Question

Prepare a 2-3 page essay which discusses each of the four capital investment evaluation methods. Be sure to include the mechanics behind the method and the pros and cons to utilizing each method. Discuss some additional factors that may impact capital investment decisions.

Answer 1

HELLO STUDENT

Before discussing the methods of evalaution of capital investment, we should have a little intro about Capital investment decision.

WHAT IS CAPITAL INVESTMENT DECISION OR CAPITAL BUDGETING DECISION?

The capital budgeting decision is a decision on an expenditure of capital nature(as against revenue expenditure) which is intended to create physical assets. The assets are in turn expected to reap benefits to the company for year to come therefore these decision are mandatory for company to take for growth and expansion of their business For instance Decision related to NEW PROJECTS which are incurred with expenditure on creation of new assets like setting up an entirely new factory, a new building etc. purchasing of a new machinery under the new project. Etc...

FOUR Methods of evaluation of capital investment are as follow

THERE ARE SEVERALS METHODS OF EVALUATION OF CAPITAL INVESTMENT. THEY MAINLY DIVIDED INTO TWO CATEGORIES

1) Methods based on the assumption of certainty of cash flow.

These are those methods which assume that whatever cashflows that have been estimated will be certain and no changes are expected in them. This method may be further divided into two categories.

a) SIMPLE METHODS-: THOSE methods which are easy to calculate & do not involve elaborate calculations and discounting of cash flows. Example- PAYBACK PERIOD, ACCOUNTING/ AVERAGE RATE OF RETURN.

b)Scientific Methods:- Those methods which take into calculation the time value of money and, therefore undertakes discounting of cash flow. They are Net Present Value(NPV), INTERNAL Rate of return(IRR),Benefit- Cost(B-C) ratio or Profitability Index(PI)

2)Methods which take into consideration uncertainty of cash flow.

These are more realistic because any future directed estimate has an element of uncertainty.Therefore, a realistic method should be one which also consider this uncertainty EXAMPLES ARE Conservative Estimates, Certainty Equivalent Coefficient, Risk- adjusted Discount rate , Probability distribution of uncertainty, Sensitivity Analysis etc.

We will not discuss all methods in details,only few and basic methods which companies normally uses in evaluation of capital investment.

PAYBACK PERIOD METHOD

The payback period is the length of time required to recover the cost of an investment. The payback period of a given investment or project is an important determinant of whether to undertake the position or project, as longer payback periods are typically not desirable for investment positions. The payback period ignores the time value of money (TVM), unlike other methods of capital budgeting such as net present value (NPV), internal rate of return (IRR), and discounted cash flow.

PAYBACK PERIOD= INITIAL CASH OUTFLOW/ ANNUAL CASH INFLOWS

Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year. The payback period for this investment is 4 years, which is found by dividing $1 million by $250,000. Consider another project that costs $200,000, has no associated cash savings, but will make the company an incremental $100,000 each year for the next 20 years ($2 million). Clearly, the second project can make the company twice as much money, but how long will it take to pay the investment back? The answer is found by dividing $200,000 by $100,000, which is 2 years. The second project will take less time to pay back and the company's earnings potential is greater. Based solely on the payback period method, the second project is a better investment.

MERIT

It is a simple method in concept , easy to understand and use. Moreover, since its emphasis is on early recovery of investment , it automatically takes care of risk.Projects with smaller payback are considered safer and secure as compared to the projects with longer payback.

Demerits

It takes into account only early cash flow which determine the payback and ignores those which come later this may be often leading wrong conclusion.

2) Accounting rate of return

The accounting rate of return (ARR) is the amount of profit, or return, an individual can expect based on an investment made. Accounting rate of return divides the average profit by the initial investment to get the ratio or return that can be expected. ARR does not consider the time value of money, which means that returns taken in during later years may be worth less than those taken in now, and does not consider cash flows, which can be an integral part of maintaining a business.

ARR= AVERAGE PAT(NET PROFIT AFTER TAX)/INTIAL INVESTMENT

EXAMPLE-:The total profit from a project over the past five years is $50,000. During this span, a total investment of $250,000 has been made. The average annual profit is $10,000 ($50,000/5 years) and the average annual investment is $50,000 ($250,000/5 years). Therefore, the accounting rate of return is 20% ($10,000/$50,000).

MERIT

THIS method is relatively simple method involving the calculation of average. It is also based on easily understood accounting information like EBIT/PAT, Depreciation, investment etc

DEMERIT

In addition to the lack of consideration given to the time value of money as well as cash flow timing, accounting rate of return does not provide any insight as to constraints, bottleneck ramifications or impacts on company throughput. Accounting rate of return isolates individual projects and may not capture the systematic impact a project may have on the entire entity – both positively and negatively. Accounting rate of return is not ideal to use for comparative purposes because financial measurements may not be consistent between projects and other non-financial factors need consideration. Finally, accounting rate of return does not consider the increased risk of long-term projects and the increased variability associated with long periods of time.

