In my opinion, this is the most important chapter in the book. The information i
ID: 2574812 • Letter: I
Question
In my opinion, this is the most important chapter in the book. The information is critical to the success of business undertakings and is an important part of the study of Finance as well as Accounting. The book discusses a number of capital budgeting methods, net present value, internal rate of return, payback period, profitability index, and the simple rate of return. Why are so many used? They share similarities and differences - like what? Is one better than the others? Which one? Please explain why? Are there other methods not discussed?
Explanation / Answer
There are various method under the capital budgeting techniques which help the investor to take the right financicing decision. The same can be divided into traditional i.e non-time adjusted techniques & other the time adjusted (discounted cash flows).
Time Adjusted techniques are as below:
A) Net Present VAlue Method -NPV method helps in acheiving the objective of maximisation of the shareholder's wealth. The rationale behind this contention is the effect on the market price of the shares as a result of acceptance of a proposal having present value more than Zero. When NPV=0, the return on investment (IRR) just equals the expected rate of return by investors. There would therefore be no change in the market price of the shares. When NPV>0, the return on investment (IRR) would be higher than the return expected by the investor. It would therefore lead to increase in share price.
IRR Method: In case of NPV method, the discount rate is the required rate of return, usually the cost of capital, its determination is external to the proposal under consideration. The IRR on the other hand is based on the facts which are internal to the proposal i.e cash otflows & cash inflows from the project being evaluated. The IRR is usually the rate of return that a project earns. It is a discount rate which equates the PV of Cash inflows with PV of cash outflows.
If IRR> the cost of capital the project may be accepted. If NPV>0, the IRR will be greater than the cost of capital.
The NPV and IRR gives the same result in case of conventional & independent investment projects, but may give contradictory results in case of mutually exclusive investment projects (disparity in investment size, time disparity of cash flows, project with unequal lives). The IRR method is not compatiable with the goal of wealth maximisation. Hence, NPV method is preferred. In case of projects with unequal lives, Annualised NPV method is more appropriate.
Profitability Index: A major shortcoming of NPV method is that being an absolute measure it is not reliable to evalute projects with different initial investments. The Profitability Index measures the present value of Return per dollar of investment. if PI >1, the project is accepted. The NPV and PI gives contradictory results in case of mutually exclusive projects. The NPV technique is superior to PI because the best project is one which add most to the shareholder's wealth. The PI technique is better than NPV in case of situation of capital rationing as it evalutes the worth of the project in terms of rgeir relative rather than absolute magnitude.
The traditional techniques are:
a) Acounting rate of return (ARR)=Average Accounting profit after tax/ Average investment over the life of the project. If ARR>cost of capital project may be taken up.
b) Pay back period.; it measures the time period required for the cash benefits to payback original outlay rquired in a investment proposal. If PB < the predetrmined PB period set-up by the management, the project may be taken-up. In case of mutually exclusive projects, project with shorter PB period may be selected. The method may be appropriate for firms suffering from liquidity crisis. THe PB period is a measure of liquidity of investments rather than their profitability. the major disadvantage is that it completely ignores the cashfloes after the pay-back period.
Other method could be Terminal Value Method. Under IRR, it is assumed that all incremental cash floes are reinvested at the same IRR, whioch may not be a correct asumption. Also NPV compuation does not explicitly shaow all the cash inflows as it does not take into account cash inflows in respect of interest earnings on returns. The terminal value method takes care of this aspect, howver the major problem in this method lies in projecting the future rate of interest at which the intermediatory cash infloes received will be re-invested.
Hence, from the above it is evident that each method has its own merits in different circumstances.
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