CAPITAL AND CAPITAL BUDGETING
Capital and Capital Budgeting: Nature and its significance-Types of Capital - Sources of raising
capital. Capital budgeting-Significance –Process- Techniques of Capital Budgeting (nondiscounted cash flow techniques and discounted cash flow of techniques).
Introduction
Finance is the prerequisite to commence and vary on business. It is rightly said to be the lifeblood of the business. No growth and expansion of business can take place without sufficient finance. It shows that no business activity is possible without finance. This is why; every business has to make plans regarding acquisition and utilization of funds.
However efficient a firm may be in terms of production as well as marketing if it ignores the proper management of flow of funds it certainly lands in financial crunch and the very survival of the firm would be at a stake.
Function of finance
According to B. O. Wheeler, Financial Management is concerned with the acquisition and utilization of capital funds in meeting the financial needs and overall objectives of a business enterprise. Thus the primary function of finance is to acquire capital funds and put them for proper utilization, with which the firm’s objectives are fulfilled. The firm should be able to procure sufficient funds on reasonable terms and conditions and should exercise proper control in applying them in order to earn a good rate of return, which in turn allows the firm to reward the sources of funds reasonably, and leaves the firm with good surplus to grow further. These activities viz. financing, investing and dividend payment are not sequential they are performed simultaneously and continuously. Thus, the Financial Management can be broken down in to three major decisions or functions of finance. They are: (i) the investment decision, (ii) the financing decision and (iii) the dividend policy decision.
CAPITAL AND IT’S SIGNIFICANCE:
Capital forms the base for the business. Capital in general does not mean only money. It may refer to money’s worth also.
Capital has different forms, creativity, innovation or new ideas can be considered as one form of capital.
Example: some people have money but they may not have idea, there are some are who have idea but they do not have money. The ideal combination of both money and idea is required to business.
Definition of capital:
“Capital is the total amount of finances required by the business to conduct its business operation both in short and long term periods”
“Capital is defined as wealth, which is created over a period of time through abstinence to spend.”
“Capital is aggregate of funds used in short term and long term.”
Significance of capital in Business:
To pay taxes
Need for capital
To businessa
To conduct business operation
To expand and DIversify
To meet contingencies
To pay taxes
To pay dividends and intetrests
To replace the asset
To support welfare programes
NEED FOR CAPITAL
NEED FOR CAPITAL:
To promote a business:
capital is required at the promotion stage .a large variety of expenses have to be incurred on project reports ,feasibilities studies and reports, preparation and filling of various documents and for meeting various other expenses in connection with the raising of capital from the public.
To conduct Business operations smoothly:
Business firms also need capital for the purpose of conducting their business operations such as R&D, Advertising, Sales and promotion, Distribution and operating expenses.
To Expand and Diversify:
The firm requires a lot capital for expansion and diversification purpose. This includes development expenses such as purchase of sophisticated machinery and equipment and also payment towards sophisticated technology.
To Meet Contingencies:
A firm needs funds to meet contingencies like sudden fall in sales ,major litigation, natural calamities like fire and so on.
To pay dividends and interests:
The firm has to meet payment towards dividends and its interest to share holders and financial institution respectively.
To pay taxes:
The firm has to meet its statutory commitments such as income tax and sales tax and excise duty.
To replace the asset:
The business needs to replace its assets like plant and machinery after certain period of use. For this purpose the firm needs funds to make suitable replacement of assets in place of old and worn-out assets.
To support welfare activities:
The company may also have to take up social welfare programs such as literacy drive and health camps. It may have to donate charitable trusts, educational institutions or public services.
To wind up:
At the time of Winding up the company may need funds to meet the liquidation expanses.
TYPES OF CAPITAL:
Capital can broadly be divided into two types:
FIXED CAPITAL:
Fixed capital is the portion of capital which is invested in acquiring long term assets such as land and buildings, plant and machinery, furniture and fixtures and so on.
It provides the basic assets as for the business needs. These assets are not mean for resale they are intended to generate revenues.
Features of fixed capital:
PERMANENT IN NATURE:
Fixed capital is more or less permanent in nature. It is generally not withdrawn as long as the business carries on its business.
PROFIT GENERATION:
Fixed assets are the sources of profits but they can never generate profits by themselves .they stocks, cash, debtors to generate profits.
