Investment appraisal techniques

capital budgeting techniques - useful to students of undergraduate. post graduate and profession course students pursuing a course in finance

1. Investment appraisal techniques Capital budgeting techniques Dr. Mohamed Kutty Kakkakunnan Associate Professor P.G. Dept. of Commerce N A M College Kallikkandy

2. INVESTMENT APPRAISAL TECHNIQUES / CAPITAL BUDGETING TECHNIQUES / INVESTMENT CRITERIA Can be broadly divided into two:- Traditional / non-discounted cash flow criteria or techniques and Discounted cash flow or non-traditional techniques I. Traditional techniques a). Payback Period b). Accounting Rate of Return II. Discounted cash flow techniques a). Net Present Value Method b). Internal Rate of Return Method c). Profitability Index Method d). Discounted Payback Period Method e). Terminal Value Method

3. PAYBACK PERIOD METHOD The most popular and widely used method Payback period is the period (number of years) required to recover the original cash outlay invested in the project. The number of years required to recover the cost of the investment At the end of the period, the accumulated cash inflows from the project will be equal to the total cash outflows Specifies the recovery time, by accumulation of the cash inflows (including depreciation) year by year until the cash inflows equal to the amount of original investment. Decision criterion : Projects with shortest payback period will be selected. Or compared with Standard payback period set by the management. Ranked according to the PBP

4. Calculation of Payback Period Two situations :- Project generates constant cash flows or equal cash flows (cash inflows remains the same for all the years or cash inflows are uniform) 2. Unequal cash flows (mixed stream) PBP is calculated by adding up (cumulating) the cash inflows until the total cash inflows is equal to the initial cash outflow. Formula- Where E = Number of years immediately preceding the year of recovery B= Balance to be recovered; C = Cash inflow during the year of final recovery ; Multiply by 12 to express the fraction in months

5. Merits Simplicity Cost effective, no need of sophisticated or analytical techniques Short-term effects Risk shield – shorter payback period – future is uncertain Liquidity - it emphasizes on the early recovery of investments. Thus, it gives insight into liquidity of the project Demerits Does not consider cash flow after payback period Does not consider all cash flows during the lifetime Fails to recognize the pattern, magnitude and timing of cash flows Does not consider the salvage value Inconsistent with shareholder values.

6. Post Payback Profitability Neglects post payback profitability (the profitability of the project during the excess of economic life period over payback period of that investment) – major limitation of PBP Post payback profitability removes this limitation Considers savings of post payback profitability or profitability of the project after the payback period in the entire economic life of the project If other things remain the same, post payback profitability (also known as surplus savings) will be considered for decisions Steps: Determine the surplus life in years (Economic life –PBP) Determine the total savings during the surplus life. If annual savings are the same during the surplus life, multiply annual savings by the number surplus years. If annual savings vary, add the savings of different years.

7. Step - 3. Add the estimated scrap value Step 4 . For better comparison, surplus savings or post payback profits are converted into index number, which shows the relative importance of each project more preciously Index of surplus savings or Index of Pot Payback Profit

8. Payback Reciprocal The two major drawbacks of Payback period are- Neglects time value (factor) Lack of a rate of return for comparison Is removed by calculating Payback Reciprocal When expressed as a percentage by multiplying by 100, it tends to more or less equal to the IRR

9. Bailout Payback Period An improvement of traditional payback period Under this method for calculating payback period, the salvage value of the asset is also considered. The salvage value is added with the cumulative savings Payback period is the period required to equate the cumulative earnings plus salvage value with the initial investment This method is generally used for evaluating risky project

10. ACCOUNTING RATE OF RETURN (ARR) Also known as Return On Investment (ROI) ARR is the ratio of the average after tax profit divided by the average investment. Based on accounting information/data Where:- Average income means Earnings after taxes but before interest. It is equal to Earnings After Tax plus Interest Average Investment – if the investment is depreciated constantly, it will be equal to half of the original investment. It can also be calculated by the total of investments book values after depreciation by the life of the project Acceptance Rule : Projects with ARR>the cut off rate or minimum rate or standard rate fixed by the management will be accepted. Projects are ranked in the order of ARR

