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Appraisal Criteria – Capital Budgeting

Appraisal Criteria – Capital Budgeting. Batch 2013 – 2016 :2 nd Sem MMM / MFM SIMSR. Classification. Evaluation Criteria. Non discounting Criteria. Discounting Criteria. Internal Rate Of Return(IRR). Pay Back Period. Net Present Value(NPV). Accounting Rate of Return (ARR).

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Appraisal Criteria – Capital Budgeting

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  1. Appraisal Criteria – Capital Budgeting Batch 2013 – 2016 :2ndSemMMM / MFMSIMSR

  2. Classification Evaluation Criteria Non discounting Criteria Discounting Criteria Internal Rate Of Return(IRR) Pay Back Period Net Present Value(NPV) Accounting Rate of Return (ARR) Annual Capital Charge BCR / NBCR

  3. Pay back period It measures the length of time required to recover the initial outlay in the project. Eg: If a project with a life of 5 years involves an initial outlay of Rs.20 lakh and is expected to generate a constant annual inflow of Rs.8 lakh, the payback period of the project =20/8 =2.5 yrs.

  4. Pay back period Eg: On the other hand if the project is expected to generate annual inflows of, say Rs.4 lakh, Rs.6 lakh, Rs.10 lakh, Rs.12 lakh and Rs.14 lakh over the 5 year period the pay back period will be equal to 3 yrs because the sum of the cash inflows over the first three years is equal to the initial outlay.

  5. Pay back period In order to use the payback period as a decision rule for accepting or rejecting the projects, the firm has to decide upon an appropriate cut –off period. Projects with pay back periods less than or equal to the cut –off period will be accepted and others will be rejected.

  6. Cons • It fails to consider the time value of money. • The cut –off period is chosen rather arbitrarily and applied uniformly for evaluating projects regardless of time span. It may accept too many short –lived projects and too few long-lived ones. • It may lead to discrimination against projects which generate substantial cash inflows in later years, the criteria cannot be considered as a measure of profitability Pay back period • Pros • It is simple in both concept and application. • It helps in wedding out risky projects by favoring only those projects which generate substantial inflows in earlier years.

  7. Discounted Pay Back Period To incorporate the time value of money in the calculation of pay back period some firms compute Discounted Pay Back Period. These firms discount the cash flows before they compute the pay back period. Eg: If a project involves an initial outlay of Rs.10 lakh and is expected to generate a net annual inflow of Rs.4 lakh for the next 4 yrs……….. Calculate the discounted pay back period represented by n no. of yrs……

  8. Discounted Pay Back Period • 4*PVIFA(12,n) =10………………..(1) Assuming the cost of funds to be 12% Equation (1) can be re-written as PVIFA(12,n) =2.5 From PVIFA Tables, we find that PVIFA(12,3) = 2.402 PVIFA (12,4) =3.037

  9. Discounted Pay Back Period Therefore ‘n’ lies between 3 and 4 and is approximately equal to 3.15 yrs n =3+(4-3) *(2.500-2.402) (3.037-2.402) = 3.15 yrs But… still this mechanism has a shortcoming…….. As it depends on the choice of an arbitrary cut –off date and ignore all cash flows after that date. In practice, companies do not give much importance to the payback period as an appraisal criteria.

  10. ARR = Avg Profit after Tax Avg book value of the investments To use it as an appraisal criterion, the ARR of a project is compared with the ARR of the firm as a whole or against some external yard –stick like the average rate of return for the industry as a whole. Accounting Rate of Return (ARR)

  11. Average investments Average investments = Net working capita + salvage value+ ½ [ initial cost of machine – Salvage Value]

  12. Example

  13. Solution Avg annual income = (30000+20000+10000)/3 = 20000 Avg net book value of investment = 0 + (90000- 0) /2 = 45000 ARR = (20000) /(45000) *100 =44% The firm will accept the project if its target avg rate of return is above 44 %

  14. Merits of ARR • Like pay back criterion, ARR is simple both in concept and application. It appeals to the businessmen who find the concept of rate of return familiar and easy to work with rather than absolute quantities. • It considers the returns over the entire life of the project and therefore serves as a measure of profitability ( unlike the pay back period which is only a measure of capital recovery)

  15. Demerits of ARR • First, this criterion ignores the time value of money. Put differently, it gives no allowance for the fact that immediate receipts are more valuable than distant flows and as a result gives too much weight to the more distant flows. • The ARR depends on the accounting income and not on the cash flows. Since cash flows and accounting income are often different and investment appraisal emphasizes cash flows, a profitability measure based on accounting income cannot be used as a reliable investment appraisal criterion.

  16. Demerits of ARR • Finally the firm using ARR as an appraisal criterion must decide on a yard stick for judging a project and this decision is often arbitrary.Often firms use their current book-return as the yard stick for comparison. In such cases if the current book return of a firm tends to be unusually high or low, then the firm can end upon rejecting good projects or accepting bad projects.