Low liquidity:
The fixed assets are cannot be converted into cash quickly.
Amount of fixed capital:
The amount of fixed capital of a company depends on number of factors such as size of the company, nature of business, method of production and so on.
Utilization for promotion and expansion:
The fixed capital is mostly needed at the time of promoting the company to purchase the fixed assets or at the time of expansion or modernization.
TYPES OF FIXED CAPITAL:
Types of fixed capital
Tangible fixed assets
Intangible fixed assets
Financial fixed assets
1.Tangible fixed assets: these are fixed items which can be seen and touched.
Example: land, building, machinery, motor vehicles, furniture etc..
2. Intangible fixed assets: These do not have physical form. They cannot be seen or touched. But these are very valuable to business.
Example: good will, brand name, trade mark, patents, copy rights
3. Financial fixed assets: These are investments in shares, foreign currencies, deposits, government bonds, and shares held by the business in others companies and so on.
WORKING CAPITAL ANALYSIS
Concept of working capital
There are two concepts of working capital:
Gross working capital
Net working capital
Gross working capital:
In the broader sense, the term working capital refers to the gross working capital. The notion of the gross working capital refers to the capital invested in total current assets of the enterprise. Current assets are those assets, which in the ordinary course of business, can be converted into cash within a short period, normally one accounting year.
Net working capital:
In a narrow sense, the term working capital refers to the net working capital. Networking capital represents the excess of current assets over current liabilities.
Net working capital may be positive or negative. When the current assets exceed the current liabilities net working capital is positive and the negative net working capital results when the liabilities are more than the current assets.
Classification or kinds of working capital
Working capital may be classified in two ways:
On the basis of concept.
On the basis of time permanency
On the basis of concept, working capital is classified as gross working capital and net working capital is discussed earlier. This classification is important from the point of view of the financial manager. On the basis of time, working capital may be classified as:
Permanent or fixed working capital
Temporary of variable working capital
Permanent or fixed working capital: There is always a minimum level of current assets, which is continuously required by the enterprise to carry out its normal business operations and this minimum is known as permanent of fixed working capital. For example, every firm has to maintain a minimum level of raw materials, work in process; finished goods and cash balance to run the business operations smoothly and profitably. This minimum level of current assets is permanently blocked in current assets. As the business grows, the requirement of permanent working capital also increases due to the increases in current assets.
Temporary or variable working capital: Temporary or variable working capital is the amount of working capital, which is required to meet the seasonal demands and some special exigencies. Thus the variable working capital can be further classified into seasonal working capital and special working capital. While seasonal working capital is required to meet certain seasonal demands, the special working capital is that part of working capital which is required to meet special exigencies such as launching of extensive marketing campaigns, for conducting research etc
Importance of working capital
Solvency of the business: Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production.
Good will: Sufficient working capital enables a business concern to make prompt payment and hence helps in creating and maintaining good will.
Easy loans: A concern having adequate working capital, high solvency and good credit standing can arrange loans from banks and others on easy and favorable terms.
Cash Discounts: Adequate working capital also enables a concern to avail cash discounts on the purchases and hence it reduces costs.
Regular supply of raw materials: Sufficient working capital ensures regular supply of raw materials and continuous production.
Regular payments of salaries wages and other day to day commitments: A company which has ample working capital can make regular payment of salaries, wages and other day to day commitments which raises the morale of its employees, increases their efficiency, reduces wastage and cost and enhances production and profits.
Exploitation of favorable market conditions: The concerns with adequate working capital only can exploit favorable market conditions such as purchasing its requirements in bulk when the prices are lower.
Ability to face crisis: Adequate working capital enables a concern to face business crisis in emergencies.
Quick and regular return on Investments: Every investor wants a quick and regular return on his investment. Sufficiency of working capital enables a concern to pay quick and regular dividends to its investors, as there may not be much pressure to plough back profits. This gains the confidence of its investors and creates a favorable market to raise additional funds in the future.
Working capital cycle:
On cash basis:
working capital cycle
raw meterial
work in progress
finished goods
sales
There are three stages:
Purchase raw material from suppliers on cash basis
Transforming raw material into finished goods
Sell the finished products to the customers on cash basis
On credit basis:
Creditors
Bills paybles
Raw meterial
work in progress
finished goods
sales
debtors
bills receivables
cash
creditors
It involves:
Purchase raw material on credit basis from the suppliers. Suppliers are called creditors to the firm for that the firm needs to pay the bills after some time that are called bills payables.
