Capital Budgeting
The projects that a firm intends to invest in have to be evaluated to determine their profitability. Capital budgeting is the selection of projects that enhance a firm’s profitability. Numerous approaches are used to determine the most suitable projects to invest in. These include the net present value, payback period, accounting rate of return, profitability index, internal rate of return, discounted payback and modified internal rate of return. This discussion explores the advantages and disadvantages of the various methods of capital budgeting to determine the most effective techniques to assess the viability of projects.
Net Present Value
Net Present Value (NPV) is a capital budgeting technique used in determining the current value of investments. NPV is the difference between the current cash outflow value and cash inflow value. NPV compares the present and future value of a dollar while taking returns and inflation into consideration (Chadwell-Hatfield, Goitein, Horvath & Webster, 2011). A positive NPV implies that the project should be undertaken while a negative NPV indicates that there will be negative cash flows and therefore, it is best to reject the project. The NPV is considered to be a suitable technique in capital budgeting since it considers the time and risk variables. Therefore, it is very popular in many organizations (Chen, 2012). One of the strengths of NPV is that calculating its value is straightforward. Moreover, there is consistency between the acceptance criteria and the wealth maximization of the shareholder. The number resulting from the evaluation using the NPV technique is also easy to interpret as it indicates the changes that the wealth will go through after the acceptance of the project. NPV also accounts for the time value of money by assuming that dollars received today are more valuable than those received after one year. Future cash flow risk is also recognized.
However, NPV has some weaknesses. This method fails to provide the visibility of how long it will take for the generation of a positive NPV of the project. The NPV method requires firms to accept investments with a NPV, which is higher than zero, but it is not clear after how many years a positive NPV can be achieved. Using the NPV method also requires sufficient finance knowledge to make cash flow estimates (Parrino, Kidwell & Bates, 2012). Moreover, the firm can choose a wrong project if the NPV analysis is not done correctly. The NPV method also assumes that capital rationing does not exist. Therefore, this method is not suitable if the resources are scarce (Gupta & Mohanty, 2012).
Profitability Index
Profitability Index (PI) refers to the investment to payoff ratio of a proposed project. PI is calculated by dividing the current value of future cash flows by the initial investment. The profitability index of a project costing $40 million and is projected to produce future net cash flows whose current value is $70 million is 1.75. PI is different from NPV as it provides the figures as ratios while NPV provides dollar figures. The NPV for this project would be calculated by subtracting $40 million from $70 million to get $30 million. Projects with a PI of over 1 are accepted while those below 1 are rejected (Chadwell-Hatfield et al., 2011)
One of the strengths of this method is that it is easy to interpret the PI number since it shows the number of dollars per the invested dollars. Furthermore, there is consistency in the acceptance criteria and shareholder wealth maximization. This method is also useful during capital rationing and calculating PI is straightforward. However, it is not possible to use PI if there is inflow in the initial cash flow. Moreover, there is need for adjustment of the PI method in the case of projects that are mutually exclusive (Gupta & Mohanty, 2012). Financial knowledge is also required in order to use PI.
Internal Rate of Return
Internal Rate of Return (IRR) is another capital budgeting technique which refers to the expected growth rate of a project. A project with a higher estimated IRR has a better chance of growing at a high rate. IRR is the expected rate of return on an investment. It is the most common and popular method because it is easily comparable to other expected returns such as bonds. A project is accepted if the IRR is higher than the minimum rate of return of the project (Baker, Dutta & Saadi, 2011). One of the advantages of IRR is the ease of interpretation as it shows the amount generated by the project. Time value of money is also considered in this method. Moreover, its acceptance criteria and shareholder health maximization are consistent. This method is suitable even during capital rationing. IRR provides reliable guidance if used properly to assess projects and is very popular.
One of the shortcomings of this method is that it is very difficult to calculate the IRR and a financial calculator is needed (Parrino et al., 2012). Moreover, knowledge of finance is necessary to calculate IRR. Another problem with the IRR method is that one project might have several IRRs or none, and this requires the adjustment of the IRR analysis so as to come up with the correct decision. The IRR method is difficult to use in projects whose discount rate is different every year. Unlike in the NPVs, it is not possible to add IRRs together and this requires the combination of projects or evaluating them on an incremental basis (Chadwell-Hatfield et al., 2011).
Modified Internal Rate of Return
The Modified Internal Rate of Return (MIRR) method aims at overcoming the disadvantages of the IRR technique. The assumption made in the IRR method is that cash flows are reinvested at the project’s IRR. In the MIRR, it is assumed that reinvestment of cash flows occurs at the cost of capital of the firm and the financing of the initial outlays is done at the financing cost of the firm (Parrino et al., 2012). MIRR is considered to be more accurate than IRR in reflecting the profitability and cost of projects. MIRR is more realistic in evaluating projects than IRR. MIRR is not a very popular method and NPV and IRR are more commonly used.