  17. Net Present Value (NPV) The Net Present Value is equal to the present value of future cash flows and any immediate cash outflows. In case of a project, the immediate cash flow will be investment (cash outflow) and the net present value will be therefore equal to the present value of future cash inflows minus the initial investment.

  18. Revision…….(Recall Net Cash Flow Calculation) Q) Sandals inc. is considering the purchase of a new leather cutting machine to replace an existing machine that has a book value of Rs.3,000 and can be sold for Rs.1,500. The estimated salvage value of the old machine in four years would be zero, and it is depreciated on a straight line basis. The new machine will reduce costs (before tax) by Rs.7,000 per year, i.e., Rs.7,000 cash savings over the old machine. The new machine has a four year life, costs Rs.14,000 and can be sold for an expected amount of Rs.2,000 at the end of the fourth year. Assuming straight –line depreciation, and a 40% tax rate, define the cash flows associated with the investment. (assume straight line method of depreciation for tax purposes)

  19. Solution

  20. Working Notes Computation of depreciation: Existing leather –cutting machine Rs.3,000/4 = Rs.750 pa New leather –cutting machine Rs.12,000/4 = Rs.3,000 pa Incremental depreciation = Rs.2,250 pa

  21. Brain Gym…..(back to NPV) • Now consider the project just described . Compute the net present value of the project, if the cost of the funds to the firm is 12%…….

  22. Solution to Brain Gym NPV = Rs.[-12,500+(4554+4065+3631+4516)] = Rs[.-12500 +16766] = Rs.4266

  23. NPV ……Rationale A project will be accepted if its NPV is positive and rejected if its NPV is negative What if the NPV works out to be exactly zero??? It it happens, theoretically speaking the decision –maker is supposed to be indifferent between accepting or rejecting the project. But in practice, NPV in the neighborhood of zero calls for a close review of the projections made in respect of such parameters that are critical to the viability of such marginally viable projects.

  24. Pros and Cons • Cons • Difficulty in comprehending the concept’s application • Most non-financial executives and business men find ‘ Rate on Capital Employee's or ‘ Average Rate of Return’ easy to interpret compared to absolute values like the NPV Pros • Conceptually sound, takes into account time value of money • Considers the cash flow stream entirely • NPV is congruent with the objectives of investment decision making viz., maximization of shareholder’s wealth

  25. Benefit –Cost Ratio (BCR) The benefit cost ( or the profitability Index) is defined as follows: BCR = PV/ I Where , PV – present value of future cash flows I – Initial Investment

  26. NBCR: Variant of BCR NBCR, net benefit cost ratio is defined as: NBCR = NPV /I = (PV –I)/I = (PV/I) –1 = BCR -1

  27. Brain Gym • Calculate the BCR and NBCR of the previous example Ans ) BCR = 16766/12500 =1.34 NBCR = 4266/12500 =0.34

  28. Decision Rule based on BCR/NBCR If Decision Rule BCR >1(NBCR>0) Accept the project BCR<1(NBCR<0) Reject the project Since the BCR measures the present value per rupee of outlay,it is considered to be a useful criterion for ranking a set of projects in the order of decreasingly efficient use of capital

  29. Limitations of BCR • First, it provides no means for aggregating several smaller projects into a package that can be compared with a large project • Second, when the investment outlay is spread over more than one period, this criterion cannot be used.

  30. Brain Gym Zeta Ltd is considering 4 projects – A , B C and D with the following characteristics The funds available for investment are limited to Rs.20 lakh and the cost of funds to the firm is 14%. Rank the 4 project(s) in terms of the NPV and BCR criteria.Which project(s) will you recommend given the limited supply of funds?

  31. Solution to Brain Gym The NPVs of the 4 projects are as follows: The BCR of the 4 projects are as follows:

  32. Which project should be accepted?? Based on the NPV and BCR criteria, all 4 projects are acceptable as both NPV and BCR are positive. But what if all the 4 projects need to be taken by the firm? It can not be due to limited availability of funds. either Zeta has to accept project A or a package consisting of projects B, C and D but not both.

  33. Limitation of BCR…. application The decision will depend upon which option maximizes the shareholder’s wealth. In this sort of a decision –making situation, the BCR becomes inapplicable because there is no way by which we can aggregate the BCRs of the projects B, C and D. On the other hand NPVs of projects B, C and D can be aggregated and compared with the NPV of project A to arrive at a decision.