Convert rawmeterial in to finished goods.
Sale the finished goods to the customer on credit base. Here the customers act as debtors to the firm. The firm needs to collect the amount from the customers these are called bills receivables.
After collecting the bills receivables the firm meets their bills payables to the creditors.
SOURCE OF FINANCE
For any business enterprise, there are two sources of finance, viz, funds contributed by owners and funds available from loans and credits. In other words the financial resources of a business may be own funds and borrowed funds.
Source of Company Finance
Based upon the time, the financial resources may be classified into (1) sources of long term (2) sources of short – term finance. Some of these sources also serve the purpose of medium – term finance.
II. Sources of Short-term Finance are:
Sources of Long Term Finance
Issue of Shares: The amount of capital decided to be raised from members of the public is divided into units of equal value. These units are known as share and the aggregate values of shares are known as share capital of the company. Those who subscribe to the share capital become members of the company and are called shareholders. They are the owners of the company. Hence shares are also described as ownership securities.
Issue of Preference Shares: Preference share have three distinct characteristics. Preference shareholders have the right to claim dividend at a fixed rate, which is decided according to the terms of issue of shares. Moreover, the preference dividend is to be paid first out of the net profit.
Issue of Equity Shares: The most important source of raising long-term capital for a company is the issue of equity shares. In the case of equity shares there is no promise to shareholders a fixed dividend. But if the company is successful and the level profits are high, equity shareholders enjoy very high returns on their investment.
Issue of Debentures:
When a company decides to raise loans from the public, the amount of loan is divided into units of equal. These units are known as debentures. A debenture is the instrument or certificate issued by a company to acknowledge its debt. Those who invest money in debentures are known as ‘debenture holders’.
Loans from financial Institutions:
Government with the main object of promoting industrial development has set up a number of financial institutions. These institutions play an important role as sources of company finance. Besides they also assist companies to raise funds from other sources.
Retained Profits:
Successful companies do not distribute the whole of their profits as dividend to shareholders but reinvest a part of the profits. The amount of profit reinvested in the business of a company is known as retained profit. It is shown as reserve in the accounts. The surplus profits retained and reinvested may be regarded as an internal source of finance. Hence, this method of financing is known as self-financing. It is also called sloughing back of profits.
Public Deposits:
An important source of medium – term finance which companies make use of is public deposits. This requires advertisement to be issued inviting the general public of deposits. This requires advertisement to be issued inviting the general public to deposit their savings with the company. The period of deposit may extend up to three years. The rate of interest offered is generally higher than the interest on bank deposits.
Sources of Short Term Finance
The major sources of short-term finance are discussed below:
Trade credit: Trade credit is a common source of short-term finance available to all companies. It refers to the amount payable to the suppliers of raw materials, goods etc. after an agreed period, which is generally less than a year. It is customary for all business firms to allow credit facility to their customers in trade business. Thus, it is an automatic source of finance.
Bank loans and advances: Money advanced or granted as loan by commercial banks is known as bank credit. Companies generally secure bank credit to meet their current operating expenses. The most common forms are cash credit and overdraft facilities. Under the cash credit arrangement the maximum limit of credit is fixed in advance on the security of goods and materials in stock or against the personal security of directors.
Short term loans from finance companies: Short-term funds may be available from finance companies on the security of assets. Some finance companies also provide funds according to the value of bills receivable or amount due from the customers of the borrowing company, which they take over.
Capital Budgeting: Capital budgeting is the process of making investment decision in long-term assets or courses of action. Capital expenditure incurred today is expected to bring its benefits over a period of time. These expenditures are related to the acquisition & improvement of fixes assets.
Capital budgeting is the planning of expenditure and the benefit, which spread over a number of years. It is the process of deciding whether or not to invest in a particular project, as the investment possibilities may not be rewarding. The manager has to choose a project, which gives a rate of return, which is more than the cost of financing the project. For this the manager has to evaluate the worth of the projects in-terms of cost and benefits. The benefits are the expected cash inflows from the project, which are discounted against a standard, generally the cost of capital.
