Question

Net Present Value (NPV) method, Internal Rate of Return (IRR) method, Equivalent Annual Annuity (EAA) method and Payback Period method are the main important decision-making tools for corporate investment. You are allowed to address the following questions in Dot points with sufficient elaboration and justification.

a) What is the investment decision? Describe the process of an investment decisionmaking in corporations.

b) Which of the abovementioned decision-making tools are discounting method and which of them are non-discounting method? Why?

c) Identify the advantages and disadvantages for Payback, NPV and IRR methods.

d) When would one use EAA method?

e) In which case may one face a conflict between NPV and IRR methods? f) If there is conflict, which method should be used, and why? g) What is capital rationing? How does this going to affect the decision making?

(1000 words limit)

Answer 1

Part (a)

Investment decisions are capital budgeting decisions on which the returns are expected to occur over a period of more than 1 year. An example will be acquisition or disposal of long-term assets and the financing ramifications of such decisions. Generally, the investment is large and it directly impacts company’s operation & growth over multiple years, hence, capital budgeting process needs to be undertaken carefully. A capital budgeting is required for various different types of projects. Some of the investment decisions are shown below:

Sl. No.	Investment Decisions	Description
1.	Replacement projects to maintain the business	· Projects undertaken to maintain / sustain the business · A full business view needs to be taken into account while evaluating these projects. These projects may be unviable standalone but should be lucrative in a full business context.
2.	Replacement projects for cost reduction	· A detailed decision, viability of project can easily be calculated by finding the cost reduction impact
3.	Expansion projects	· Increase in production capacity, adding a new product line or acquisition of a business · Increased complexity in evaluating these projects because demand has to be forecasted
4.	New product development projects	· Highly risky but potentially highly rewarding projects · A careful examination of demand on new products should be done
5.	Mandatory projects	· To meet regulatory, safety, health and environmental requirements · Example: a statutory compliance to a government regulation
6.	Other Projects	· Projects falling out of the purview of categories defined above

Process of investment decision:

Sl. No.	Step / stage	Activities
1.	Identification of requirement/opportunity	· Assessment of the type of capital expenditure project required in line with a company’s goals and objectives · Ideas and suggestion can emanate from any department or managerial level in the organization · Crucial most important step in the process and also leads to the initiation of the capital budgeting process
2.	Search	· Preliminary research and exploration of all the options and alternatives available around the capital investment theme · Proposal diligence by each department in the entity’s value chain to pass only value accretive projects to the next stage
3.	Evaluation	· (Qualitative as well as quantitative) Analysis of available information to estimate the potential cash flows and the profitability of the projects that pass through the Search stage: o Quantitative - Estimating initial capital outlay, subsequent years’ cash flows, the net working capital requirements, the salvage value o Qualitative; Nonfinancial measures such as customer expectation and satisfaction, need for training, government requirements, tech evolution etc. are also considered while evaluating the project
4.	Selection	· At this stage the company chooses projects for implementation on the basis of financial analysis (NPV, IRR or payback period) and nonfinancial considerations. · Risk and return profile of all the projects compared · Post assessment, projects whose risk / return passes the internal benchmarks (qualifying criteria)of the company are selected
5.	Financing	· Once the projects are shortlisted, Management starts exploring funding avenues for the project. Source of funding can be internal accruals, debt or equity.
6.	Implementation & monitoring	· This is the final stage in which the project is implemented and monitored over time to ensure project develops as per schedule.

Part (b)

Discounting methods: NPV, IRR, EAA because they take into consideration time value of money.

and which of them are non-discounting method: Payback period, becaue it doesn't take into account the time value of money

Part (c)

Advantages of Payback Period method:

•   Simple & easy to understand & calculate
•   Provides rough measure of liquidity and risk; can enable the company to concentrate on more liquid projects, thereby avoiding tying up capital for long periods of time; can help a firm evaluate quick profits vs. uncertain conditions
•   Useful for a quick, preliminary screening when there are many proposals
•   Useful when expected cash flows in later years of the project are uncertain
•   Useful tool for project evaluation where risk of technological obsolescence exist

Disadvatages of Payback period Method:

•   Ignores time value of money
•   Ignores post payback period cash flows
•   Ignores the cost of capital,
•   Does not give weight to profitability
•   Bias towards short term projects irrespective of profitability

Relative advantages and disadvantages of NPV and IRR methods:

1. NPV is an absolute value (in Rs., $ etc.) unlike IRR, which is a %. There are decision makers who are so stuck with IRR that NPV doesn’t appeal to them. IRR is easier to visualize and interpret than NPV.