3) NET PRESENT VALUE METHOD

Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting to analyze the profitability of a projected investment or project.

The following is the formula for calculating NPV:

NPV = C x {(1 - (1 + R)^-T) / R} ? Initial Investment

In this equation:

C_t = net cash inflow during the period t

C_o = total initial investment costs

r = discount rate, and

t = number of time periods

A positive net present value indicates that the projected earnings generated by a project or investment (in present dollars) exceeds the anticipated costs (also in present dollars). Generally, an investment with a positive NPV will be profitable, and an investment with a negative NPV will result in a net loss. This concept is the basis for the Net Present Value Rule, which dictates that the only investments that should be made are those with positive NPV values.

When the investment in question is an acquisition or a merger, one might also use the Discounted Cash Flow metric.

Apart from the formula itself, net present value can often be calculated using tables, spreadsheets such as Microsoft Excel, or Investopedia’s own NPV calculator.

For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, and then discount those cash flows into one lump-sum present value amount — let's say $500,000. If the owner of the store were willing to sell his or her business for less than $500,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. If the owner agreed to sell the store for $300,000, then the investment represents a $200,000 net gain ($500,000 - $300,000) during the calculated investment period. This $200,000, or the net gain of an investment, is called the investment’s intrinsic value. Conversely, if the owner would not sell for less than $500,000, the purchaser would not buy the store, as the acquisition would present a negative NPV at that time and would, therefore, reduce the overall value of the larger clothing company.

Let's look at how this example fits into the formula above. The lump-sum present value of $500,000 represents the part of the formula between the equal sign and the minus sign. The amount the retail clothing business pays for the store represents C_o. Subtract C_o from $500,000 to get the NPV: if C_o is less than $500,000, the resulting NPV is positive; if C_o is more than $500,000, the NPV is negative and is not a profitable investment.

MERIT

a) It consider Time value of money

b) It is an absolute value

c)NPV for different rates of interest can be found separetely

DEMERIT

One primary issue with gauging an investment’s profitability with NPV is that NPV relies heavily upon multiple assumptions and estimates, so there can be substantial room for error. Estimated factors include investment costs, discount rate and projected returns. A project may often require unforeseen expenditures to get off the ground or may require additional expenditure at the project’s end.

Additionally, discount rates and cash inflow estimates may not inherently account for risk associated with the project and may assume the maximum possible cash inflows over an investment period. This may occur as a means of artificially increasing investor confidence. As such, these factors may need to be adjusted to account for unexpected costs or losses or for overly optimistic cash inflow projections.

4) INTERNAL RATE OF RETURN(IRR)

Internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments. Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same formula as NPV does.

The following is the formula for calculating NPV:

Where:

C_t = net cash inflow during the period t

C_o= total initial investment costs

r = discount rate, and

t = number of time periods

To calculate IRR using the formula, one would set NPV equal to zero and solve for the discount rate (r), which is the IRR. Because of the nature of the formula, however, IRR cannot be calculated analytically and must instead be calculated either through trial-and-error or using software programmed to calculate IRR.

Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake. IRR is uniform for investments of varying types and, as such, IRR can be used to rank multiple prospective projects on a relatively even basis. Assuming the costs of investment are equal among the various projects, the project with the highest IRR would probably be considered the best and be undertaken first.

IRR is sometimes referred to as "economic rate of return" or "discounted cash flow rate of return." The use of "internal" refers to the omission of external factors, such as the cost of capital or inflation, from the calculation.

MERIT

TIME VALUE OF MONEY

The first and the most important thing is that it considers the time value of money in evaluating a project which is a big lacking in accounting rate of return.

SIMPLICITY

The most attractive thing about this method is that it is very simple to interpret after the IRR is calculated. It is very easy to visualize for managers and that is why this is preferred till the time they come across certain occasional situations such as mutually exclusive projects etc.

HURDLE RATE / REQUIRED RATE OF RETURN HAS NOT REQUIRED

The hurdle rate is a difficult and subjective thing to decide. In IRR, the hurdle rate or the required rate of return is not required for finding out IRR. It is not dependent on the hurdle rate and hence the risk of a wrong determination of hurdle rate is mitigated.

REQUIRED RATE OF RETURN IS A ROUGH ESTIMATE

A required rate of return is a rough estimate being made by the managers and the method of IRR is not completely based on required rate of return. Once IRR is found out, we can compare it with the hurdle rate. If the IRR is far away from the estimated required rate of return, the manager can safely take the decision on either side and also keep a room for estimation errors.