Capital Budgeting Process:
Project Generation:
In the project generation, the company has to identify the proposal to be undertaken depending upon its future plans of activity. After identification of the proposals they can be grouped according to the following categories:
Replacement of equipment: In this case the existing outdated equipment and machinery may be replaced by purchasing new and modern equipment.
Expansion: The Company can go for increasing additional capacity in the existing product line by purchasing additional equipment.
Diversification: The Company can diversify its product line by way of producing various products and entering into different markets. For this purpose, It has to acquire the fixed assets to enable producing new products.
Research and Development: Where the company can go for installation of research and development suing by incurring heavy expenditure with a view to innovate new methods of production new products etc.,
Project evaluation: In involves two steps.
Project selection:
There is no standard administrative procedure for approving the investment decisions. The screening and selection procedure would differ from firm to firm. Due to lot of importance of capital budgeting decision, the final approval of the project may generally rest on the top management of the company. However the proposals are scrutinized at multiple levels. Some times top management may delegate authority to approve certain types of investment proposals. The top management may do so by limiting the amount of cash out lay. Prescribing the selection criteria and holding the lower management levels accountable for the results.
Project Execution:
In the project execution the top management or the project execution committee is responsible for effective utilization of funds allocated for the projects. It must see that the funds are spent in accordance with the appropriation made in the capital budgeting plan. The funds for the purpose of the project execution must be spent only after obtaining the approval of the finance controller. Further to have an effective cont. It is necessary to prepare monthly budget reports to show clearly the total amount appropriated, amount spent and to amount unspent.
Project Review:
After the execution, a continuous monitoring of the project is imperative so that expected and actual operating results compared. This helps in taking corrective action against the responsible people
IMPORTANCE OF CAPITAL BUDGETING
Involvement of heavy fund
Capital budgeting decisions require large capital outlays. It is therefore absolutely necessary that the firm should carefully plan they are put to most profitable use.
Long term implication
The effect of capital budgeting decision will be felt by the firm over a long period and therefore they have decisive influence on the rate and direction of the growth of the firm.
Irreversible decision
In most cases, capital budgeting decisions are irreversible. This is because it is very difficult to find a market for the capital assets. The only alternative will be to scrap the capital assets so purchased or sell them at a substantial loss in the event of the decision being proved wrong.
Most difficult to make
The capital budgeting decision require an assessment of future events which are uncertain . It is really difficult task to estimate the probable future events, the probable benefits and cost accurately in quantitative terms because of economic ,political, social , and technological factors.
Determination of Cash Inflows (CFAT): | |
Cash Sales Revenue Less: Cash Operating Cost Cash Flows Before Depreciation and Taxes(CFBT) Less: Depreciation Profit Before Taxes Less: Taxes Profit After Taxes Add: Depreciation Cash Flow After Taxes (CFAT) | xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxx |
Computation of Cash flows:
Capital Budgeting Methods
Traditional Methods (Non Discounting Methods) | Modern Methods (Discounting Methods) |
1. Pay Back Period Method (PBP) 2. Average Rate of Return or Accounting Rate of Return (ARR) | 1. Net Present Value Method(NPV) 2. Internal Rate of Return(IRR) 3. Profitability Index(PI) |
1. Traditional methods
A. Pay-back period method: It is the most popular and widely recognized traditional method of evaluating the investment proposals. It can be defined, as ‘the number of years required to recover the original cash out lay invested in a project’.
According to Weston & Brigham, “The payback period is the number of years it takes the firm to recover its original investment by net returns before depreciation, but after taxes”.
According to James. C. Vanhorne, “The payback period is the number of years required to recover initial cash investment.
The payback period is also called payout or payoff period. This period is calculated by dividing the cost of the project by the annual earnings after tax but before depreciation under this method the projects are ranked on the basis of the length of the payback period. A project with the shortest payback period will be given the highest rank and taken as the best investment. The shorter the payback period, the less risky the investment is the formula for payback period is
Cash outlay (or) original cost of project
Pay-back period = -------------------------------------------
Annual cash inflow
When cash flows are not equal
Accept – Reject Rule:
If calculated Pay Back Period is < Standard Payback Period then Accept the proposal
If calculated Pay Back Period is > Standard Payback Period then Reject the proposal
If calculated Pay Back Period is =Standard Payback Period then Consider the proposal
1.
