In the previous article we learned about the importance of capital budgeting and its process. In this concluding part of the article we analyze the tools used for capital budgeting process which are as follows:
- Payback Period
The payback period is the number of years that is required to recover the original investment in a project. It is based on the cash flow.
For example: If you invest Rs. 10 crore in a project how long will it take to recover the full amount?
Formula: Payback Period = Cost of Project / Annual Cash Inflows
- Discounted payback period
The discounted payback period is the number of years it takes for the cumulative discounted cash flow from a project to equal the original investment. The discounted payback period partially addresses the weaknesses of the payback period. This takes into account the time value of money that is ignored by the payback period rule.
Though discounted payback period considers the time value and the risk it ignores the cash flow once the discounted payback period is reached. Thus, it has two consequences:
- It is not a good measure of profitability as it ignores the cash flow after the discounted payback period.
- The negative cash flow projects are never considered in the discounted payback period.
- Accounting Rate of Return
It is the rate of return that one can expect based on the investment made. It is calculated by dividing the average profit by the initial investment. It helps the owners to compare the profit that can potentially be generated.
Accounting rate of return does not consider the cash flow and the time value of money.
- Profitability index
It is the present value of project’s future cash flows which is divided by the initial investment made by the organization.
PI = 1 + NPV/initial investment
If the NPV is positive then PQ will be greater than 1.0, conversely if the PI is negative then the NPV will less than 1.
Net present value v/s Internal return rate
NPV and IRR are the most conventional tools that are used to select any project. In an independent project, NPV and the IRR do not make any difference but when the projects are mutually exclusive this is when the problem arises.
A project with a positive NPV and higher IRR is normally preferred. But what if in the case of two mutually exclusive projects, project A has a higher NPV while project B has a lower NPV compared to A and higher IRR compared to A.
Which project will you select? Will you select the project with the higher NPV or the project with the higher IRR?
Each of the rules have their pros and cons. NPV defines or selects a project based on the financial impact on the company, which makes allocation of capital easier. However, it assumes a discount rate and that this discount rate would be stable.
The capital would be reinvested at this discount rate, which in the real world is quite difficult due to fluctuating interest rates.
While IRR gives an appropriate discount rate based on the inflow and the outflow of project, it does not take into account the financial impact on the firm.
So what do we select?
The NPV method, because this method is the direct measure of the expected changes in the firm value from undertaking a capital project. In theory, a positive NPV project should cause a proportionate increase in a company’s stock price.
For any queries or doubts just leave a comment below!