  34. Internal Rate Of Return (IRR) The internal rate of return is that rate of interest at which the net present value of a project is equal to zero, or in other words, it is the rate which equates the present value of the cash inflows to the present value of the cash outflows. While under the NPV method the rate of discounting is known (the firm’s cost of capital) under IRR this rate which makes NPV zero has to be found out

  35. Brain Gym A project has the following pattern of cash flows: What is the IRR of this project?

  36. Solution to Brain Gym • To determine the IRR, we have to compute the NPV of the project for different rates of interest until we find that rate of interest at which the NPV of the project is equal to zero or sufficiently close to zero. To reduce the number of iterations involved in this trial and error process, we can use the following short –cut procedure:

  37. Steps to IRR calculation Step 1 Find the average annual net cash flow based on the given future net cash flows.In our eg. it turns out to be (5+5+3.08+1.20)/4 =3.57 Step 2 Divide the initial outlay by the average annual net cash flow ie, 10/3.57 =2.801

  38. Steps to IRR calculation Step 3 From the PVIFA table find that the interest rate at which the PVIFA of Re 1 will be nearly equal to 2.801 in 4 yrs ie, the duration of the project ( remember this is only a hint for finding the IRR, which actually needs to be found out by hit and trial method)

  39. Steps to IRR calculation • The NPV at r =15% -10+ (5*0.870)+(5*0.756)+(3.08*0.658) +(1.2*0.572) = 0.84 • The NPV at r =18% -10+ (5*0.848)+(5*0.719)+(3.08*0.609) +(1.2*0.516) = 0.33 • The NPV at r =20% -10+ (5*0.833)+(5*0.694)+(3.08*0.579) +(1.2*0.482) = 0 We find that at r=20%, the NPV is zero and therefore the IRR of the project is 20%

  40. The decision To use IRR as an appraisal criterion, we require information on the ‘ cost of capital or funds employed’ in the project. If we define IRR as ‘r’ and cost of funds employed as ‘k’,then the decision rule based on IRR will be: Accept the project if r> k Reject the project if r< k If r=k, it is a matter of indifference

  41. Merits of IRR • It takes into account the time value of money. • It considers the cash flow stream over the entire investment horizon. • Like ARR, it makes sense to businessmen who prefer to think in terms of rate of return on capital employed.

  42. Limitations of IRR • IRR is uniquely defined only for a project whose cash flow pattern is characterized by cash outflow(s) followed by cash inflows ( such projects are called simple investments). If the cash flow stream has one or more cash outflows interspersed with cash inflows, there can be multiple internal rates of return. This point can be clarified with the help of the following table where four projects with different patterns of cash flows are given:

  43. Illustration of Limitation of IRR • Projects A and B are simple investments and therefore will have unique IRR values. But projects C and D can have multiple internal rates of return because their cash flows and outflows are interspersed. For such projects IRR cannot be a meaning full criterion of appraisal.( Work out the IRRs and see the limitation)

  44. Limitations of IRR • The IRR criterion can be misleading when the decision-maker has to choose between mutually exclusive projects that differ significantly in terms of outlays. In spite of these defects, IRR is still the best criterion today to appraise a project financially. Financial Institutions insist that projects having substantial outlay specially in the medium and large scale sectors must show the computation of IRR in the Detailed Project Report (DPR), which they appraise before sanctioning financial assistance.

  45. Annual Capital Charge • This appraisal criterion is used for evaluating mutually exclusive projects or alternatives which provide similar service but have differing patterns of costs and often unequal life spans, eg, choosing between fork –lift transportation and conveyor-belt transportation.

  46. Steps Involved in Calculation Step 1 Determine the present value of the initial investment and operating costs using the cost of capital(k) as the discount rate. Step 2 Divide the present value by PVIFA(k,n) where ‘n’ represents the life span of the project. The quotient is defined as the annual capital charge or the equivalent annual cost. Once the annual capital charge for the various alternatives are defined, the alternative which has the minimum annual capital charge is selected

  47. Brain Gym • Hindustan Forge Ltd is evaluating two alternative systems: A and B , for internal transportation. While the two systems serve the same purpose, system A has a life of 7 years and system B has a life s of 5 years. The initial outlay and operating costs(in Rs.) associated with these systems are as follows:

  48. Brain Gym Calculate the annual capital charge associated with these two systems,if the cost of capital is 12%. ( You can assume that the net salvage values of the two system at the end of their economic lives will be zero.

  49. Solution to Brain Gym Present value of costs associated with system A = Rs.10,00,000+(100000*0.893)+(125000 *0.797)+(150000*0.712)+(175000*0.636) +(200000*0.567)+(225000*0.507)+ (200000*0.452) = 17,24,900 Annual capital charge associated with system A = 17,24,900/ [PVIFA(12,7)] = Rs.3,77,936

  50. Solution to Brain Gym Present value of costs associated with system B = Rs.8,00,000+(75000*0.893)+(100000 *0.797)+(120000*0.712)+(140000*0.636) +(100000*0.567 = 11,77,855 Annual capital charge associated with system B = 11,77,855 / [PVIFA(12,5)] = Rs.3,26,728

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