State your preferred combination and briefly discuss the pros and cons of the in

Question

State your preferred combination and briefly discuss the pros and cons of the individual methods involved.

Also, explain how the particular combination helps to alleviate the negative aspects of the individual pieces.

The four methods of evaluating potential capital budgeting decisions presented in this chapter each have their pro and cons. Most organizations use a combination of the different tools to make decisions. If you were making a capital budgeting determination.what combination would you use?

Explanation / Answer

A number of capital budgeting techniques are used in practice. They may be grouped in the following two categories: - I. Capital budgeting techniques under certainty; and II. Capital budgeting techniques under uncertainty

Capital budgeting techniques under certainty: Capital budgeting techniques (Investment appraisal criteria) under certainty can also be divided into following two groups: A) Non-Discounted Cash Flow Criteria; which can be further divided into - (1) Pay Back Period (PBP) (2) Accounting Rate Of Return (ARR); and B) Discounted Cash Flow Criteria; which can be further divided into (1) Net Present Value (NPV) (2) Internal Rate of Return (IRR) (3) Profitability Index (PI)

Non discounted Methods -

1) Payback - It is the number of years required to recover the original cash outlay invested in a project. The PBP can be used as a decision criterion to select investment proposal. If the PBP is less than the maximum acceptable payback period, accept the project. If the PBP is greater than the maximum acceptable payback period, reject the project.

Pros -

1. It is simple both in concept and application and easy to calculate.

2. It is a cost effective method which does not require much of the time of finance executives as well as the use of computers.

3. It is a method for dealing with risk. It favours projects which generates substantial cash inflows in earlier years and discriminates against projects which brings substantial inflows in later years . Thus PBP method is useful in weeding out risky projects.

4. This is a method of liquidity. It emphasizes selecting a project with the early recovery of the investment.

Cons -

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

2. It ignores cash flows beyond PBP. This leads to reject projects that generate substantial inflows in later years.

3. It is a measure of projects capital recovery, not profitability so this can not be used as the only method of accepting or rejecting a project. The organization need to use some other method also which takes into account profitability of the project.

4. It gives equal weightage to the projects if their PBP is same but their pattern is different.

5. There is no logical base to decide standard PBP of the organization it is generally a subjective decision. 6. It is not consistent with the objective of shareholders’ wealth maximization. The PBP of the projects will not affect the market price of equity shares.

2) Accounting Rate of Return - The ARR is the ratio of the average after tax profit divided by the average investment. The ARR can be used as a decision criterion to select investment proposal. If the ARR is higher than the minimum rate established by the management, accept the project. If the ARR is less than the minimum rate established by the management, reject the project.

Pros:

1. It is simple to calculate.

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

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

Cons:

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

2. It does not take into consideration time value of money so benefits in the earlier years or later years cannot be valued at par.

3. This method does not take into consideration any benefits which can accrue to the firm from the sale or abandonment of equipment which is replaced by a new investment. ARR does not make any adjustment in this regard to determine the level of average investments.

4. Though it takes into account all years income but it is averaging out the profit.

5. The firm compares any project’s ARR with the one which is arbitrarily decided by management generally based on the firm’s current return on assets. Due to this yardstick sometimes super normal growth firm’s reject profitable projects if it’s ARR is less than the firm’s current earnings.

Discounted cash flow Methods - These are also known as modern or time adjusted techniques because all these techniques take into consideration time value of money.

1) Net Present Value (NPV):

The NPV is the difference between the present value of future cash inflows and the present value of the initial outlay, discounted at the firm’s cost of capital. The procedure for determining the present values consists of two stages. The first stage involves determination of an appropriate discount rate. With the discount rate so selected, the cash flow streams are converted into present values in the second stage.

The present value method can be used as an accept-reject criterion. The present value of the future cash streams or inflows would be compared with present value of outlays. The present value outlays are the same as the initial investment. If the NPV is greater than 0, accept the project. If the NPV is less than 0, reject the project. This method can be used to select between mutually exclusive projects also. Using NPV the project with the highest positive NPV would be ranked first and that project would be selected.