A project requires an initial investment of Rs. 1,00,000 with an useful life of 5 years. The projected cash inflows after tax(CFAT) are as follows
2. A machine costs Rs. 4,00,000 and is expected to generate the following cash inflows during its life time. Compute the pay back period
A company has to choose one of the following two mutually exclusive projects. Investment required for each project is Rs 30,000. Both the projects have to be depreciated on straight line basis The tax rate is 50%.
Merits:
Demerits:
B. Accounting (or) Average rate of return method (ARR):
It is an accounting method, which uses the accounting information repeated by the financial statements to measure the probability of an investment proposal. It can be determined by dividing the average income after taxes by the average investment i.e., the average book value after depreciation.
According to ‘Soloman’, accounting rate of return on an investment can be calculated as the ratio of accounting net income to the initial investment, i.e.,
Average net income after taxes
ARR= ------------------------------------ X 100
Average Investment
Total Income after Taxes
Average net income after taxes = -----------------------------
No. Of Years
Total Investment
Average investment = ----------------------
2
On the basis of this method, the company can select all those projects whose ARR is higher than the minimum rate established by the company. It can reject the projects with an ARR lower than the expected rate of return. This method can also help the management to rank the proposal on the basis of ARR. A highest rank will be given to a project with highest ARR, where as a lowest rank to a project with lowest ARR.
Accept – Reject Rule:
If calculated ARR is >One then Accept the proposal
If calculated ARR is < One then Reject the proposal
If calculated ARR is = One then consider the proposal
A machine costs Rs. 10, 00,000 has a 5 years life and no scrap. It is depreciated on straight line basis. The expected net earnings after depreciation and taxes are as follows
Year | 1 | 2 | 3 | 4 | 5 |
NEAT | 1,00,000 | 1,50,000 | 2,00,000 | 1,80,000 | 1,70,000 |
Calculate ARR
Determine the Average Rate of Return from the following data of two machines A and B
Particulars | M-A | M-B |
Original Cost of machine | 60,000 | 60,000 |
Net Working Capital | 5,000 | 6,000 |
Scrap value | 3,000 | 3,000 |
Annual Income after taxes: I Year II Year III Year IV Year V Year |
4,000 6,000 8,000 9,000 12,000 |
12,000 9,000 8,000 6,000 4,000 |
Merits:
It is very simple to understand and calculate.
It can be readily computed with the help of the available accounting data.
It uses the entire stream of earning to calculate the ARR.
Demerits:
It is not based on cash flows generated by a project.
This method does not consider the objective of wealth maximization
IT ignores the length of the projects useful life.
It does not take into account the fact that the profits can be re-invested.
II: Discounted cash flow methods:
The traditional method does not take into consideration the time value of money. They give equal weight age to the present and future flow of incomes. The DCF methods are based on the concept that a rupee earned today is more worth than a rupee earned tomorrow. These methods take into consideration the profitability and also time value of money.
A. Net present value method (NPV)
The NPV takes into consideration the time value of money. The cash flows of different years and valued differently and made comparable in terms of present values for this the net cash inflows of various period are discounted using required rate of return which is predetermined.
According to Ezra Solomon, “It is a present value of future returns, discounted at the required rate of return minus the present value of the cost of the investment.”
According the NPV technique, only one project will be selected whose NPV is positive or above zero. If a project(s) NPV is less than ‘Zero’. It gives negative NPV hence. It must be rejected. If there is more than one project with positive NPV’s the project is selected whose NPV is the highest.
The formula for NPV is
NPV= Present value of cash inflows – investment.
CF1 CF2 CF3 CFn
NPV = ------ + ------- + -------- +………..+-----+ ------- __ Co
(1+K) 1 (1+K)2 (1+K)3 (1+K)n
Co- investment
CF1, CF2, CF3… CFn = cash inflows in different years.
K= Cost of the Capital (or) Discounting rate
n= No. of Years.
Accept – Reject Rule:
If calculated NPV is >Zero then Accept the proposal
If calculated NPV is <Zero then Reject the proposal
If calculated NPV is =Zero then consider the proposal
A choice is to be made between the two competing proposals which require an equal investment of Rs50,000/- and are expected to generate net cash flows as under
Year | Project-A | Project-B |
1 | 25,000 | 10,000 |
2 | 15,000 | 12,000 |
3 | 10,000 | 18,000 |
4 | Nil | 25,000 |
5 | 12,000 | 8,000 |
6 | 6,000 | 4,000 |
Cost of capital of the company is 10%. The following are the present factor at 10% P.A. Which proposal should be selected using NPV method? Suggest the best project.
