Financial mangers often use different capital budgeting methods to evaluate the feasibility of projects. All potential investors require a minimum rate of return on their investments in any project. In order to evaluate the return on an investment financial managers often use different capital budgeting techniques which ensure that a project is feasible for investment or not. It is a rule of thumb that cash flows are often used to evaluate the return on investment in most capital budgeting methods due to the factor of time value of money.
From an analytical perspective, the investment analysis can be classified into two categories, non discounted and discounted cash flows. Average rate of return and payback method is the part of non discounted cash flows. Both methods are very easy to compute and also quite handy to understand results. Both non discounted methods are very popular among practitioners. However, a slight problem is that they can’t consider the factor of time value of money. In discounted cash flows three methods Net Present Value (NPV), Internal Rate of Return (IRR) and benefit cost ratio.
In all of the three procedures, the factor of time value of money is discussed before making the investment. All in all, capital budgeting decisions can bring about a significant impression on the organization’s future business operations. One can argue that a high-risk project with a good return is less desirable than a lower-risk project with a similar return but in this context we cannot neglect the risk associated with the return. The risk indicates the probability of the company getting a specific benefit from the proposed investment. Where the probability of success is high, risk is low and vice versa.
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Adaptations and practices of new approaches of capital budgeting in the spotlight of global business scenario is quite handy for financial managers as it helps them make the appropriate decision at the appropriate time. Also an important feature of capital budgeting techniques is to identify the existing gap between the theory and practical which create hurdles the future’s financial managers in adopting the appropriate decision.
Capital budgeting plays a very dominant part in making important financial decisions. Capital budgeting is a technique that helps the financial managers to support and base their business decisions on.
Capital budgeting techniques may be employed when making capital investments. The firm mainly focuses on the outlays which mainly comprise of fixed assets and have significance in relation with the cash resources which also has an impact on the future cash flows. In this context, addition, disposition, modification, impairment and replacement of fixed assets also bears some importance in capital budgeting. Such paramount decisions may have some implications on the profitability and also consequences for the firm’s future growth. Capital budgeting can be a sophisticated practice or exercise.
An efficient and meaningful capital budgeting analyses translates the simple picture of the benefits, costs, and risks associated with potential investments and expenditures. In addition, a capital budgeting decision and the adaptations of the techniques may have long-term effects on the company’s future cost structure. The rationale behind the capital budgeting decisions is efficiency. Acceptance of strategic investment changes the company’s expected profits and also the risk which is associated with these profits.
TECHNIQUES OF CAPITAL BUDGETING
When a finance manager makes an investment portfolio, he/she focuses on adopting proper investment appraisal technique becauses every potential investor looks for reward when he/she makes an investment. Discounted Cash flow is an approach aimed at evaluating the financial aspects of a project, a company or its assets, and it uses the concepts of Time Value of Money (Pike and Neale 2006, p. 240). All future cash flows are discounted and estimated to their present values. The discounting methodology is employed in determining the economic attractiveness of capital investment projects, which reduces the value of future cash receipts or payments.
The selection of proper investment appraisal technique is upon the discretion of the investor. There may be various types of techniques used for capital budgeting, the most common ones include NPV, IRR and Payback, which are briefly discussed below:
The Net Present Value, in simple words, can be described as the present value of cash flows minus the investments. The NPV of an investment in a particular project is the present value of expected cash inflows less the present value of the project’s expected cash outflows, discounted at the appropriate cost of capital as described by Brealey, Myers and Marcus (2001)
IRR is defined as the rate of return that equates the Present value of an investment’s expected benefits (inflows) with the present value of its costs (outflows), as expressed by Mathur (2002). Equivalently, the internal rate of return may be defined as the discount rate for which the NPV of an investment is zero.
Payback period is another method of investment appraisal which is measured in terms of time. It describes the amount of time required until cash flows recover the initial investment of the project. The payback rule states that a project should be accepted if its payback period is less than a specified cut-off period.
