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Discuss capital budgeting techniques including: the Payback Rule, IRR, NPV, and the Profitability Index. Be sure to discuss the advantages and disadvantages of each one. 

Capital budgeting is the process of decision making on capital project i.e., projects which entail large amount of irreversible investments. Therefore, it is one of most important responsibility of a financial manager, and also lays the foundation for the future success of the firm. The techniques used for capital budgeting are as follows:

Payback Period: It is period (or number of years) by which undiscounted net cash flows from the project equate the original/initial cost of investment/project. In other words, payback period is determined from the cumulative net cash flows.

Decision criterion: Accept the project, if the payback period is within the prescribed range. (Shorter the payback period, better the project)

Advantage:

  • Measure of liquidity/Focus on liquidity availability.
  • Simple to compute.

Disadvantage:

  • It does not take into account time value of money.
  • It also doesn't consider the cash flows beyond the payback period.

Note: In place of Payback period, Discounted payback-period may be used that factor in the time value of money and compares the discounted cumulative cash flows with the initial cost of project to arrive at the payback period.

Internal Rate of Return (IRR): It is the discount rate that equates the present value of expected incremental after-tax cash flows to the present value of initial cost of the project / investment. In other word, it is the discount rate which makes the net present value (NPV) of a project to 'zero'. IRR is calculated by trial & error method.

Decision criterion: Accept the project, if IRR > required rate of return.

Advantage:

  • It takes into account time value of money.
  • It considers all cash flows of project life and shows the return on each dollar invested.

Disadvantage:

  • There may be no IRR or multiple IRR (in case of unconventional cash flows) in a project.

Net Present Value (NPV): It can be defined as the sum of present values of all expected incremental after-tax cash flows. The discount rate used here is the cost of capital to the entity or specifically to the project.

Decision criterion: Accept the project, if project NPV is positive.

Advantage:

  • It takes into account time value of money.
  • It considers all cash flows of whole project life and gives the real addition to the wealth of shareholders of the entity.

Disadvantage:

  • It does not give any consideration to the size of project.

Profitability Index (PI): Profitability index can be defined as 'sum of present values of expected cash flows to the initial cost or outlay of the project'. Mathematically, PI can be written as, 'PV of cash flows / Initial outlays' or '1 + NPV/Initial outlay'.

Decision criterion: Accept the project, if PI > 1.

Advantage:

  • It takes into account time value of money.
  • It considers all cash flows of the project.

Disadvantage:

It is not suitable for firms, which have liquidity constraints i.e., require payback of outlay at earliest.

2. Give an example of each capital budgeting technique above using your own numbers including cash flows, interest rate, and duration of the hypothetical project analyzed. Be creative with it. You can insert your numbers in the word document. 

Answer:

Google Inc. is considering installing equipment at its newly opened office in China. The equipment will require initial outlay of $50000. The equipment will have economic life of 5 years, and would have salvage value of $5000 at end of life. This equipment will help in reducing the costs of $22000 per annum, but will increase other operating expenses to the tune of $5000 per annum. The applicable tax rate is 30%. The required rate of return for this project is 10%.

Answer:

Computation of Cash flows:

Amount in $

 

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Reduction in cost

 

22000.0

22000.0

22000.0

22000.0

22000.0

Incremental operating cost

 

(5000.0)

(5000.0)

(5000.0)

(5000.0)

(5000.0)

Depreciation {(50000-5000)/5}

 

(9000.0)

(9000.0)

(9000.0)

(9000.0)

(9000.0)

Profit before tax

 

8000.0

8000.0

8000.0

8000.0

8000.0

Taxation @30%

 

2400.0

2400.0

2400.0

2400.0

2400.0

Profit after tax

 

5600.0

5600.0

5600.0

5600.0

5600.0

Add: Depreciation (non cash)

 

9000.0

9000.0

9000.0

9000.0

9000.0

Operating Cash flow

 

14600.0

14600.0

14600.0

14600.0

14600.0

 

 

 

 

 

 

 

Initial Outflows

(50000.0)

 

 

 

 

 

Terminating inflows

 

 

 

 

 

5000.0

 

 

 

 

 

 

 

Net Cash Flows

(50000.0)

14600.0

14600.0

14600.0

14600.0

19600.0

 

A. Payback period:

Initial outlay = 50000

Cumulative Cash flows till end of three years = 14600 + 14600 +14600= 43800

Remaining flows required = 50000-43800 = 6200

Therefore payback period = 3 years + 6200/14600 = 3.42 years

B. Internal Rate of Return: Computation of IRR by trial & error method, with objective to find out discounting rate which makes the Present Value of initial outlays = sum of present value of after tax incremental cash flows.

Amount in $

 

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Initial cost

(50000.0)

         

Incremental after-tax cash flows

 

14600.0

14600.0

14600.0

14600.0

19600.0

 

1.00

1.16

1.35

1.57

1.82

2.11

Discounting factor @16.15%

1.00

0.86

0.74

0.64

0.55

0.47

PV

(50000.0)

12569.7

10821.7

9316.8

8021.2

9270.7

NPV

0.0

         

Hence, IRR of the project is 16.15%. Given that the required rate of return for the company is 10%, the project should be accepted.

C. NPV: Computation of net present value using required rate of return at 10%:

Amount in $

 

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Net Cash Flows

(50000.0)

14600.0

14600.0

14600.0

14600.0

19600.0

 

 

 

 

 

 

 

Discounting factors @10%

1.00

0.91

0.83

0.75

0.68

0.62

Present value

(50000.0)

13272.7

12066.1

10969.2

9972.0

12170.1

NPV @10%

8450.1

 

 

 

 

 

 

The NPV of the projects is positive $8450.1. The company should accept this project as it will add $8450.1 dollars to the wealth of its shareholders.

D.    Profitability Index (PI):

Profitability Index = Sum of PV of all incremental Cash flows / sum of PV of Initial outlay

                              = (13272.7 + 12066.1 + 10969.2 + 9972.0 + 12170.1) / 50000

                              = 1.17

The PI of the project is >1, hence should be accepted by the company.

3. Explain which capital budgeting technique is superior to the rest and why.

Answer:

All four tools have their pros and cons. The payback period focuses on liquidity, while it does not consider time value of money and even ignores all cash flows after the payback period. The Profitability Index is nothing but transformed format of NPV; but it fails to provide magnitude of impact of project on the wealth of shareholder. The IRR provide good sense about the return on each dollar of investment. However, there may be multiple IRR (in case of unconventional cash flows) or no IRR for a given project. The NPV method considers the timing and size of cash flows from the project. It takes into account all cash flows during the life project. Finally, NPV provide the real amount of increase in wealth of shareholder, due to the project under consideration. Therefore, NPV method/technique is superior to the rest of three techniques.

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