Capital Budgeting

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- AVERAGE RATE OF RETURN

Average rate of return means the average rate of return or profit taken for considering the project evaluation. This method is one of the traditional methods for evaluating the project proposals

MERITS

- It is easy to calculate and simple to understand.

- It is based on the accounting information rather than cash inflow.

- It is not based on the time value of money.

- It considers the total benefits associated with the project.

DEMERITS

- It ignores the time value of money.

- It ignores the reinvestment potential of a project.

ACCEPT / REJECT CRITERIA

If the actual accounting rate of return is more than the predetermined required rate of return, the project would be accepted. If not it would be rejected.

- PROFITIBILITY INDEX

It is also a time adjusted method of evaluating investment proposal. Profitability index also called as Benefit- Cost ratio or desirability factor is relationship between present value of cash inflow and the present value of cash outflow.

MERITS

- It is consistent with goal of maximizing the shareholders wealth.

- It uses cash flow.

- It recognized the time value of money.

DEMERITS

- The main demerit of this method is that is requires detailed long term forecast of incremental benefits and costs.

- It also have the difficulty in determining appropriate discount rate.

- NET PRESENT VALUE

The Net Present Value or NPV is a discounting technique of capital budgeting wherein the profitability of investment is measured through the difference between the cash inflows generated out of the cash outflows or the investments made in the project.

The formula to calculate the Net Present value is:

Net present value = n∑t=1 Ct / (1+r)t – C0

Where, Ct = cash inflow at the end of year t

n= life of the project

r= discount rate or the cost of capital

Co= cash outflow

ACCEPT/REJECT CRITERIA: If the NPV is positive, the project is accepted.

MERITS OF NET PRESENT VALUE

- It takes into consideration the Time Value of Money.

- It measures the profitability of the entire project by considering the profits throughout its life.

- It is easy to alter the discount rate, by just changing the value of the denominator.

- This method is particularly suitable for the mutually exclusive projects.

- It is consistent with the objective of maximizing the net wealth of the company.

DEMERITS OF NET PRESENT VALUE

- The forecasting of cash flows is difficult because of several uncertainties involved in the operations of the firm.

- It is difficult to compute the discount rate precisely. And this is one of the crucial factors in the computation of net present value as with the change in the discount factor the NPV results also changes.

- Another problem is that it is an absolute measure, it accepts or rejects the projects only on the basis of its higher value irrespective of the cost of initial outlay.

- Thus, to compute the Net Present value, a firm should determine the cash inflows and the outflows along with the discount rate or a rate of return that firm desires during the lifetime of the project.

- INTERNAL RATE OF RETURN

The Internal Rate of Return or IRR is a rate that makes the net present value of any project equal to zero. In other words, the interest rate that equates the present value of cash inflow with the present value of cash outflow of any project is called as Internal Rate of Return.

Unlike the Net present value method where we assume that the discount rate is known, in the case of internal rate of return method, we put the value of NPV zero and then find out the discount rate that satisfies this condition.

The formula to calculate IRR is:

CFo = n∑t=1 Ct / (1+r)t

Where,

CFo = Investment

Ct = Cash flow at the end of year t

r = internal rate of return

n= life of the project

ACCEPT/REJECT CRITERIA

If the project’s internal rate of return is greater than the firm’s cost of capital, accept the proposal.

- MODIFIED INTERNAL RATE OF RETURN

The Modified Internal Rate of Return or MIRR is a distinct improvement over the internal rate of return that assumes the cash flows generated from the project are reinvested at the firm’s cost of capital rather that at the company’s internal rate of return.

The formula to calculate the Modified Internal Rate of Return is:

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Where, n= no. of periods

Terminal value is the future net cash inflows that are reinvested at the cost of capital.

ACCEPT-REJECT CRITERIA

If the project’s MIRR is greater than the firm’s cost of capital, accept the proposal.