Pros:

1. It explicitly recognizes the time value of money.

2. It takes into account all the years cash flows arising out of the project over its useful life.

3. It is an absolute measure of profitability.

4. A changing discount rate can be built into NPV calculation. This feature becomes important as this rate normally changes because the longer the time span, the lower the value of money & higher the discount rate.

5. This is the only method which satisfies the value-additivity principle. It gives output in terms of absolute amount so the NPVs of the projects can be added which is not possible with other methods. For example, NPV (X+Y) = NPV (X) + NPV (Y). Thus, if we know the NPV of all project undertaken by the firm, it is possible to calculate the overall value of the firm

6. It is always consistent with the firm’s goal of shareholders wealth maximization

Cons:

1. This method requires estimation of cash flows which is very difficult due to uncertainties existing in business world due to so many uncontrollable environmental factors.

2. It requires the calculation of the required rate of return to discount the cash flows. The discount rate is the most important element used in the calculation of the present values because different discount rates will give different present values. The relative desirability of the proposal will change with a change in the discount rate

3. When projects under consideration are mutually exclusive, it may not give dependable results if the projects are having unequal lives, different cash flow pattern, different cash outlay etc. 4. It does not explicitly deal with uncertainty when valuing the project and the extent of management’s flexibility to respond to uncertainty over the life of the project.

4. It ignores the value of creating options. Sometimes an investment that appears uneconomical when viewed in isolation may, in fact, create options that enable the firm to undertake other investments in the future should market conditions turn favourable. By not accounting properly for the options that investments in emerging technology may yield, naive NPV analysis can lead firms to invest too little

2) Profitability Index (PI):

Profitability Index (PI) or Benefit-cost ratio (B/C) is similar to the NPV approach. PI approach measures the present value of returns per rupee invested. It is observed in shortcoming of NPV that, being an absolute measure, it is not a reliable method to evaluate projects requiring different initial investments. It is a relative measure and can be defined as the ratio which is obtained by dividing the present value of future cash inflows by the present value of cash outlays. Using the PI ratio, Accept the project when PI>1 Reject the project when PI<1 May or may not accept when PI=1, the firm is indifferent to the project.

Pros:

1. PI considers the time value of money as well as all the cash flows generated by the project.

2. At times it is a better evaluation technique than NPV in a situation of capital rationing especially. For instance, two projects may have the same NPV of Rs. 20,000 but project A requires an initial investment of Rs. 1, 00,000 whereas B requires only Rs. 50,000. The NPV method will give identical ranking to both projects, whereas PI will suggest project B should be preferred. Thus PI is better than NPV method as former evaluate the worth of projects in terms of their relative rather than absolute magnitude.

3. It is consistent with the shareholders’ wealth maximization.

Cons:

Though PI is a sound method of project appraisal and it is just a variation of the NPV, it has all those limitation of NPV method too. 1. When cash outflow occurs beyond the current period, the PI is unsuitable as a selection criterion.

2. It requires estimation of cash flows with accuracy which is very difficult under ever changing world.

3. It also requires correct estimation of cost of capital for getting correct result.

4. When the projects are mutually exclusive and it has different cash outlays, different cash flow pattern or unequal lives, it may not give unambiguous results.

3) Internal rate of return:

The internal rate of return (IRR) is the discount rate that equates the NPV of an investment opportunity with Rs.0 (because the present value of cash inflows equals the initial investment). It is the compound annual rate of return that the firm will earn if it invests in the project and receives the given cash inflows.

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

If the IRR is greater than the cost of capital, accept the project.

If the IRR is less than the cost of capital, reject the project.

Pros:

1. It considers the time value of money and it also takes into account the total cash flows generated by any project over the life of the project.

2. IRR is a very much acceptable capital budgeting method in real life as it measures profitability of the projects in percentage and can be easily compared with the opportunity cost of capital.

3. It is consistent with the overall objective of maximizing shareholders wealth.

Cons:

1. It requires lengthy and complicated calculations.

2. When projects under consideration are mutually exclusive, IRR may give conflicting results.

3. We may get multiple IRRs for the same project when there are nonconventional cash flows especially.

4. It does not satisfy the value additivity principle which is the unique virtue of NPV

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