11. Evaluation of ARR Merits Simplicity – simple to understand and use, no need of complicated calculations Accounting data – based on accounting information – readily available, no need for calculating cash flows and other adjustment Considers the entire stream of income in calculating project’s profitability Demerits Cash flows are ignored – non cash items Ignores time value of money Arbitrary cut-off rate Conclusion: ARR is used as a tool for performance evaluation and control measure. As an investment criterion, it is not preferable

12. II – Discounted Cash Flow (DCF) Techniques or Time Adjusted Rate of Return These are the methods based on the concept of time value of money Time value of money Financial decisions involve cash inflows and outflows in different periods. Majority of decisions involve current outlay of cash and a series of future inflows. Cash flows differ in timings. Thus, risk comparison of absolute flows taking place in different periods is meaningless. To be meaningful comparison of cash flows be made after making adjustments for their difference in timing and risk In other words, for comparison and decisions making one has to consider the time value of money and risk Thus, Financial decisions should consider time value of cash flows and risk

13. What is time value of money? As a rational/economic men, which of the following do you prefer and why? i ). To receive Rs. 5000 today for services rendered today or ii). To receive Rs. 5000 tomorrow for services rendered today Why? Birds-in-hand theory A rational or economic men prefer to receive an amount today itself than receiving the same amount tomorrow or a future date

14. Time value of money (TVM) or time preference for money is an individual’s preference for possession of a given amount of money now, rather than the same amount at some future Why we do prefer? Why time value for money? Three reasons :- Risk – uncertainty about future Preference for consumption – to enjoy now Investment opportunities Thus, a person expects more amount to receive in future than an amount received today

15. The Required Rate of Return Since he has to receive more amount, the additional amount can be called as the return or interest . The time preference for money is expressed as the interest rate. The rate will be positive even in the absence of risk. Because he will receive the interest, if deposits the same in a bank. Thus, it is known as risk-free interest rate. But for investing in business, which is risky, he has to get additional return. The return expected by him in addition to the risk-free interest rate is known as the risk premium This required rate of return is also known as opportunity cost of capital . This required rate of return helps to convert different cash flows at different time periods into amounts of equal value in the present Required rate of return = Risk free rate + Risk premium

16. Compounding and Discounting The two most common methods of adjusting cash flows for time value of money are the compounding and discounting Compounding is the process of determining future values of cash flows and discounting is the process of calculating present values of future cash flows Compounding is the process of finding the future values of cash flows by applying the concept of compound interest. Compound interest received on principal and on interest earned, not withdrawn during the earlier period. It determines the future value of an amount at a prescribed rate – growth of the amount after a period Simple interest is the interest calculated on the original amount (principal) without compounding or considering the interest for further interest calculations

17. Present value of cash flow refers to the present value of a future cash flow (inflow /outflow) It is the amount of current cash that is of equivalent value of a future cash flow to the decision maker. This value is determined by means of discounting process. The rate used for determining the present value or for discounting is known as discount rate. This rate will be the required rate of return determined by the management or cost of capital Discounting is the process of determining the present future value of a series of cash flows. Through compounding and discounting, the present value of future cash flows will be determined

18. Determination of the Present Value of Cash Flows NPV means the difference between the present value of cash outflows and cash inflows. Since cash outflow takes place at the initial time, there is no need of calculating the present value of cash outflow. But inflow takes place in future, the present value of future cash inflows need be calculated. For calculating the Present value, appropriate discount rate is used. The discount rate can be the overall cost of capital or the standard rate determined by the management After discounting the cash flows, the sum of the cash inflows will be determined for comparison with the cash out flows

