules lead to identical decisions? Yes, provided two conditions are satisfies. First, the cash flows of the project must be conventional, implying that the first cash flow (initial investment) is negative and the subsequent cash flows are positive. Second, the project must be independent, meaning that the project can be accepted or rejected without reference to any other project.

Problems with IRR

There are problems in using IRR when the cash flows of the project are not conventional or when two or more projects are being compared to determine which one is the best. In the first case it is difficult to define ‘what is IRR’ and in the second case IRR can be misleading. Further IRR cannot distinguish between

NPV Profile NPV

Discount Rate 0 15

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lending and borrowing. Finally, IRR is difficult to apply when short – term interest rates differ from long – term interest rates.

1. Non – conventional Cash Flows 2. Mutually Exclusive Projects 3. Lending Vs Borrowing 4. Differences Between Short – term and Long –term

Interest Rates

1. Non – conventional Cash Flows consider a project which has the following cash flow stream associated with it:

Project C0 C1 C2 M (160,000) 1,000,000 (1,000,000)

The IRR equation for this cash flow stream is:

( ) ( ) 01

000,000,1

1

000,000,1000,160 2 =

+−

++−

rr

There are two roots of this equation, viz. 1.25 and 5.00. The IRRs corresponding these roots are 25 percent and 400 percent respectively. If we shown in the NPV profile the NPV is zero at two discount rates, viz. 25 per cent and 400 percent. Which of these is the correct IRR? We can’t say. There is no unambiguously correct answer. This is the problem in multiple rates of return and in such cases the IRR rules breaks down.

As if this were not enough, there can also be cases in which no IRR exists. For example, project P has a positive NPV for all discount rates and hence no IRR

Project C0 C1 C2 P 15,000 (45,000) 37,500

IRR percent – None and NPV at 15% is 4225 and 30% is 10562

Several modification of the IRR rule have been suggested for such cases. These modifications are neither adequate nor necessary, for the simple solution lies in using the NPV rule.

2. Mutually Exclusive Projects Often firms have to choose from two or more mutually exclusive projects. In such cases IRR can be misleading.

Consider projects P and Q

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Cash Flow IRR NPV

Project C0 C1 r =12% P

Q

(10,000)

(50,000)

20,000

75,000

100%

50%

7,857

16,964

Both the projects are good, but Q, with its higher NPV, contributes more to the value of the firm. Yet from an IRR point of view P looks better than Q. Hence the IRR rule seems unsuitable for ranking projects of different scale.

The IRR rule, of course, can be salvaged in such cases by considering the IRR on the incremental cash flow. Here is how we do it. Looking at P, the project which requires the smaller outlay, we find that it is highly attractive because its IRR is 100%, far above the cost of capital which is 12 percent. Now we ask: What is the rate of return on the incremental cash flow if we switch from P (the low-outlay project) to Q (the high-outlay project)? The incremental cash flow associated with such a switch is:

000,55000,4010 CC

− The IRR of this stream is 37.5 percent, much above the cost of

capital. Hence it is desirable to switch from P to Q.

Thus, unless you look at the incremental cash flow, IRR is not a reliable rule for ranking projects of different scale.

IRR is also unreliable for ranking project which have different patterns of cash flow over time. Consider two projects, X and Y, being evaluated by a firm that has a cost of capital of 10 percent.

Project C0 C1 C2 C3 C4 IRR NPV at 10% X

Y

(110,000)

(110,000)

31,000

71,000

40,000

40,000

50,000

40,000

70,000

20,000

22%

25%

36,613

31,314

Both the projects look good but X, with its higher NPV, contributes more to the value of the firm. Yet from an IRR point of view Y looks more attractive. Hence the IRR rule can be misleading when a choice has to be made between mutually exclusive projects which have different patterns of cash flow over time.

Of course, in the case too the IRR rule can be salvaged by considering the IRR on the incremental cash flow.

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As the previous example suggest, when mutually exclusive projects are evaluated it is much simpler to use the NPV rule rather than the IRR rule with such involved additional computations.

3. Lending Vs Borrowing The IRR rule cannot distinguish between lending and borrowing and hence a high IRR need not necessarily be a desirable thing.