One advantage of the MIRR technique is that it is not as rigid as the IRR. It also enables firms to know whether there is an increase in the value of an investment (Baker et al., 2011). MIRR also considers the time value of money, future cash flow risks and project cash flows. One of the disadvantages of this method is that there is a need to adjust some MIRR techniques in order for them to be applicable in real-world organizations. Adjustments are necessary when the choices produced by the MIRR method do not maximize value (Gupta & Mohanty, 2012).
Payback
Payback (PB) is another method which is used by several companies. This method is very popular among organizations, especially in Europe (Chen, 2012). Payback period refers to the amount of time within which an investment can be recovered. A project is adopted if its PB period is less than the projected period. Organizations should not use this method as it does not provide an accurate analysis of the project viability. PB is calculated by dividing the initial investment by the annual average cash inflow. For example, the payback period of $40,000 at an annual rate of $5,000 is eight years. The PB method is simple to use. Moreover, project cash flows are used in this method. PB also favors short-term projects whose return of capital is rapid (Parrino et al., 2012).
One of the disadvantages of the method is that PB does not put into consideration the time value of money in the payback period (Parrino et al., 2012). Moreover, PB does not consider the cash inflow occurring after the payback period is over. The PB method does not put risk into consideration. Another disadvantage is that the payback cutoffs are determined arbitrarily (Gupta & Mohanty, 2012). This method should not be used by organizations as it gives an inaccurate analysis.
Discounted Payback
The Discounted Payback (DPB) technique is an improvement of the PB method. DPB takes into account the time value of money (Parrino et al., 2012). This enables the calculation of the amount of time it will take to recover the investment on a discounted basis. Viable projects are those with short payback periods. This method focuses more on profitability. One of the advantages of the DPB is it solves the shortcomings of PB by taking the time value of money into consideration. The firm is able to know how long it will take to achieve a NPV of zero (Parrino et al., 2012). Furthermore, DPB is easy to calculate and understand. However, it still has the other weaknesses of the PB method. DPB does not consider the cash inflow occurring after the payback period is over (Parrino et al., 2012). Moreover, the DPB method does not put risk into consideration and the payback cutoffs are determined arbitrarily (Acharya, Gottschalg, Hahn & Kehoe, 2013). Furthermore, it is necessary to estimate the capital before calculating the payback.
Accounting Rate of Return
Accounting Rate of Return (ARR) refers to the ratio of a project’s estimated accounting profit to the project’s average investment. The project estimated accounting profit is divided by its average investment in order to get the ARR (Chadwell-Hatfield et al., 2011). This is one of the least popular methods as it is not effective in correctly determining the viability of investments. An advantage of the ARR technique is that it measures a project’s profitability and is also easy to compute and understand. However, this method is very flawed and should not be used by organizations. ARR is not an effective method because cash flow is not taken into consideration. The time value of money is also ignored in this technique (Parrino et al., 2012). Moreover, there is no adjustment for risk while using this method. ARR also has no specified rate of return determined by the market. The project’s terminal value is also not considered by the ARR method.
Conclusion
This discussion has evaluated the various methods used to assess a project’s viability before investment and it is evident that each technique has both strengths and shortcomings. The NPV, PB and IRR are some of the most popular techniques used in organizations. On the other hand, PB and ARR are seriously flawed and should not be used by organizations to assess projects. No single method is perfect and organizations have to weigh them and choose one or a combination of methods that is most suited to their needs.
References
Acharya, V. V., Gottschalg, O. F., Hahn, M., & Kehoe, C. (2013). Corporate governance and value creation: Evidence from private equity. Review of Financial Studies, 26(2), 368-402.
Baker, H., Dutta, S., & Saadi, S. (2011). Corporate Finance Practices in Canada: Where Do We Stand? Multinational Finance Journal, 15(3/4), 157-192.
Chadwell-Hatfield, P., Goitein, B., Horvath, P., & Webster, A. (2011). Financial criteria, capital budgeting techniques, and risk analysis of manufacturing firms. Journal of Applied Business Research, 13(1), 95-104.
Chen, J. (2012). Adding Flexibility for NPV Method in Capital Budgeting. Global Conference on Business & Finance Proceedings, 7(2), 49-56.
Gupta, D., & Mohanty, R. P. (2012). Critical evaluation of capital budgeting techniques. International Journal of Accounting and Finance, 3(4), 308-319.
Parrino, R, Kidwell, D & Bates, T. (2012). Fundamentals of Corporate Finance. (2nd ed.). Hoboken, NJ: John Wiley & Sons.
