Question

To support growth strategies and combat competition with rivals, businesses seek external capital to further develop products and services in hopes to create new sales opportunities. Since capital investment often involves a huge money investment, longer time engagement and risks of uncertainties, any decision shall not be taken lightly and shall be carefully evaluated before putting money to start a long-term project. The goal is to ultimately make the right accept/reject decision. Respond to the following in a minimum of 175 words:

Briefly describe (not define) the six models of a capital budgeting decision, which are typically defined as a 'go or no-go' decision. These are -

1. Payback period (standard)
2. Discounted payback period (modified from payback period)
3. Net present value (NPV) (standard)
4. Internal rate of return (IRR) (standard)
5. Modified internal rate of return (MIRR) (modified from IRR)
6. Profitability index (PI) (modified from NPV)

In reviewing these, which one(s) is appropriate for small projects and which one(s) is appropriate for larger projects?

Which criteria and techniques do you consider the most useful? Please explain

Please choose one of these models and provide an example by showing the model's calculation in action.

Answer 1

payback period (standard)

The payback period refers to the amount of time it takes to recover the cost of an investment or how long it takes for an investor to reach breakeven.Account and fund managers use the payback period to determine whether to go through with an investment.Shorter paybacks mean more attractive investments, while longer payback periods are less desirable.The payback period is calculated by dividing the amount of the investment by the annual cash flow.

Discounted payback period

The discounted payback period is used as part of capital budgeting to determine which projects to take on.More accurate than the standard payback period calculation, the discounted payback period factors in the time value of money.The discounted payback period formula shows how long it will take to recoup an investment based on observing the present value of the project's projected cash flows.The shorter a discounted payback period is, means the sooner a project or investment will generate cash flows to cover the initial cost.

Net present value (NPV) (standard)

Net present value, or NPV, is used to calculate today’s value of a future stream of payments.If the NPV of a project or investment is positive, it means that the discounted present value of all future cash flows related to that project or investment will be positive, and therefore attractive.To calculate NPV you need to estimate future cash flows for each period and determine the correct discount rate.

Internal rate of return (IRR) (standard)

• IRR is the annual rate of growth an investment is expected to generate.
• IRR is calculated using the same concept as NPV, except it sets the NPV equal to zero.
• IRR is ideal for analyzing capital budgeting projects to understand and compare potential rates of annual return over time.

​Modified internal rate of return (MIRR)

The modified internal rate of return (MIRR) is a financial measure of an investment's attractiveness.^[1][2] It is used in capital budgeting to rank alternative investments of equal size. As the name implies, MIRR is a modification of the internal rate of return (IRR) and as such aims to resolve some problems with the IRR.

profitability index

The profitability index (PI) is a measure of a project's or investment's attractiveness.The PI is calculated by dividing the present value of future expected cash flows by the initial investment amount in the project.A PI greater than 1.0 is deemed as a good investment, with higher values corresponding to more attractive projects.Under capital constraints and mutually exclusive projects, only those with the highest PIs should be undertaken.

payback period method works very well for small projects and for those that have consistent cash flows each year.it is siple to calculate and easy to understand.

Net present value is the best method forlarger projects as it is  also accounts when a project has non-normal cash flows. Non-normal cash flows exist if there is a large cash outflow during or at the end of the project.and also the NPV method uses a reinvestment rate close to its current cost of capital, the reinvestment assumptions of the NPV method are more realistic than those associated with the IRR method.

Which criteria and techniques do you consider the most useful?

The most commonly used methods for capital budgeting are the payback period, the net present value and an evaluation of the internal rate of return.The payback period method is popular because it's easy to calculate. Quite simply, the payback period is a calculation of how long it takes to get your original investment back.Unlike the payback method, the net present value approach does consider the time value of money for as long as the projects generate cash flow. The net present value method uses the investor's required rate of return to calculate the present value of future cash flow from the project.The internal rate of return method is a simpler variation of the net present value method. The internal rate of return method uses a discount rate that makes the present value of future cash flows equal to zero. This approach gives a method of comparing the attractiveness of several projects.

provide an example by showing the model's calculation in action.

Apple Limited has two project options. The initial investment in both the projects is Rs. 10,00,000.

Project A has even inflow of Rs. 1,00,000 every year.

Project B has uneven cash flows as follows:

Year 1 – Rs. 2,00,000

Year 2 – Rs. 3,00,000

Year 3 – Rs. 4,00,000

Year 4 – Rs. 1,00,000

Now let us apply the payback period method to both the projects.

The formula for computing payback period with even cashflows is:

initial investment / net annual cash inflows

Project A

If we use the formula, Initial investment / Net annual cash inflows then:

10,00,000/ 1,00,000 = 10 years

Project B

Total inflows = 10,00,000 (2,00,000+ 3,00,000+ 4,00,000+ 1,00,000)

Total outflows = 10,00,000

Project B takes four years to get back the initial investment.

Now, let us modify the cash flows of project B and see how to get the payback period:

Say, cash inflows are –

Year 1 – Rs. 2,00,000

Year 2 – Rs. 3,00,000

Year 3 – Rs. 7,00,000

Year 4 – Rs. 1,50,000

The payback period can be calculated as follows:

Year	Total flow ( in Lakhs)	Cumulative flow
0	(10)	(10)
1	2	(8)
2	3	(5)
3	7	2
4	1.5	3.5

Now to find out the payback period:

Step 1: We must pick the year in which the outflows have become positive. In other words, the year with the last negative outflow has to be selected. So, in this case, it will be year two.

Step 2: Divide the total cumulative flow in the year in which the cash flows became positive by the total flow of the consecutive year.

So that is: 5/7 = 0.71

Step 3: Step 1 + Step 2 = The payback period is 2.71 years.

Therefore, between Project A and B, solely on the payback method, Project B (in both the examples) will be selected.