To illustrate this point, let us consider two projects A and B

Project C0 C1 IRR NPV at 10% A

B

(4000)

4000

6000

(7,000)

50%

75%

145

(236)

The IRR for project A is 50 percent, whereas the IRR for project B is 75 %. Does this mean that B is more attractive than A? Certainly not. A is very attractive project, whereas B is a highly undesirable project. Why? A involves investing 4000 at a rate of return of 50 percent, whereas B involves borrowing 4000 at a rate of return of 75 percent. Yet if we go by the IRR figures, B appears more attractive than A.

4 Difference between Short – term and Long – term Rates Recall our general formula for calculating NPV:

( )∑=

−+

=n

tt

t

t InvestmentInitialr

CNPV

1 1

Thus, the cash flow for year 1, C1, is discounted at the opportunity cost of capital for year1, r1; the cash flow for year 2, C2, is discounted at the opportunity cost of capital for year 2, r2 ; so on and so forth.

The IRR rule says that a projected should be accepted if its IRR is greater than the opportunity cost of capital. But what should we do when there are several opportunity costs? Should we compare IRR with r1 or r2 or r3… or rn ? We have to, in effect, compute a complex weighted average of various rates to get a number comparable to IRR. Given the difficulty in doing so, it makes sense to ignore IRR, when short – term interest rates differ from long – term interest rates, and simply calculate NPV.

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Redeeming Qualities

Despite its deficiencies, IRR is immensely popular in practice, even more than NPV. It perhaps fills a need that NPV does not. Managers as well as financial analysts are wanted to think in terms of rates of return than absolute rupee values. Although IRR can be misleading the result can be readily interpreted by all parties.

Further, in certain situations, the IRR offers a practical advantage over NPV. You can’t estimate the NPV unless you know the discount rate, but you can still calculate the IRR. Suppose you don’t know the discount rate but you find that the projects because it is unlikely that the discount rate would be that high. The pros and cons of IRR are summarized below.

Pros Cons Closely related to NPV May lead to multiple rates of return Easy to understand and interpret May result into incorrect decisions in

comparing mutually exclusive projects

4. Modified Internal Rates of Return (MIRR)

The most significant problem with the IRR calculation is that the formula assumes that you are reinvesting the annual cash flow at the same rate as calculated by the IRR. As a result, when you have a property that generates significant cash flow, the calculated IRR will overstate the likely financial return of the property. The MIRR allows you to enter a different rate that is applied to the property's annual cash flow. This rate used is generally a bank or savings rate. Using the MIRR will more closely mimic reality as you rarely are able to reinvest the cash flow at the same rate of return as determined by the IRR formula.

The finance rate is the annual interest rate that you would pay to cover any negative cash flows incurred during the life of the investment.

The reinvestment rate is the interest rate that you would earn on cash that the investment generates during its life.

While the internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR, the modified IRR assumes that all cash flows are reinvested at the firm's cost of capital. Therefore, MIRR more accurately reflects the profitability of a project.

For example, say a two-year project with an initial outlay of $195 and a cost of capital of 12%, will return $110 in the first year and $121 in the second year. To find the IRR of the project so that the net present value (NPV) = 0:

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NPV = 0 = -195 + 110/(1+ IRR) + 121/(1 + IRR)NPV = 0 when IRR = 11.87% Solving for NPV using MIRR, we will replace the IRR with our MIRR = cost of capital of 12% :

NPV = -195 + 110/(1+ .12) + 121/(1 + .12)NPV = -0.32 when MIRR = 12% Thus, using the IRR could result in a positive NPV (good project), but it could turn out to be a bad project (NPV is negative) if the MIRR were used. As a result, using MIRR versus IRR better reflects the value of a project.

Modified Internal Rate of Return (MIRR) is a financial measure used to determine the attractiveness of an investment. It is generally used as part of a capital budgeting process to rank various alternative choices. As the name implies, MIRR is a modification of the financial measure Internal Rate of Return (IRR).

There are a few misconceptions about the IRR calculation. The major one is that IRR automatically assumes that all cash outflows from an investment are reinvested at the IRR rate. IRR is the "internal rate of return" with "internal" meaning each dollar in an investment. It makes no assumptions about what an investor does with money coming out of an investment. Whether the investor gives it away or puts it in a coffee can, the IRR stays the same.