19. Determination of the Present Value of Cash Flows Example: Project X costs Rs. 2,500 and is expected to generate year-end cash inflows of Rs. 900, Rs. 800, Rs. 700, Rs. 600, and Rs. 500 in years 1 through 5. the opportunity cost of capital may be assumed to be 10%. Calculate NPV NPV = PV of cash inflows – PV of cash outflows = 818.18+661.16+525.92+409.81+310.46 = 2725.53 NPV = 2725.53-2500 = 225.53

20. Use of Tables for calculating Present Values Calculation of present value based on the above method is difficult. To make calculations easy tables can be used There are two tables . First one is The Present Value Factor Table, which shows present value of Re 1 received in different years at different interest rates. This table is used when the cash flow vary from year to year. This table contain PV factors. Interest rate is shown in columns and years are shown in rows. By looking into the table, it is easy to ascertain the respective PV factor for the year at the prescribed discount rate or interest rate. To determine the present value of cash flow, the cash flow is multiplied by the present factor In our previous example: The PV factors at 10% interest rate are, 0.909, 0.82 , 0.751, 0.683 and 0.621 respectively for 1 through 5 yrs. Multiplying the cash flow by the PV Factor, we get 900 x .909 + 800 x 0.826 + 700 x 0.751 + 600 x 0.683 + 500 x 0.621 = 2725 NPV = 2725-2500 = 225

21. Second table is the Present Value of Annuity Table. When the cash flow remains constant over the years this table is used . This table also contain annuity factor. Usage of the table is similar to the first one discussed. Example: Project X costs Rs. 2500 and annual cash inflow is estimated to be Rs. 700 for 5 years. Assume interest rate to be 10%. Determine NPV NPV = PV of cash inflows – PV of cash outflows PV of cash inflows = 700 X 3.7909 = 2653.63 Thus, NPV = 2653.63-2500 = 153.63 OR (700x.909)+(700x.827)+(700x.751)+(700x.683)+(700x.621) - 2500

22. Second table is the Present Value of Annuity Table. When the cash flow remains constant over the years this table is used . This table also contain annuity factor. Usage of the table is similar to the first one discussed. Example: Project X costs Rs. 2500 and annual cash inflow is estimated to be Rs. 700 for 5 years. Assume interest rate to be 10%. Determine NPV NPV = PV of cash inflows – PV of cash outflows PV of cash inflows = 700 X 3.7909 = 2653.63 Thus, NPV = 2653.63-2500 = 153.63 OR (700x.909)+(700x.827)+(700x.751)+(700x.683)+(700x.621) - 2500

23. NPV – Acceptance Rule Accept the project when NPV is positive NPV>0 Reject the project when NPV is negative NPV<0 May accept the project when NPV=0 Positive NPV contributes to the wealth of shareholders and would result in the increased price of shares. Positive NPV indicates that the project generates cash inflows at a rate higher than the opportunity cost of capital. Zero NPV indicates that the rate of cash inflow is equal to the opportunity cost of capital. In case of mutually exclusive projects, projects with highest NPV is accepted NPV method can be used for ranking the projects. Projects are ranked in the order of NPV, first rank will be given to the project with highest positive NPVs and so one

24. Evaluation of NPV method NPV is considered a true measure of profitability due to the following merits- Recognizes time value of money True measure of profitability – considers all cash flows Value additivity - the discounting process in NPV method facilitates measuring cash flows in terms of present values i.e. in terms of equivalent current rupees. Therefore NPVs of different projects can be added. NPV (A+B) = NPV (A) + NPV (B). This is called value additivity. It means that if the NPVs of individual projects are known, the value of the firm will increase by the sum of their NPV Value additivity is an important property of an investment criterion because it means that each project can be evaluated independent of others, on its own merit Shareholder value- the NPV method is always consistent with the objective of the shareholder value maximization. This is the greatest merit of this method

25. Demerits Accurate forecast of future cash inflows is very difficult due to the uncertainty Difficulty in estimating the precise or accurate discount rate In case of mutually exclusive projects, with unequal lifetime and unequal outlays, the NPV method may give false results