2. For conventional projects, the NPV and IRR will agree on whether to invest or not to invest.

3. NPV and IRR may give conflicting results if there is difference in project size, cash flow pattern, project life or cost of capital over the project term. Some examples are shown below.

4. Generally, NPV is preferred for evaluating capital budgeting projects. It is consistent with the objective of maximizing shareholder’s wealth. Shareholder’s wealth is the NPV of the firm’s future cash flows at its weighted average cost of capital.

5. NPV values of individual projects can be added together to estimate the effect of accepting some possible combination of projects.

6. Since IRR is a %, multiple projects can’t be added or averaged to evaluate combination of projects. Hence, Project with highest IRR is preferred.

7. Both the methods have heavy reliance on hurdle rate or RRR. Any error in estimating the benchmark rate can lead to a wrong selection of projects by both the methods.

8. NPV is more appropriate in cases where required rate of return for a project varies over the project tenure since discounting can be done at different required rates. In the case of IRR, comparison of project IRR will be difficult with multiple required rate of return.

9. A project will have as many IRRs as many times its cash flow changes its sign. So in a project with a mix of positive and negative cash flows during the tenure of the project, there will be multiple IRRs. However, in most of the cases, it has been seen that just one of them will be a reasonable value while all others will be quite unreasonable or even negative. See example below.

10. An IRR ignores the size of the project completely.

d) When would one use EAA method?

When we are comparing two projects with different lives, then we should use EAA method.

e) In which case may one face a conflict between NPV and IRR methods?

You can face conflict between NPV and IRR methods in following cases:

• When there are projects of different size (initial investment)
• When the projects have different Cash flow Pattern: Say one project has higher proportion of cash flows coming in later years while the other has higher proportion of cash flows in earlier years.

f) If there is conflict, which method should be used, and why?

If there is a conflict, NPV should be chosen. NPV is a more reliable evaluation tool, because it results in an absolute amount of profit. The convention is to use the NPV rule when the two methods are inconsistent, as it better reflects our primary goal: to grow the financial wealth of the company. Find out which of the proposed projects has the highest NPV at the given cost of capital (hurdle rate) and the same should be selected.

g) What is capital rationing? How does this going to affect the decision making?

Capital budgeting decisions can get complicated depending upon the availability of capital. If an unlimited amount of capital available, then capital budgeting is a simple decision. The firm invests in all of the projects that have a positive NPV or an IRR > hurdle rate, or whatever criteria have been set by the firm. But this may not be the situation always. Capital rationing is the situation where limited capital is available for investment leading to a regulated allocation of capital to the projects based on ranking or any other criterion. In a situation where there is a limited amount of money for investment, it becomes much more critical to rank these projects and then determine which individual project or projects will provide the highest rate-of-return. If there is a capital rationing (limited capital available), just the sheer size of a project can render it ineligible for execution even if it meets the NPV or IRR or any other investment decision criteria. On the other hand, due to capital rationing, two or more projects can be selected collectively that may result higher NPV than a single project that require investment more than capital available with the firm.
Thus when firms / companies have fixed amount of capital to allocate amongst capital projects, capital rationing is the allocation of this fixed amount of capital among the set of available projects such that the selection will maximize shareholder’s wealth. Projects with negative NPVs are to be discarded irrespective of availability of capital. There are two types of capital rationing:
•   Hard capital rationing – funds allocated to the manager of capital project cannot be increased
•   Soft capital rationing – manager of capital project is allowed to increase allocated capital budget provided they can justify to senior management of creating shareholder value on that additional capital