It does however have a few drawbacks. First, IRR is not made to calculate negative cash flows after the initial investment. If an investment has an outflow of $1,000 in year three and an IRR of 30%, the $1,000 is discounted at 30% per year back to a present value. You would have to put this PV amount in an investment earning 30% per year for the IRR to reflect the true yield. Also, IRR ignores the reinvestment potential of positive cash flows. Since most capital investments will have intermediate positive cash flows, the firm will need to reinvest these cash flows, and the firm's cost of capital is a reasonable proxy for the return to be expected. Investments with large or early positive cash flows will tend to look far better with IRR than with MIRR for this reason.

To illustrate: a firm has investment options with returns that are generally moderate. An unusually attractive investment opportunity comes up with much higher return. The cash spun off from this latter investment will probably be reinvested at the moderate rate of return rather than in another unusually high-return investment. In this case, IRR will overstate the value of the investment, while MIRR will not.

The modified internal rate of return assumes all positive cash flows are re-invested (usually at the WACC) to the terminal year of the project. All negative cash flows are discounted and included in the initial investment outlay.

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Despite NPV’s conceptual superiority, managers seem to prefer IRR over NPV because IRR is intuitively more appealing as it is a percentage measure. Is there a percentage measure that overcomes the shortcoming of the regular IRR? Yes, there is one and it is called the modified IRR or MIRR.

The procedure for calculating MIRR is as follows:

1. Calculate the present value of the costs (PVC) associated with the project, using cost of capital (r) as the discount rate:

( )∑= +

=n

tt

t

r

outflowCashPVC

0 1

2. Calculate the terminal value (TV) of the cash inflows expected from the projects:

( )∑=

−+=n

t

tnt rlowCashTV

0

1inf

3. Obtain MIRR by solving the following equation:

( )nMIRR

TVPVC

+=

1

To illustrate the calculation of MIRR let us consider an example. Pentagon Limited is evaluation a project that has following cash flow stream associated with it:

Year 0 1 2 3 4 5 6 Cash Flow (Rs in Million) -120 -80 20 60 80 100 120

The cost of capital for Pentagon is 15 percent. The present value of costs is:

120+80/1.15 = 189.6

The terminal value of cash inflow is

( ) ( ) ( ) ( )46712011576.10526.9198.34

12015.110015.18015.16015.120 234

=++++=++++

The MIRR is obtained as follows:

( )162.0

1

4676.189 6

=+

=

MIRR

MIRR

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Evaluation

MIRR is superior to the regular IRR in two ways.

1. First, MIRR assumes that project cash flows are reinvested at the cost of capital whereas the regular IRR assumes that project cash flows are reinvested at the project’s own IRR. Since reinvestment at coast of capital (or some other explicit rate) is more realistic than reinvestment at IRR, MIRR reflects batter the true profitability of a project.

2. Second, the problem of multiple rates does not exit with MIRR.

Thus, MIRR is a distinct improvement over the regular IRR. Is it as good as NPV in choosing between mutually exclusive projects? Without getting, into technicalities, let us note the following:

• If the mutually exclusive projects are of the same size, NPV and MIRR lead to the same decision irrespective of variations in life.

• If the mutually exclusive projects differ in size there is a possibility of conflicts.

What is the verdict? MIRR is better than the regular IRR in measuring true rate of return. However, for choosing among mutually exclusive projects of different size, NPV is a better alternative in measuring the contribution of each project to the values of the firm.

5. Payback Period

The payback period is the length of time required to recover the initial cash outlay on the project. For example, if a project involves a cash outlay of Rs 600,000 and generates cash inflows of Rs 100,000, Rs 150,000 and Rs 200,000, in the first, second, third, and fourth year, respectively, its payback period is 4 years because the sum of cash inflows during 4 years is equal to the initial outlay. When the annual cash inflow is a constant sum, the payback period is simply the initial outlay divided by annual cash inflow. For example, a project which has an initial cash outlay of Rs 1,000,000 and a constant annual cash inflow of Rs 300,000 has a payback period of Rs 1,000,000/300,000 = 3.333 years.

According to the payback criterion, the shorter the payback period, the more desirable the project. Firms using this criterion generally specify the maximum acceptable payback period. If this is n years, projects with a payback period of n years or less are deemed worth while and projects with a payback period exceeding n years are considered unworthy.

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Evaluation

A widely used investment criterion, the payback period seems to offer the following advantage:

1. It is simple, both in concept and application. It does not use involved concepts and tedious calculation and has few hidden assumptions.