Mathematically; Payback Period = Cost of project / Annual cash inflows As a rough rule of thumb the payback rule may be adequate, but it is easy to see that it can lead to nonsensical decisions. Myers, Brealey and Marcus (2001) have described an example, comparing projects A and B. Project A has a 2 year payback and a large positive NPV. Project B also has a 2-year payback but a negative NPV. Project A is clearly superior, but the payback rule ranks both equally. This is because payback does not consider any cash flows that arrive after the payback period.
A firm that uses the payback criterion with a cut-off of two or more years would accept both A and B despite the fact that only A would increase shareholder wealth and also ignores the total profitability and cash flows anticipated over the entire life of an investment (Pettinger 2000, p. 105) . A second problem with payback is that it gives equal weight to all cash flows arriving before the cut-off period, despite the fact that the more distant flows are less valuable. For example, look at project C. It also has a payback period of 2 years but it has an even lower NPV than project B.
This is because its cash flows arrive later within the payback period. To use the payback rule a firm has to decide on an appropriate cut-off period. If it uses the same cut-off regardless of project life, it will tend to accept too many short-lived projects and reject too many long-lived ones. The payback rule will bias the firm against accepting long-term projects because cash flows that arrive after the payback period are ignored.
Another method is Modified Internal Rate of Return (MIRR) which debates on the discount rate at which the project cost is equal to the Present Value (PV) of its terminal value.
Another feature of MIRR is that it is invested at the firm’s cost of capital. Moreover, MIRR also makes a reflection on the profitability of the project.
Benefit Cost Ratio (BCR) debates on the overall value of money that is to be invested in any project. This ratio is quite beneficial in discussing the cost and benefits associated with the project. This ratio is also beneficial in decision making process regarding the project. Moreover, all costs and benefits expressed in discounted present values.
It was observed that most of the firms use Net present Value (NPV), Internal Rate of Return (IRR) and payback period when analysing any proposed investment. Going first with payback period, their is a debatable issue attached to it and that is firms with capital constraint mostly consider only the short term net cash-flows attached to any project when employing payback (Sagner,2007, pg. 39). It is often observed that businesses reveal a lot of money on their balance sheets but have fewer attractive capital investments
Similarly investors tend towards short term investment rather than long term investments (Sagner, 2007, pg. 39). It is primarily known that CFOs of most companies give preference to Payback over DCF analysis, which includes both NPV and IRR, the reason being that the future is uncertain and both NPV and IRR ignore all the macro-level factors that may directly effect the cash flow stream attached to an investment. Financial managers know for a fact that worthwhile capital investments are unusual and likely to be short lived
Most of the financial managers suggest that it is not an appropriate decision to allocate the funds to a project, only on the basis of a higher NPV and IRR. Because as stated earlier NPV and IRR do not address other important factors that may affect the expected cash flows. It is primarily evident that prediction regarding future cash inflows are based on optimistic grounds and most of the time it works upon hope and desire that a project be funded rather than be based upon hard research and specific evidence
There may be various factors that can be difficult to forecast, a change in which may create deviation of the net cash flows from the expected. This may include factors such as a new tax policy, increase in oil prices, or prices of other raw materials, or any macro-level factor that impacts the future cash flow streams. The current world era determines its dimensions regarding the use of probabilities in improving capital budgeting decisions (Sagner, 2007, pg. 43).
It is an open book fact that the future is uncertain and unpredictable, due to which financial managers focus on discounted payback plus (DPP) and sensitivity analysis (Sagner, 2007, pg. 43). In sensitivity analysis, worst case scenarios are taken into perspective, varying in different variables’ assumptions. In DPP, financial managers estimate returns on a projected payback moments plus an assignment of probabilities for cash inflows beyond the payback period (Sagner, 2007, pg. 43). The use of probabilities makes it a lot easier to evaluate the risk attached to a project.
