Techniques Of Capital Budgeting

Write about the Techniques of Capital Budgeting for Business and Management.

 

	Project A	Project B
Cost	$     500,000.00	$  300,000.00
Profit/ Loss - Year 1	$     145,000.00	$   90,000.00
Profit/ Loss - Year 2	-$        5,000.00	-$   10,000.00
Profit/ Loss - Year 3	$        6,000.00	$   20,000.00
Estimated residual value	$       35,000.00	$   30,000.00
Adding Depreciation value back to cash-flow
Depreciation amount	$     465,000.00	$  270,000.00	( Cost - Estimated residual value )
Annual Depreciation	$     155,000.00	$   90,000.00	( Depreciation amount / No of years )
Cash-flow including depreciation			( Annual Profit or Loss + Annual Depreciation )
Year 1	$     300,000.00	$  180,000.00
Year 2	$     150,000.00	$   80,000.00
Year 3	$     161,000.00	$  110,000.00

Net Present Value

Total Cash flows A
Cost of Capital	10%				scrape
Year	0	1	2	3	3
Cash flow	-$     500,000.00	$  300,000.00	$  150,000.00	$  161,000.00	$       35,000.00
PV ( FV/(1+r)^n )	-$     500,000.00	$  272,727.27	$  123,966.94	$  120,961.68	$       26,296.02
NPV for Project A	$    43,951.92				( NPV = Sum of PV from Y0 to Y3 + Scrape )
Total Cash flows B
Cost of Capital	10%				scrape
Year	0	1	2	3	3
Cash flow	-$     300,000.00	$  180,000.00	$   80,000.00	$  110,000.00	$       30,000.00
PV ( FV/(1+r)^n )	-$     300,000.00	$  163,636.36	$   66,115.70	$   82,644.63	$       22,539.44
NPV for Project B	$    34,936.14				( NPV = Sum of PV from Y0 to Y3 + Scrape )

 

Internal rate of return

Total Cash-flows A
Cost of Capital	10%
Year	0	1	2	3
Cash-flow	-$     500,000.00	$  300,000.00	$  150,000.00	$  196,000.00
IRR for Project A	15.42%	(15.42% less cost of capital 10% = 5.42% profit)
Total Cash-flows B
Cost of Capital	10%
Year	0	1	2	3
Cash-flow	-$     300,000.00	$  180,000.00	$   80,000.00	$  140,000.00
IRR for Project B	16.93%	(16.93% less cost of capital 10% = 6.93% profit)

 

Payback Period

Total Cash-flows A
Cost of Capital	10%
Year	0	1	2	3
Cash-flow	-$     500,000.00	$  300,000.00	$  150,000.00	$  196,000.00
Cash Y1+Y2	$     450,000.00
Shortfall	-$      50,000.00				( The sum of Cash-flow + (Cash Y1+Y2) )
Cash Y3	$     196,000.00
Cash Monthly Y3	$       16,333.33	Cash Daily Y3	$        536.99
Months required	3.06	Days required	93.11
Payback Period A	2 years and 3.06 months or 2 years and 93 days
Total Cash-flows B
Cost of Capital	10%
Year	0	1	2	3
Cash-flow	-$     300,000.00	$  180,000.00	$   80,000.00	$  140,000.00
Cash Y1+Y2	$     260,000.00
Shortfall	-$      40,000.00
Cash Y3	$     140,000.00
Cash Monthly Y3	$       11,666.67	Cash Daily Y3	$        383.56
Month required	3.43	Days required	104.29
Payback Period B	2 years and 3.43 months or 2 years and 104 days

 

Profitability Index (PI)	( PI = NPV/investment outlay )
Project A	$0.09
Project B	$0.12

 