2. It is rough and ready method for dealing with risk. It favours projects which generate substantial cash inflows in earlier years and discriminates against projects which bring substantial cash inflows in later years but not in earlier years. Now, if risk tends to increase with futurity – in general, this may be true – the payback criterion may be helpful in weeding out risky projects.

3. since it emphasizes earlier cash inflows, it may be a sensible criterion when the firm is pressed with problems of liquidity.

Limitations

The limitations of the payback criterion, however, are very serious:

1. It failed to consider the time value of money. Cash inflows, in the payback calculation, are simply added without suitable discounting. This violates the most basic principle of financial analysis which stipulates that cash flows occurring at different points of time can be added or subtracted only after compounding/discounting.

2. It ignores cash flows beyond the payback period. This leads to discriminations against project which generates substantial cash inflows in later years. To illustrates, consider the cash flows of two projects, A and B:

Years Cash Flow of A Cash Flow of B 0

1

2

3

4

5

6

Rs (100,000)

50,000

30,000

20,000

10,000

10,000

-

Rs (100,000)

20,000

20,000

20,000

40,000

50,000

60,000

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The payback criterion prefers A, which has a payback period of 3 years in comparison to B which has a payback period of 4 years, even though B has very substantial cash inflows in years 5 and 6.

3. It is a measure of the project’s capital recovery not profitability.

4. Though it measures a project’s liquidity, it does not indicates the liquidity positions of the firm as a whole, which is more important.

Payback period in business and economics refers to the period of time required for the return on an investment to "repay" the sum of the original investment. For example, a $1000 investment which returned $500 per year would have a two year payback period. It is intuitively the measure that describes how long something takes to "pay for itself"; shorter payback periods are obviously preferable to longer payback periods (all else being equal). Payback period is widely used due to its ease of use despite recognized limitations, described below.

The expression is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be described of having a payback period of a certain number of years or operating hours (assuming certain costs); here, the return to the investment consists of reduced operating costs. Although primarily a financial term, the concept of a payback period is occasionally extended to other uses, such as energy payback period (the period of time over which the energy savings of a project equal the amount of energy expended since project inception); these other terms may not be standardized or widely used.

Payback period as a tool of analysis is often used because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavour. When used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to compare an investment with "doing nothing", payback period has no explicit criteria for decision-making (except, perhaps, that the payback period should be less than infinity).

The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not properly account for the time value of money, inflation, risk, financing or other important considerations. Alternative measures of "return" preferred by economists are internal rate of return and net present value. An implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment.

The length of time required to recover the cost of an investment.

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The Payback Period is defined as the length of time required to recover an initial investment through cash flows generated by the investment. The Payback Period lets you see the level of profitability of an investment in relation to time. The shorter the time period the better the investment opportunity:

Calculated as:

( )InflowsCashAnnual

InvestmentorojectofCostPeriodBackPay

Pr=

All other things being equal, the better investment is the one with the shorter payback period.

For example, if a project cost $100,000 and was expected to return $20,000 annually, the payback period would be $100,000 / $20,000, or five years.

There are two main problems with the payback period method:

1) It ignores any benefits that occur after the payback period and, therefore, does not measure profitability.

2) It ignores the time value of money.

Because of these reasons, other methods of capital budgeting like net present value, internal rate of return or discounted cash flow are generally preferred.

Payback period = Expected number of years required to recover a project’s cost.

Expected Net Cash Flow

Year Project L Project S

0

1

2

3

($100)

10

60

80

($100)

(90)

(30)

50

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PaybackL = 2 + $30/$80 years

= 2.4 years. PaybackS = 1.6 years.

Weaknesses of Payback:

1. Ignores the time value of money. This weakness is eliminated with the discounted payback method.

6. Discounted payback period

A major shortcoming of the conventional playback period is that it does not take into account the time value of money. To overcome this limitation, the discounted payback period has been suggested. In this modified method, cash flows are first converted to their present values (by applying suitable discounting factors) and then added to ascertain the period of time required to recover the initial outlay on the project. In the following example, the calculation of discounted payback period is explained. Looking at the last column in this exhibit, we find that the discounted payback period is between 3 and 4.