DPP and sensitivity analysis both consider the risk factor from the cost of funds rather than focussing on returns that the firm expects to earn on the investment. Due to the new economic dimensions better valuation for capital budgeting techniques should be incorporated. RO analysis is a powerful financial tool that resolves the complexities that the project management team faces in the form of uncertainty. It also resolves the complexity of independent investment decision of new economy. It adds great value to a firm’s worth.
Also more flexibility that exists in RO analysis supports the managers in decision making and has an obvious advantage over NPV. RO analysis, in fact is not separate to the NPV technique, rather it is an expansion and improvement in the technique itself, giving better insights into strategic valuations (Madhani, 2008, pg 65). According to Arnold and Hatzopoulos, from the theoretical perspective text books often tend to prefer or rate NPV as a better technique arguing that it is has an edge over other methods. Arnold and Hatzopoulos also states that most of the financial books argue in favour of the NPV.
The reason behind is the increasing knowledge and acceptance of the arguments presented in the textbooks. When companies use other methods, all the studies and textbooks followed assumptions are not always met in practice.
ADVANTAGES OF CAPITAL BUDGETING METHODS
There are some advantages of different capital budgeting methods which are stated below:
- Payback method is quite handy in those industries where products become obsolete more rapidly.
- Both Payback and ARR take lesser time in providing the result.
- NPV provides best results in mutually exclusive events.
- Both NPV and IRR consider the factor of time value of money.
- IRR deals in terms of the total cash inflows and outflows.
DISADVANTAGES OF CAPITAL BUDGETING METHODS
There are different methods used for evaluating investment appraisals, but on the whole NPV is the method which is widely used by the financial managers. In NPV different forecasts regarding the assessment of the project is used in order to get a single forecast for the average project value, neglecting the irrelevant information in the data set (Madhani, 2008, pg 49).
From the perspective of NPV, alternative investment appraisal projects with the same amount of capital investment are non-existent practically.
- One cannot compare the result of NPV with payback method and ARR.
- IRR does not recognize investments as long term or short term
- The major shortfall of IRR is that all cash flows are reinvested at the percentage of IRR.
- Accounting rate of Return (ARR) is simply focusing on accounting profit rather than on cash flows.
- Both ARR and payback method ignores the factor of time value of money.
Sometimes the assumptions used might be insufficient or inappropriate, which might put the firm in a position of defending the numbers, rather focusing on the information that helps the manager to make a good business decision. If the project has not proposed a clear strategic or financial goal, then the underlying assumptions are useless.
RECOMMENDATIONS / OUTCOMES
After evaluating and accessing the various approaches to capital budgeting, a summary of the expected outcomes is stated below:
- The ethical dilemma that the financial manager bears is that there is too much cash chasing too few acceptable projects.
- Carefully focus on the underlying assumptions used in capital budgeting in an appropriate manner like making plans to utilise the additional working capital, when making investments or forecasting the future cash flows.
- Take a realistic approach to evaluating the project’s risk and the factors and determinates associated with.
- From the theoretical perspective, most of the instructors argue in favor of the NPV and provide substantial and valid evidences to support NPV.
In conclusion, non financial factors may dictate the appropriate course of action. Such factors may include, for example, compliance with laws, corporate image, employee morale, and various aspects of social responsibility. Management must remain alerts to such consideration. Sometimes the assumptions used might be insufficient or inappropriate, which might put the firm in a position of defending the numbers, rather focusing on the information that helps the manager to make a good business decision.If the project has not proposed a clear strategic or financial goal, then the underlying assumptions are useless.
- Arnold, Glen C. and Hatzopoulos, Panos D. (2000). “The theory-Practice Gap in Capital Budgeting: Evidence from the United Kingdom”. Journal of Business Finance & Accounting 27(5) & (6).
- Brealey, Richard A. , Myers, Stewart C. & Marcus, Alan J. (2001). Corporate Finance. McGraw-Hill.
- Keown, Arthur J. (2004). Financial Management: Principles & Applications. Collier Macmillan. Mathur, Iqbal (2002). Introduction to financial m
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