Appraisal Criteria – Capital Budgeting. Batch 2013 – 2016 :2 nd Sem MMM / MFM SIMSR. Classification. Evaluation Criteria. Non discounting Criteria. Discounting Criteria. Internal Rate Of Return(IRR). Pay Back Period. Net Present Value(NPV). Accounting Rate of Return (ARR).
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Appraisal Criteria – Capital Budgeting
Batch 2013 – 2016 :2ndSemMMM / MFMSIMSR
Non discounting Criteria
Pay Back Period
BCR / NBCR
It measures the length of time required to recover the initial outlay in the project.
Eg: If a project with a life of 5 years involves an initial outlay of Rs.20 lakh and is expected to generate a constant annual inflow of Rs.8 lakh, the payback period of the project =20/8 =2.5 yrs.
Eg: On the other hand if the project is expected to generate annual inflows of, say Rs.4 lakh, Rs.6 lakh, Rs.10 lakh, Rs.12 lakh and Rs.14 lakh over the 5 year period the pay back period will be equal to 3 yrs because the sum of the cash inflows over the first three years is equal to the initial outlay.
In order to use the payback period as a decision rule for accepting or rejecting the projects, the firm has to decide upon an appropriate cut –off period. Projects with pay back periods less than or equal to the cut –off period will be accepted and others will be rejected.
risky projects by favoring only
those projects which generate substantial
To incorporate the time value of money in the calculation of pay back period some firms compute Discounted Pay Back Period.
These firms discount the cash flows before they compute the pay back period.
Eg: If a project involves an initial outlay of Rs.10 lakh and is expected to generate a net annual inflow of Rs.4 lakh for the next 4 yrs……….. Calculate the discounted pay back period represented by n no. of yrs……
Assuming the cost of funds to be 12%
Equation (1) can be re-written as
From PVIFA Tables, we find that
PVIFA(12,3) = 2.402
PVIFA (12,4) =3.037
Therefore ‘n’ lies between 3 and 4 and is approximately equal to 3.15 yrs
n =3+(4-3) *(2.500-2.402)
= 3.15 yrs
But… still this mechanism has a shortcoming…….. As it depends on the choice of an arbitrary cut –off date and ignore all cash flows after that date. In practice, companies do not give much importance to the payback period as an appraisal criteria.
ARR = Avg Profit after Tax
Avg book value of the investments
To use it as an appraisal criterion, the ARR of a project is compared with the ARR of the firm as a whole or against some external yard –stick like the average rate of return for the industry as a whole.
Average investments = Net working capita + salvage value+ ½ [ initial cost of machine – Salvage Value]
Avg annual income =
Avg net book value of investment
= 0 + (90000- 0) /2
ARR = (20000) /(45000) *100
The firm will accept the project if its target avg rate of return is above 44 %
The Net Present Value is equal to the present value of future cash flows and any immediate cash outflows.
In case of a project, the immediate cash flow will be investment (cash outflow) and the net present value will be therefore equal to the present value of future cash inflows minus the initial investment.
Q) Sandals inc. is considering the purchase of a new leather cutting machine to replace an existing machine that has a book value of Rs.3,000 and can be sold for Rs.1,500. The estimated salvage value of the old machine in four years would be zero, and it is depreciated on a straight line basis. The new machine will reduce costs (before tax) by Rs.7,000 per year, i.e., Rs.7,000 cash savings over the old machine. The new machine has a four year life, costs Rs.14,000 and can be sold for an expected amount of Rs.2,000 at the end of the fourth year. Assuming straight –line depreciation, and a 40% tax rate, define the cash flows associated with the investment. (assume straight line method of depreciation for tax purposes)
Computation of depreciation:
Existing leather –cutting machine
Rs.3,000/4= Rs.750 pa
New leather –cutting machine
Rs.12,000/4= Rs.3,000 pa
Incremental depreciation = Rs.2,250 pa
NPV = Rs.[-12,500+(4554+4065+3631+4516)]
= Rs[.-12500 +16766]
A project will be accepted if its NPV is positive and rejected if its NPV is negative
What if the NPV works out to be exactly zero???