Year Cash Flow Discounting Factor @ 10%

Present value Cumulative net cash flow after discounting

0

1

2

3

4

5

6

7

-10,000

3,000

3,000

4,000

4,000

5,000

2,000

3,000

1.000

0.909

0.826

0.751

0.683

0.621

0.565

0.513

-10,000

2,727

2,478

3,004

2,732

3,105

1,130

1,539

-10,000

-7,273

-4,795

-1,791

941

---

---

---

Reasons for Popularity of Payback Period

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Despite its serious shortcomings the payback period is widely used in appraising investment. Why? It appeals that the payback measure serves as a proxy for certain types of information which are useful in investment decision-making.

1. The Payback period may be regarded roughly as the reciprocal for the internal rate of return when the annual cash inflow is constant and the life of the project fairly long.

2. The payback period conveys information about the rate at which the uncertainty associated with a project is resolved. The shorter the payback period, the faster the uncertainty associated with the project is resolved. The longer the payback period, the slower the uncertainty associated with the project is resolved. Decision – making, it may be noted, prefer an early resolution of uncertainty. Why? An early resolution of uncertainty enables a decision – maker to take prompt corrective action, adjust his consumption patters, and modify/change other investment decisions.

7. Return on Investment (ROI)

In finance, rate of return (ROR) or return on investment (ROI), or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or net income/loss. The money invested may be referred to as the asset, capital, principal, or the cost basis of the investment.

ROI is also known as rate of profit, rate of return or return. Return can also refer to the monetary amount of gain or loss. ROI is the return on a past or current investment, or the estimated return on a future investment. ROI is usually given as a percent rather than decimal value.

ROI does not indicate how long an investment is held. However, ROI is most often stated as an annual or annualized rate of return, and it is most often stated for a calendar or fiscal year. In this article, “ROI” indicates an annual or yearly rate of return, unless otherwise noted.

ROI is used to compare returns on investments where the money gained or lost -- or the money invested – are not easily compared using monetary values. For instance, a $1,000 investment that earns $50 in interest obviously generates more cash than a $100 investment that earns $20 in interest, but the $100 investment earns a higher return on investment.

• $50/$1,000 = 5% ROI • $20/$100 = 20% ROI

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Since rates of return are percentages, negative rates cannot be averaged with positive rates for purposes of calculating monetary returns. However, it is common practice in finance to estimate monetary returns by averaging periodic rates of return; these estimations are most useful when the averaged periodic returns are all positive, all negative, or have low variances.

A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.

Return on investment is a very popular metric because of its versatility and simplicity. That is, if an investment does not have have a positive ROI, or if there are other opportunities with a higher ROI, then the investment should be not be undertaken.

Keep in mind that the calculation for return on investment can be modified to suit the situation -it all depends on what you include as returns and costs. The term in the broadest sense just attempts to measure the profitability of an investment and, as such, there is no one "right" calculation. For example, a marketer may compare two different products by dividing the revenue that each product has generated by its respective expenses. A financial analyst, however, may compare the same two products using an entirely different ROI calculation, perhaps by dividing the net income of an investment by the total value of all resources that have been employed to make and sell the product.

This flexibility has a downside, as ROI calculations can be easily manipulated to suit the user's purposes, and the result can be expressed in many different ways. When using this metric, make sure you understand what inputs are being used.

8. Accounting rate of return (ARR)

ARR provides a quick estimate of a project's worth over its useful life. ARR is derived by finding profits before taxes and interest.

ARR is an accounting method used for purposes of comparison. The major drawbacks of ARR are that it uses profit rather than cash flows, and it does not account for the time value of money.

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ARR provides a quick estimate of a project's worth over its useful life. ARR is derived by finding profits before taxes and interest.

A fairly simple way of gauging your return on an investment in a major project or purchase is the accounting rate of return (ARR). The formula is:

Accounting Rate of Return =

Annual Cash Inflows - Depreciation

Initial Investment

For purposes of this formula, depreciation is calculated very simply, using the straight-line method:

Depreciation =

Cost - Salvage Value

Useful Life

As an example of how ARR works, let's say you're looking at equipment costing $7,500 that is expected to return roughly $2,000 per year for five years. After five years you'll sell the equipment for $500. The depreciation would be ($7,500 - $500) ÷ 5, or $1,400.

