Question

Discuss the various methods used to evaluate capital investment proposals? (Hint: Average rate of return, cash payback period, net present value, and internal rate of return. For the more adventurous, include -MIRR—Modified Internal Rate of Return.)

Answer 1

Capital budgeting is the decision making procedure for establishing whether or not a company should invest in projects such as new facilities or products.Capital budgeting decisions are of paramount importance in financial decision making as long time period working, irreversible nature, involvement of large amount of funds, risk analysis and effective in profitability.

A firm may have various investment proposals for its consideration depending upon following proposals:

 Accept reject decision

 Mutually competitive decision

 Priority order decision

Following four methods are usually used for the evaluation of capital investment proposals:

1. The average rate of return method.

2. The payback period method (also known as cash payback period method).

3. The net present value method.

4. The internal rate of return method

Method 1 and 2 are the methods that do not use the present values. Method 3 and 4 use the present values. So these methods for the evaluation of capital investment can be grouped into tow categories:

Methods that Do Not Use Present Value Methods that Use Present Value ↓ ↓ ↓ ↓ Average rate of return method. Payback period method net present value method internal rate of return method

1.Accounting Rate of Return method /Average rate of return method: This is a percentage value of the average rate at which a fixed asset can generate benefits over its economic life. Management is responsible for setting the ARR for accepting capital investments. The Accounting rate of return (ARR) method uses accounting information, as revealed by financial statements, to measure the profit abilities of the investment proposals. The accounting rate of return is found out by dividing the average income after taxes by the average investment.

Accounting rate can be calculated as following:

ARR= Average income/Average Investment

Advantages: • It is very simple to understand and use.

• It can be readily calculated using the accounting data.

Limitations: • It uses accounting, profits, not cash flows in appraising the projects.

• It ignores the time value of money; profits occurring in different periods are valued equally.

2.Payback period: The payback (or payout) period is one of the most popular and widely recognized traditional methods of evaluating investment proposals, it is defined as the number of years required to recover the original cash outlay invested in a project, if the project generates constant annual cash inflows, the payback period can be computed dividing cash outlay by the annual cash inflow.

Payback period = Cash outlay (investment) / Annual cash inflow = C / A

Advantages: • A company can have more favourable short-run effects on earnings per share by setting up a shorter payback period.

• The riskiness of the project can be tackled by having a shorter payback period as it may ensure guarantee against loss

Limitations: • It fails to take account of the cash inflows earned after the payback period.

It is not an appropriate method of measuring the profitability of an investment project, as it does not consider the entire cash inflows yielded by the project.

3.Net present value method: The net present value (NPV) method is a process of calculating the present value of cash flows (inflows and outflows) of an investment proposal, using the cost of capital as the appropriate discounting rate, and finding out the net profit value, by subtracting the present value of cash outflows from the present value of cash inflows.

This is simply the present value of benefits less the present value of cost. PVC is the initial cost of a capital investment.

Advantages: • It recognizes the time value of money

• It considers all cash flows over the entire life of the project in its calculations

Limitations: • It presupposes that the discount rate which is usually the firm’s cost of capital is known. But in practice, to understand cost of capital is quite a difficult concept.

• It may not give satisfactory answer when the projects being compared involve different amounts of investment.

4.Internal Rate of Return Method: Internal rate of return is a prescribed rate at which the potential earnings of a capital investment asset are determined based on the present value of cash flows that the investment will generate during its economic life. It is called internal rate because it depends solely on the outlay and proceeds associated with the project and not any rate determined outside the investment.

The IRR can be stated in the form of a ratio as shown below:

P.V. of Cash Inflows – P.V. of Cash Outflows = Zero

The IRR is to be obtained by trial and error method to ascertain the discount rate at which the present values of total cash inflows will be equal to the present values of total cash outflows.

Advantages: • It considers cash flows over the entire life of the project.

• It satisfies the users in terms of the rate of return on capital

Limitations: • It involves complicated computation problems.

• It may not give unique answer in all situations. It may yield negative rate or multiple rates under certain circumstances.

5.Modified Internal rate of return :The modified internal rate of return (MIRR) is a modification of the internal rate of return (IRR) and is used in capital budgeting as a ranking criterion for mutually exclusive projects. The idea behind the MIRR method is that all project cash outflows are discounted at the cost of capital, and all cash inflows are reinvested at the reinvestment rate.

Advantages and Disadvantages of the MIRR Method

The modified internal rate of return resolves two problems inherent to the IRR.

1. All cash inflows are reinvested at the reinvestment rate, which is more realistic than reinvesting at the IRR.
2. The method of calculation eliminates the problem of multiple IRR for projects with abnormal cash flows.

The main disadvantage of the MIRR method is the potential conflict with the NPV method. The reason may be due to a difference in project scale or in the timing of cash flows (the problem was discussed in “NPV vs IRR method”). Furthermore, if the reinvestment rate is lower than the cost of capital, there is a conflict with the basic assumption of the NPV method, which is that all expected cash inflows are reinvested at the cost of capital (discount rate). Thus, the project can simultaneously have positive NPV and MIRR lower than the cost of capital. That is the reason why some academic studies recommend using the reinvestment rate equal to the cost of capital raised for a project.