It it happens, theoretically speaking the decision –maker is
supposed to be indifferent between accepting or rejecting
the project. But in practice, NPV in the neighborhood of zero
calls for a close review of the projections made in respect of
such parameters that are critical to the viability of such
marginally viable projects.
executives and business
men find ‘ Rate on Capital
Employee's or ‘ Average
Rate of Return’ easy to interpret compared to
absolute values like the NPV
time value of money
flow stream entirely
with the objectives of
investment decision making
viz., maximization of shareholder’s wealth
The benefit cost ( or the profitability Index) is defined as follows:
BCR = PV/ I
PV – present value of future cash flows
I – Initial Investment
NBCR, net benefit cost ratio is defined as:
NBCR = NPV /I
= (PV –I)/I
= (PV/I) –1
= BCR -1
Ans ) BCR = 16766/12500 =1.34
NBCR = 4266/12500 =0.34
If Decision Rule
BCR >1(NBCR>0) Accept the project
BCR<1(NBCR<0) Reject the project
Since the BCR measures the present value per rupee of outlay,it is considered to be a useful criterion for ranking a set of projects in the order of decreasingly efficient use of capital
Zeta Ltd is considering 4 projects – A , B C and D with the following characteristics
The funds available for investment are limited to Rs.20 lakh
and the cost of funds to the firm is 14%. Rank the 4 project(s) in terms of the NPV and BCR criteria.Which project(s) will you recommend given the limited supply of funds?
The NPVs of the 4 projects are as follows:
The BCR of the 4 projects are as follows:
Based on the NPV and BCR criteria, all 4 projects are acceptable as both NPV and BCR are positive.
But what if all the 4 projects need to be taken by the firm?
It can not be due to limited availability of funds.
either Zeta has to accept project A or a package consisting
of projects B, C and D but not both.
The decision will depend upon which option maximizes the shareholder’s wealth. In this sort of a decision –making situation, the BCR becomes inapplicable because there is no way by which we can aggregate the BCRs of the projects B, C and D.
On the other hand NPVs of projects B, C and D can be aggregated and compared with the NPV of project A to arrive at a decision.
The internal rate of return is that rate of interest at which the net present value of a project is equal to zero, or in other words, it is the rate which equates the present value of the cash inflows to the present value of the cash outflows.
While under the NPV method the rate of discounting is known (the firm’s cost of capital) under IRR this rate which makes NPV zero has to be found out
A project has the following pattern of cash flows:
What is the IRR of this project?
Find the average annual net cash flow based on the given future net cash flows.In our eg. it turns out to be
Divide the initial outlay by the average annual net cash flow ie, 10/3.57 =2.801
From the PVIFA table find that the interest rate at which the PVIFA of Re 1 will be nearly equal to 2.801 in 4 yrs ie, the duration of the project ( remember this is only a hint for finding the IRR, which actually needs to be found out by hit and trial method)
+(1.2*0.572) = 0.84
+(1.2*0.516) = 0.33
+(1.2*0.482) = 0
We find that at r=20%, the NPV is zero and therefore the IRR of the project is 20%
To use IRR as an appraisal criterion, we require information on the ‘ cost of capital or funds employed’ in the project.
If we define IRR as ‘r’ and cost of funds employed as ‘k’,then the decision rule based on IRR will be:
Accept the project if r> k
Reject the project if r< k
If r=k, it is a matter of indifference
In spite of these defects, IRR is still the best criterion today to appraise a project financially. Financial Institutions insist that projects having substantial outlay specially in the medium and large scale sectors must show the computation of IRR in the Detailed Project Report (DPR), which they appraise before sanctioning financial assistance.
Determine the present value of the initial investment and operating costs using the cost of capital(k) as the discount rate.
Divide the present value by PVIFA(k,n) where ‘n’ represents the life span of the project. The quotient is defined as the annual capital charge or the equivalent annual cost.
Once the annual capital charge for the various alternatives are defined, the alternative which has the minimum annual capital charge is selected
Calculate the annual capital charge associated with these
two systems,if the cost of capital is 12%. ( You can assume
that the net salvage values of the two system at the end of
their economic lives will be zero.
Present value of costs associated with system A
Annual capital charge associated with system A
= 17,24,900/ [PVIFA(12,7)] = Rs.3,77,936
Present value of costs associated with system B
Annual capital charge associated with system B
= 11,77,855 / [PVIFA(12,5)] = Rs.3,26,728
Since the annual capital charge associated with system B is lower than that of system A , system B is preferred.
A wide variety of measures are used in practice for appraising investments. But whatever method is used, the appraisal must be carried out in explicit, well defined , preferably standardized terms and should be based on sound economic logic.