ARR =

$2,000 - $1,400

$7,500

= 8%

The accounting rate of return, also called the average rate of return, is defined as

InvestmenttheofValueBook

TaxAfterofitPr

The numerator of this ratio may be measured as the average annual Post-tax profit over the life of the investment and the denominator as the average book value of fixed assets committed to the project. To illustrate the calculation consider a project:

151

Year Book Value of fixed investment

Profit After Tax

1

2

3

4

5

90,000

80,000

70,000

60,000

50,000

Rs 20,000

22,000

24,000

26,000

28,000

The accounting rate of return is:

( )( ) %34

000,50000,60000,70000,80000,9051

000,28000,26000,24000,22000,2051 =++++++++

Obviously, the higher the accounting rate, of return, the better the project. In general, projects which have an accounting rate of return equal to or greater than a pre – specified cut – off rate of return – which is usually between 15 between 30 between percent - are accepted; other are rejected.

Evolution

Traditionally a popular investment appraisal criterion, the accounting rate of return has the following virtues:

1. It is simple to calculate.

2. It is based on accounting information which is readily available and familiar to businessman.

3. It considers benefits over the entire life of the project.

Its shortcoming, however, seems to be considerable:

1. It is based upon accounting profit, not cash flow.

2. It does not take into account the time value of money. To illustrate this point, consider two investment proposals A and B, each requiring an outlay of Rs 100,000. Both the proposal have an expected life of 4 years after which their salvage value would be nil.

Year

Book Value

Depreciation

PAT Cash Flow

Book Value

Depreciatio

PAT Cash Flow

152

n 0

1

2

3

4

100,000

75,000

50,000

25,00

0

0

25,000

25,000

25,000

25,000

0

40,000

30,000

20,000

10,000

(100,000)

65,000

55,000

45,000

35,000

100,000

75,000

50,000

25,000

0

0

25,000

25,000

25,000

25,000

0

10,000

20,000

30,000

40,000

(100,000)

35,000

45,000

55,000

65,000

Both the proposal, with an accounting rate of return equal to 40 percent, look alike from the accounting rate of return point of view, through project A, because it provides benefits earlier, is much more desirable. While the payback period criterion gives no weightage.

3. The accounting rate of return measure is internally inconsistent. While the numerator of this measure represents profit belonging to equity and preference stockholders, its denominator represents fixed investment which is rarely, if ever, equal to the contribution of equity and preference stockholders.

Using ARR can give you a quick estimate of the project's net profits, and can provide a basis for comparing several different projects. Under this method of analysis, returns for the project's entire useful life are considered (unlike the payback period method, which considers only the period it takes to recoup the original investment). However, the ARR method uses income data rather than cash flow and it completely ignores the time value of money. To get around this problem, you should also consider the net present value of the project, as well as its internal rate of return.

Accept/Reject rule for ARR:

The firm fixes target or a standard ARR or it considers it’s cost of capital k.

This is then compared with the given project(s)’s ARR.

If project’s (ARR) > Target ARR or cost of capital ‘k’ then the project is accepted.

If project’s (ARR) < Target ARR or cost of capital ‘k’ then the project is rejected.

If project’s (ARR) = Target ARR or cost of capital ‘k’ then one is indifferent to the project. Acceptance or rejections will make no difference to the value of the firm.

When ‘n’ numbers of projects are to be ranked then projects with greatest/ highest value of ARR is accepted. In brief, we can state that greater is the ARR of any projects,

153

greater is the profitability of that project and it is ranked higher than the projects with lower ARR i.e. such projects are selected for the long-term investment by the firm.

9. Profitability Index (P.I)

The profitability index measures the present value of returns per rupee invested.

An index that attempts to identify the relationship between the costs and benefits of a proposed project through the use of a ratio calculated as:

A ratio of 1.0 is logically the lowest acceptable measure on the index. Any value lower than 1.0 would indicate that the project's PV is less than the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed project.

An index used to evaluate proposals for which net present values have been determined. The profitability index is determined by dividing the present value of each proposal by its initial investment. An index value greater than 1.0 is acceptable and the higher the number, the more financially attractive the proposal.

