Royal Airways is listed on local Stock Exchange. It is considering a proposal known as project GAMMA. This project has to be discussed at the finance meeting. In this project we have done some analysis on certain methods of Capital Budgeting like IRR, NPV, Pay Back Period, etc. we have selected Net Present Value for evaluating our project.
Critical Evaluation of techniques
There are many tools through with which we can analyze the feasibility of any capital budgeting project. At a glance these are as follows
1. Internal Rate of Return
2. Net Present Value
3. Pay Back Period
4. Discounted Payback Period
5. Accounting Rate of Return
These are explained in detail as follows
1. Internal Rate of Return
Under this method the exact rate at which the present value of all cash inflows will be equal to the present value of all cash outflows. Here the NPV is zero. When we evaluate the project in terms of IRR then we can say that that project will be preferred which has higher IRR as compared to the project which have lower IRR. As the one which has higher will yield the amount invested in less time than the one which has lower IRR as it will return the amount invested in more time. It is also known as ERR (Economic Rate of Return). This rate helps in comparing the earnings of two entities. This is also called as discounted cash flow rate of return. When we look from the view point of loan it is also called as effective interest rate. It is also known as annualized effective compounded return rate. IRR is a measure of efficiency, quality, or yield of an investment. This is in contrast with the net present value, which is an indicator of the value or magnitude of an investment. Every company has its own Internal Rate of Return which is also known as minimum acceptable rate of return or cost of capital. When we evaluate the project in terms of IRR then we can say that that project will be preferred which has higher IRR as compared to the project which have lower IRR. As the one which has higher will yield the amount invested in less time than the one which has lower IRR as it will return the amount invested in more time. The other use of IRR is comparison of capital projects. The example we can relate to expanding versus extension. The company can either purchase a new plant or it can increase the capacity of the existing plant. For this purpose IRR can be used. In order for a project to get accepted the Internal Rate of Return calculated should be more than the company’s cost of capital. In case if more than one project have IRR more than the company’s cost of capital than that project will be selected which has a higher Internal Rate of Return. Further IRR is helpful in evaluating whether to buyback or not. If a company allocates a substantial amount to a stock buyback, the analysis must show that the company's own stock is a better investment (has a higher IRR) than any other use of the funds for other capital projects, or than any acquisition candidate at current market prices
2. Net Present Value
It is a method where we compare two mutually exclusive projects and find out which of them is better. We prefer that project which has higher Net Present Value. It is the difference between two things
a. The present value of cash inflows discounted at ko i.e. cost of capital
b. The present value of all cash outflows discounted at ko i.e. cost of capital
This helps in analyzing the profitability of a project. The best advantage of NPV is that it utilizes time value of money which means that a dollar earned today will not be as worthy as a dollar earned tomorrow or in future. Either its value will increase or decrease depending upon the economic condition of a country to which the currency belongs. The only difficulty with this method is to identify or calculate the discount rate. This calculation is subjective. Many things are required to be considered
The rate which is used to discount future cash flows to the present value is a key aspect of this process.
The weighted average cost of capital is the one which is most often used. But many researchers believe that it is better to use a discount rate which is much higher as it will be able to adjust the risk, opportunity cost and certain other factors like duration, etc. A variable discount rate with higher rates applied to cash flows occurring further along the time span might be used to reflect the yield curve premium for long-term debt.
The better approach of calculating discount rate is the CAPM model. It is known as Capita Asset Pricing Model. This is a model that shows relationship between two things. One is risk and the other is other is expected return in the mindset of the investors. This model helps in pricing securities. Here the approach is to compensate the investor in two forms. One is the time value of money and the other is the risk they take by investing in the company. The time value of money has a denotation risk free rate. This is the one that compensate the investors. One can say it is an opportunity cost, the cost of next best alternative forgone. This rate is calculated by using a risk factor known as beta. Basically beta helps a company in comparing results with the other firms in the market. It is the expected return that an investor expects from the market. It consists of certain terms such as Rf which is known as risk free rate, Rm which is known as Risk premium and b which is known as Beta.
Net Present value indicates the amount of premium an investment adds to the project it means how much one gets over and above his investment. The only disadvantage of this method is that when we compare projects with different lives we cannot come to conclusion using this method. Under this method the focus is only on the difference between the inflow and the outflow. Both are discounted at cost of capital. A project that has a higher duration than the project which has a lesser duration is assumed to be same under this. Here a modified IRR is used. Further we assume that there is no new investment in between the project
If... Result Action to be taken
NPV > 0 The company should go with the project The chances of acceptance of a project increases
NPV < 0 The company will incur losses by accepting such project No need to accept the project
NPV = 0 The company will be indifferent Use other techniques to evaluate the project such as IRR, Payback and Discounted Payback
3. Payback Period
This method is used under capital budgeting to evaluate the time period in which the amount invested will be recovered by the entity. One can say it as a breakeven point. Payback period is the time period within which an entity will recover its investment of its cash inflow. But the negative side of payback period is that it does not consider time value of money. For the purpose of decision making those projects are preferred that have a shorter payback period than those that have a higher payback period. The best part of it is that this method is easy to apply than all the other methods. The solution can be arrived quickly. It is very easy to understand irrespective of the field in which one is working
4. Discounted Pay Back Period
The project takes years to implement. In between these years it may happen that the entity starts earnings that might result in cash inflows and these inflows reduce the amount of investment. Discounted Payback Period is the amount of time required to recover the cost of the investment made in the project. Here we add all positive discounted cash flows. The only advantage of Discounted Payback Period over payback period is that Discounted Payback Period considers time value of money whereas payback period does not consider time value of money. All those projects that have negative NPV will never have a Discounted Payback Period. Future cash flows are considered are discounted to time "zero."
5. Accounting Rate of Return
This is the amount or rate of return an investor can expect based on his/her investment made on the company. It divides the average profits earned by the company with the initial investments in order to get the rate of return in the project. This helps any investor to make a comparison the profit potential for projects, products and investments.
The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested (yearly). If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects.
ARR=Average Return during the period/Average Investment
Average Investment = Book value at the beginning of the year 1+ book value at the end of the useful life/2