The appraisal methods enable an organization to evaluate objectively the cost of implementing a project (or investment) and the returns that could be earned from the project (or investment).
In this way, the appraisal methods help organizations to choose the most profitable and feasible project from a pool of numerous projects. Selection of right project is highly critical for the financial well-being of any organization. The organization has to make huge investment at the beginning in order to get good return over a long period of time. Poor appraisal of any project may lead under-investment (which results in underutilization of organization’s resources leading to decline in market position) or over-investment (which causes excessive strain on organization’s resources, expenses exceed the income).
CAPITAL BUDGETING TECHNIQUES / METHODS
There are different methods adopted for capital budgeting. The traditional methods or non discount methods include: Payback period and Accounting rate of return method. The discounted cash flow method includes the NPV method, profitability index method and IRR.
(I) PAYBACK PERIOD METHOD
As the name suggests, this method refers to the period in which the proposal will generate cash to recover the initial investment made. It purely emphasizes on the cash inflows, economic life of the project and the investment made in the project, with no consideration to time value of money. Through this method selection of a proposal is based on the earning capacity of the project.
Payback period = Cash outlay (investment) / Annual cash inflow
With simple calculations, selection or rejection of the project can be done, with results that will help gauge the risks involved. However, as the method is based on thumb rule, it does not consider the importance of time value of money and so the relevant dimensions of profitability.
(II) ACCOUNTING RATE OF RETURN METHOD (ARR)
This method helps to overcome the disadvantages of the payback period method. The rate of return is expressed as a percentage of the earnings of the investment in a particular project. It works on the criteria that any project having ARR higher than the minimum rate established by the management will be considered and those below the predetermined rate are rejected.
ARR= Average income/Average Investment
This method takes into account the entire economic life of a project providing a better means of comparison. It also ensures compensation of expected profitability of projects through the concept of net earnings. However, this method also ignores time value of money and doesn’t consider the length of life of the projects. Also it is not consistent with the firm’s objective of maximizing the market value of shares.
(III) NET PRESENT VALUE (NPV) METHOD
This is one of the widely used methods for evaluating capital investment proposals. In this technique the cash inflow that is expected at different periods of time is discounted at a particular rate. The present values of the cash inflow are compared to the original investment. If the difference between them is positive (+) then it is accepted or otherwise rejected. This method considers the time value of money and is consistent with the objective of maximizing profits for the owners. However, understanding the concept of cost of capital is not an easy task.
NPV = PVB – PV
PVB = Present value of benefits
PVC = Present value of Costs
(IV) PROFITABILITY INDEX (PI)
It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one. The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows.
PI = PV cash inflows/Initial cash outlay
(V) INTERNAL RATE OF RETURN (IRR)
This is defined as the rate at which the net present value of the investment is zero. The discounted cash inflow is equal to the discounted cash outflow. This method also considers time value of money. It tries to arrive to a rate of interest at which funds invested in the project could be repaid out of the cash inflows. However, computation of IRR is a tedious task.
It is called internal rate because it depends solely on the outlay and proceeds associated with the project and not any rate determined outside the investment.
If IRR > WACC then the project is profitable.
If IRR > k = accept
If IR < k = reject