Profitability index identifies the relationship of investment to payoff of a proposed project. The ratio is calculated as follows:

(PV of future cash flows) / (PV Initial investment) = Profitability Index

Profitability Index is also known as Profit Investment Ratio, abbreviated to P.I. and Value Investment Ratio (V.I.R.). Profitability index is a good tool for ranking projects because it allows you to clearly identify the amount of value created per unit of investment, thus if you are capital constrained you wish to invest in those projects which create value most efficiently first.

NB Statements below this paragraphy assume the cash flow calculated DOESN'T include the investment made in the project. Where investment costs are included in the computed cash flow a PV>0 simply indicates the project creates more value than the cost of capital which is determined by the Weighted Average Cost of Capital (WACC).

A ratio of one is logically the lowest acceptable measure on the index. Any value lower than one would indicate that the project's PV is less than the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed project.

Rules for selection or rejection of a project:

154

If PI > 1 then accept the project if PI < 1 then reject the project

For Example

Given:

Investment = 40,000 life of the Machine = 5 Years

CFAT Year CFAT

1 18000 2 12000 3 10000 4 9000 5 6000

Calculate NPV @10% and PI

Year CFAT PV@10% PV 1 18000 0.909 16362 2 12000 0.827 9924 3 10000 0.752 7520 4 9000 0.683 6147 5 6000 0.621 3726 Total present value 43679 (-) Investment 40000 NPV 3679 PI = 43679 / 40000 = 1.091 = >1 = so accept the project

Acceptance or rejection of the projects makes no difference to the overall value of the firm.

PI implies that a project’s PV is greater than its initial cash outflows. NPV and PI give the same result regarding any number of projects proposals but having same initial investment.

When initial investments of the two or more projects are different then NPV and PI give contradictory ranking. In such a case one must always prefer NPV methods as it gives true profitability or earning potential of the proposal by measuring the value added to Shareholder’s/Firm’s investment.

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5.14 Economic Value Added (EVA)

It is popular measure currently being used by several firms to determine whether and existing/proposed investment positively contributes to the owners’/shareholders’ wealth. The EVA is equal to after – tax operating profits of a firm less the cost of funds used to finance investment. A positive EVA would increase owners’ value/wealth. Therefore, only investment with positive EVA would be desirable from the view points of maximizing shareholders’ wealth. To illustrate, assuming an after-tax profit of Rs 40 crore and associated costs of financing the investments of Rs 38 crore, the EVA = Rs 2 crore. With a positive EVA, the investment would add value and increase the wealth of the owners and should be accepted. The computations of the after-tax operating profits attributable to the investment and consideration as well as the cost of funds used to finance it would, however, involved numerous accounting and financial issues.

Economic Value Added (EVA) is an estimate of true economic profit after making corrective adjustments to GAAP accounting, including deducting the opportunity cost of equity capital. EVA can be measured as Net Operating Profit After Taxes (or NOPAT) less the cost of capital, equity as well as debt. The concept of Economic Profit is closely linked to EVA. However, Economic Profit is not adjusted.

Economic Value Added is the financial performance measure that comes closer than any other to capturing the true economic profit of an enterprise. EVA also is the performance measure most directly linked to the creation of shareholder wealth over time. Stern Stewart & Co. guides client companies through the implementation of a complete EVA-based financial management and incentive compensation system that gives managers superior information - and superior motivation - to make decisions that will create the greatest shareholder wealth in any publicly owned or private enterprise.

Put most simply, EVA is net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise. As such, EVA is an estimate of true "economic" profit, or the amount by which earnings exceed or fall short of the required minimum rate of return that shareholders and lenders could get by investing in other securities of comparable risk.

A measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis). (Also referred to as "economic profit".)

The formula for calculating EVA is as follows:

= Net Operating Profit After Taxes (NOPAT) - (Capital * Cost of Capital)

In the field of corporate finance, economic value added is a way to determine the value created, above the required return, for the shareholders of a company.

156

The basic formula is:

where

, called the return on capital employed (ROCE)

is the firm's return on capital, NOPAT is the Net Operating Profit After Tax, c is the Weighted Average Cost of Capital (WACC) and K is capital employed.

Shareholders of the company will receive a positive value added when the return from the capital employed in the business operations is greater than the cost of that capital; see Working capital management. Any value obtained by employees of the company or by product users is not included in the calculations.