Optimal rate of return

Total Available funds		$     500,000.00
Total funds required to invest in both the projects		$     800,000.00
Shortage of funds		$     300,000.00
In case of shortage of funds, capital rationing can be applied in the following manner:
Firstly $ 300000 will be allocated to project B as it has higher profitability index than that of project A
Then, the remaining $ 200000 will be allocated to the project A as the nature of this project is divisible.
Initial Investment
Profit or Loss for the 3 years	-$     200,000.00
Year 1	$     120,000.00
Year 2	$       60,000.00
Year 3	$       64,400.00
Residual Value	$       14,000.00

 

New NPV of Project A

 

Total Cash-flows A
Cost of Capital	10%				Scrape
Year	0	1	2	3	3
Cash-flow after taking into account depreciation	-$     200,000.00	$  120,000.00	$   60,000.00	$   64,400.00	$       14,000.00
PV ( FV/(1+r)^n )	-$     200,000.00	$  109,090.91	$   49,586.78	$   48,384.67	$       10,518.41
NPV for Project A	$    17,580.77				( NPV = Sum of PV from Y0 to Y3 + Scrape )
NPV for Project B	$    34,936.14
Optimal Return on Investment	NPV of Project (A+B)
	Total initial investment in Project (A+B)
	$       52,516.90
	$     500,000.00
Optimal Rate of Return on Investment	10.5%

Note: All the cash flows, after considering depreciation effect, of years 1, 2 and 3 are calculated on the basis of investment of $ 200000 as only this much amount of investment is available for project B.

Application of different capital budgeting techniques has allowed us to state that Project A is better than project B in NPV terms as the former has higher NPV. Payback period is the period which is taken by a project to cover its initial investment. Project A has a payback period of 2 years 93 days whereas that of Project B is 2 years 110 days. The payback period of both the projects is nearly similar with a slight difference of 11 days. However, it must not be chosen as the criteria to select a project because this technique does not take into account the cash flows after the payback period. The IRR of project B is 16.93% and project A is 15.42%. Higher IRR is the indication of effectiveness of project B as it signifies more chances of higher growth of project as at this level the project incurs no loss and no profits. Also, profitability index shows the quantum of value created by the project for every unit of initial investment. Project B are higher than those results of Project A. As a project manager, I would have chosen Project B since it more beneficial in terms of IRR and PI. The application of different techniques of capital budgeting has proved that it is not necessary that a project that is favourable as per the results of one technique will be favourable as per the other techniques of capital budgeting (Ryan & Ryan, 2002).  

Yes, it is correct to say that all the shareholders whether small or larger ones are treated equally in the eyes of law except the fact that bigger shareholders have higher voting rights. All the shareholders are provided equal rate of returns by way of dividend, irrespective of the fact that how many shares are held by them. For example, if a shareholder of the company is holding only 20 shares and the other shareholder is holding 500 shares. Now, if the company declares the dividend at 14 %, then all the shareholders will be given a dividend per share at 14% of the face value of the shares held by them. However, corporate law states that for each share, there is one voting rights. This shows that all the shareholders whether small or bigger ones have equal voting right per shares. But, whenever a decision is to be taken in the company the voting rights of large shareholders will prevail over small shareholders as the former will have more voting rights because of more number of shares held by them (Wong, 2013).

There are various sources of finance available to a company. But majorly finance is raised either through the issue of equity shares or preference shares or banks loans or through the issuance of debentures or bonds (Beck, Levine & Loayza, 2000). With each source of finance, there are some qualities attached like equity shareholders of the company are its owners whereas banks or debenture-holders are the lenders of the company who charge interest in consideration of provision of debt financing to the company. However, the preference shareholders of the company are hybrid natured as they are neither the pure owners nor the pure lenders of debt to the company (Beck, Demirgüç-Kunt, & Maksimovic, 2008). They enjoy preference of dividend over the equity shareholders of the company as they are offered the dividend firstly and in case if there remains any surplus after payment of preference dividend, then only equity shareholders are entitled to the dividend. Also, since equity shareholders obtain ownership of the company they have the privilege to participate in the important business matters through their voting rights so that they can satisfy themselves about the functioning of company.