DEMERITS

ECONOMIES OF SCALE IGNORED

One pitfall in the use of IRR method is that it ignores the actual dollar value of benefits. A project value of $1000000 with 18% rate of return should always be preferred over a project value of $10000 with 50% rate of return. No need of analysis, we can apparently see that the dollar benefit of the former project is $180000 whereas the latter one is only $5000. Absolutely No Comparison. IRR method will rank the latter project, with very less dollar benefit, first simply because the IRR of 50% is higher than 18%.

IMPRACTICAL IMPLICIT ASSUMPTION OF REINVESTMENT RATE

While analyzing a project with IRR method, it implicitly assumes that the positive future cash flows are reinvested at IRR. If a project has low IRR, it will assume reinvestment at a low rate of return and on the contrary if the other project has very high IRR, it will assume reinvestment rate at the very high rate of return. This situation is practically not valid. At the time you receive those cash flows, having the same level of investment opportunity is rarely possible.

DEPENDENT OR CONTINGENT PROJECTS

Many times, finance managers come across a situation when the project under evaluation creates a compulsion of investing in other projects. For example, if you invest in a big transporting vehicle, you would need to arrange a place for parking that also. Such projects are called dependent or contingent projects which have to be considered by the manager. IRR may permit buying of the vehicle but if the total proposed benefits are wiped off in arranging the parking space, there is no point investing.

MUTUALLY EXCLUSIVE PROJECTS

Sometimes investors come across mutually exclusive projects which mean if one is accepted other cannot be accepted. Building a hotel or a commercial complex on a particular plot of land is an example of mutually exclusive projects. In such situations, knowing whether they are worth investing is not enough. The challenge is to know which one is the best. IRR will give a percentage interpretation value which is not enough. Refer the first disadvantage of economies of scale which is ignored by IRR.

DIFFERENT TERMS OF PROJECTS

Consider two projects with different project duration. One ends after 2 years and the other ends after 5 years. The first project has an additional point of reinvesting the money which is unlocked at the end of the 2nd year for another 3 years till the other project ends. This point is not considered by IRR method.

A MIX OF POSITIVE AND NEGATIVE FUTURE CASH FLOWS

When a project has some negative cash flow in between other positive cash flow, the equation of IRR is satisfied with more than one rate of return i.e. it reaches the trap of Multiple IRR

Factors influencing capital expenditure decisions

1. Availability of Funds

All the projects are not requiring the same level of investments. Some projects require huge amount and having high profitability. If the company does not have adequate funds, such projects may be given up.

2. Minimum Rate of Return on Investment

Every management expects a minimum rate of return or cut-off rate on capital investment. It refers to the point of below which a project would not be accepted.

3. Future Earnings

The future earnings may be uniform or fluctuating. Even though, the company expects guaranteed future earnings in total which affects the choice of a project.

4. Quantum of Profit Expected

It is necessary to assess the quantum of profit expected on implementation of selected project. Here, the term profit refers to realized amount of projects as per the accounting records.

5. Cash Inflows

The term cash inflows refers to profit after tax but before depreciation. The reason is that recording of depreciation is a book entry and there is no actual cash outflow. Hence, depreciation amount is included in the cash inflow.

6. Legal Compulsions

The management should consider the legal provisions while-selecting a project. In the case of leather and chemical industries, there are number of legal provisions created to protect environment pollution. Now, the management gives much importance to legal provisions rather than cost and profit.

7. Ranking of the Capital Investment Proposal

Sometimes, a company has two or more profitable projects in hand. If there is only one profitable project out of many and huge amount is available in the hands of management, there is no need of ranking of capital investment proposal. Ranking is necessary if there is many profitable projects in hand and limited funds is available in the hands of management.

8. Degree of Risk and Uncertainty

Every proposal involves certain risk and uncertainty due to economic conditions, competition, demand and supply conditions, consumer preferences etc. The degree of risk and uncertainty affects the profitability of the project. Hence, degree of risk and uncertainty of the project is taken into consideration for selection.

9. Urgency

A project may be selected immediately due to emergency or urgency. The reason is that such immediate selection saves the life of the company i.e. survival of a company is the primary importance than other factors.

10. Research and Development Projects

Research and Development project is highly required for technology based industries. The reason is that there is a lot of changes made within short period in technology. The research and development project gives more benefits in the long run. Hence, profitability is getting less importance and survival of business is getting much importance in the case of research and development project.

11. Obsolescence

The replacement of existing fixed assets is compulsory since there is an obsolescence of plant and machinery.

12. Competitors Activities

Every company should watch the activities of the competitors. The company should take a decision by considering the activities of the competitors. If so, the company can withstand in competition by implementing new projects.

13. Intangible Factors

Goodwill of the company, industries relations, safety and welfare of the employees are considered while selecting a project instead of considering profit alone. These factors are also high responsible for selection of any project.