Calculation

EVA is essentially the surplus left after making an appropriate charge for the capital employed in the business. It may be calculated in any of the following, apparently different but essentially equivalent, ways:

( )

( )

*EVA=NOPAT-c

*

1 *

e

CAPITAL

EVA CAPITAL r c

EVA PAT INT t c CAPITAL

EVA PAT PAT k EQUITY

×= −

⎡ ⎤= + − −⎣ ⎦

= = −

Where

EVA = Economic Value Added

c*= cost of capital

CAPITAL = Economic book value of the capital employed in the firm

r = Return on capital = NOPAT/CAPITAL

PAT = Profit After Tax

INT = Interest Expanse of the Firm

t = Marginal Tax rate of the firm

ke = Cost of Equality

157

EQUITY = Equity employed in the firm

To illustrate the calculation of EVA using the above formulae let us look at the balance sheet and profit and loss account of Melvin Corporation given in the following table.

Balance Sheet and Profit and Loss Account of Melvin Corporation

Balance Sheet as on 31-03-2002 Profit and Loss account for the year Ending on 31-03-2002

Liabilities Equity 100 Dept 100 ----- 200 Assets Fixed Assets 140 Net Current Assets 60 ----- 200

Net sales 300 Cost of Goods Sold 258 PBIT 42 Interest 12 PBT 30 Tax 9 PAT 21

Melvin’s cost of equity is 18 per cent. The interest rate on its debt is 12 percent which, given a marginal tax rate of 30 percent, translate to a post – tax cost of debt 8.4 percent. Since Melvin employs debt and equity in equal proportions, its weighted average cost of capital is:

0.5(18.0)+0.5(8.4) = 13.2 percent

Melvin’s NOPAT is: PBIT (1-Tax rate) = 42(1-0.3) = 29.4 million. Given a CAPITAL of Rs 200 million, Melvin’s return on capital works out to 29.4/200 = 0.147 or 14.7 percent.

Based on the information, Melvin’s EVA may be computed in four different, yet equivalent, ways:

( )( )

( )( )

( )

*EVA=NOPAT-c

29.4 0.132 200 3

*

200 0.147 0.132 3

1 *

21 12 0.7 0.132 200 3

21 0.18 100 3e

CAPITAL

Rs million

EVA CAPITAL r c

Rs million

EVA PAT INT t c CAPITAL

Rs million

EVA PAT PAT k EQUITY

Rs million

×= − × =

= −

= − =

⎡ ⎤= + − −⎣ ⎦

⎡ ⎤= + − × =⎣ ⎦

= = −= − × =

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The three components of EVA

As we have seen, EVA is a function of net operating profit after tax (NOPAT), cost of capital (c*), and capital employed in the business (CAPITAL), these are defined below.

1. Net Operating Profit After Tax (NOPAT) is defined as:

(Profit before interest and Tax (PBIT) – (1-Tax Rate)

This definition is based on two principles:

i. Separate the investment and financing side of a firm. This implies that financing charges (like interest and dividend) are not considered when we look at profits (or cash flows) on the investment side. Financing charges will be reflected in the cost of capital figure used for discounting the profits (or cash flows) on the investment side. ii. Do all analysis in post tax terms.

2. Cost of Capital Provides of capital (Shareholders and lenders) want to be suitably compensated for investing capital in the firm. The cost of capital reflects what they expect. The cost of capital should have the following features:

• It represents weighted average of the costs of all sources of capital • It is calculated in post tax terms • It reflects the risks borne by various provides of capital

The formula employed for estimating the cost of capital is:

c* = (Cost of Equity) (Proportion of Equity in the capital employed) + (Coat of Preference) (proposition of preference in the capital employed) + (pre-tax cost of Debt) (1- Tax rate) (proportion of debt in the capital employed)

3. Capital Employed To obtain the capital employed in the business we have to make adjustments to the “accounting” balance sheet to drive the “economic book value” balance sheet. These adjustments are meant to reflect the economic value of assets in place rather then the accounting values or determine by inherently conservative historical cost based generally accepted accounting principles.

The merits of EVA are:

1. Its relative simplicity and

2. Its strong link with wealth maximization of the owners.

It prima facie exhibits a strong link to share prices that is positive EVA is associated with increasing price of shares and vice versa. However, EVA is, in effect, a repackaged and well marketed application of the NPV techniques of investment

159

decisions. But EVA is certainly a useful for operationalising the owners’ value maximization goal, particularly with respect to the investment decisions.