Internal rate of return is one of key technique used while making capital budgeting related decisions. It is the important metric that is applied to determine whether to invest funds and other resources in a particular investment or not (Management Study Guide, 2018). Calculation of IRR requires taking into consideration the concept of money’s time value. Also, the total cash flows that the project is going to generate are considered by it. The results obtained under this technique are sophisticated and realistic in nature but it suffers from certain limitations and pitfalls which will be discussed further.

The mathematical formula that is used to calculate IRR is quite complex and not every time it provides the correct and realistic answers. In various cases, the IRR calculation actually ends up offering multiple rates due to the pattern of cash flows occurred in such situations. Therefore, in those cases results for IRR comes out multiple rates instead of one particular rate that can be used and analysed by the project manager to understand the project’s feasibility. At times, IRR comes out as negative which indicates that the project firm is actually losing its value. However, in the practical world it is not possible. In cases where cash flows varies on both positive and negative sides with the change in time, application of IRR method to select a capital project, leads to incorrect decisions. In such cases Net present Value technique of capital budgeting proves to be correct as it provides better results even in the case of changes in the pattern of project’s cash flows (Management Study Guide, 2018).

 IRR takes into account the Time Value of Money (TVM) and the concept of TVM tell that there are different cost of capital that keeps on changing because of increase in the number of project years. To use the method of IRR in such cases, a project manager must either use IRR and the discounting rate factors at such rate for each year or they can compute a weighted average IRR to take project decisions. However, in either ways, the calculation becomes hassle and also the interpretation of outcomes of IRR gets tough. Use of NPV is quite easier in such cases as it takes into account all the cash flows throughout the project life and on the basis of their present values, provides the final outcome that is used to determine the project feasibility (Bennouna, K., Meredith & Marchant, 2010).

At IRR, NPV of the project is zero and NPV calculates the amount that will be added to the shareholder’s wealth if the project is accepted. IRR method doesn’t understand the value of economies of scale and therefore it neglects the project’s dollar value. If two projects have identical IRR but different dollar values, IRR would not differentiate between those two projects and that often leads to the wrong decisions by the project manager and ultimately it affects the profitability of project that in turn affects the returns of project’s shareholders. However, NPV offers results in absolute dollar terms therefore it enables the managers to undertake the decisions that positively contributes to enhancement of shareholder’s wealth (Finance Management, 2018). 

Beck, T., Demirgüç-Kunt, A., & Maksimovic, V. (2008). Financing patterns around the world: Are small firms different?. Journal of Financial Economics, 89(3), 467-487.

Beck, T., Levine, R., & Loayza, N. (2000). Finance and the Sources of Growth. Journal of financial economics, 58(1-2), 261-300.

Bennouna, K., Meredith, G. G., & Marchant, T. (2010). Improved capital budgeting decision making: evidence from Canada. Management decision, 48(2), 225-247.

Finance Management. (2018). Why Net Present Value is the Best Measure for Investment Appraisal? Retrieved from: https://efinancemanagement.com/investment-decisions/why-net-present-value-is-the-best-measure-for-investment-appraisal

Management Study Guide. (2018). Problems With Using Internal Rate of Return (IRR) for Investment Decision Making. Retrieved from: https://www.managementstudyguide.com/problems-with-using-internal-rate-of-return.htm

Management Study Guide. (2018). What is Internal Rate of Return (IRR) ? Retrieved from:  https://www.managementstudyguide.com/internal-rate-of-return.htm

Ryan, P. A., & Ryan, G. P. (2002). Capital budgeting practices of the Fortune 1000: how have things changed. Journal of business and management, 8(4), 355-364.

Wong., S. (2013). Rethinking “One Share, One Vote”. Retrieved from: https://hbr.org/2013/01/rethinking-one-share-one-vote.