Year | Discount Factor | Project-A | Project-B | ||
Cash Flows | Present Value | Cash Flows | Present Value | ||
1 | 0.909 | 25,000 | 22,725 | 10,000 | 9,090 |
2 | 0.826 | 15,000 | 12,390 | 12,000 | 9,912 |
3 | 0.751 | 10,000 | 7,510 | 18,000 | 13,518 |
4 | 0.683 | Nil | Nil | 25,000 | 17,075 |
5 | 0.620 | 12,000 | 7,452 | 8,000 | 4,968 |
6 | 0.564 | 6,000 | 3,384 | 4,000 | 2,256 |
Total present value of inflows | 53,461 |
| 56,819 | ||
Total present value of outflow | 50,000 |
| 50,000 | ||
Net Present Value | 3,461 |
| 6,819 | ||
Interpretation:Since project B has the highest NPV, hence project B should be accepted.
A firm whose cost of capital is 12% is considering two mutually exclusive projects X and Y, the details are:
Year | CFAT(Machine -X) | CFAT(Machine -Y) |
0 | 70,000 | 70,000 |
1 | 10,000 | 50,000 |
2 | 20,000 | 40,000 |
3 | 30,000 | 20,000 |
4 | 45,000 | 10,000 |
5 | 60,000 | 10,000 |
Find NPV for the two projects.
Merits:
It recognizes the time value of money.
It is based on the entire cash flows generated during the useful life of the asset.
It is consistent with the objective of maximization of wealth of the owners.
The ranking of projects is independent of the discount rate used for determining the present value.
Demerits:
It is difficult to understand and use.
The NPV is calculated by using the cost of capital as a discount rate. But the concept of cost of capital. If self is difficult to understood and determine.
It does not give solutions when the comparable projects are involved in different amounts of investment.
It does not give correct answer to a question whether alternative projects or limited funds are available with unequal lines.
Internal Rate of Return Method (IRR)
The IRR for an investment proposal is that discount rate which equates the present value of cash inflows with the present value of cash out flows of an investment. The IRR is also known as cutoff or handle rate. It is usually the concern’s cost of capital.
The IRR is not a predetermine rate, rather it is to be trial and error method. It implies that one has to start with a discounting rate to calculate the present value of cash inflows. If the obtained present value is higher than the initial cost of the project one has to try with a higher rate. Likewise if the present value of expected cash inflows obtained is lower than the present value of cash flow. Lower rate is to be taken up. The process is continued till the net present value becomes Zero. As this discount rate is determined internally, this method is called internal rate of return method.
LDPV-OI
IRR = LDF%+ ∆DF X---------------
LDPV-HDPV
LDF- Lower discount rate
∆DF – change in discount factor
LDPV - Present value of cash inflows at lower rate.
HDPV - Present value of cash inflows at higher rate.
OI- Original investment
OR
Accept – Reject Rule:
If calculated IRR is >RRR(Required Rate of Return) then Accept the proposal
If calculated IRR is < RRR(Required Rate of Return) then Reject the proposal
If calculated IRR is = RRR(Required Rate of Return) then consider the proposal
Year | CFAT(Machine -X) | CFAT(Machine -Y) |
0 | 70,000 | 70,000 |
1 | 10,000 | 50,000 |
2 | 20,000 | 40,000 |
3 | 30,000 | 20,000 |
4 | 45,000 | 10,000 |
5 | 60,000 | 10,000 |
A firm whose cost of capital is 10% is considering two mutually exclusive projects X and Y, the details are:
Find IRR for the two projects.
Find IRR for the two projects.
Year | Discount Factor 25% | Project-X | |||
Cash Flows | Present Value | Factor @30% | Present Value | ||
1 | 0.800 | 10,000 | 8,000 | 0.769 | 7,690 |
2 | 0.640 | 20,000 | 12,800 | 0.592 | 11,840 |
3 | 0.512 | 30,000 | 15,360 | 0.455 | 13,650 |
4 | 0.410 | 45,000 | 18,450 | 0.350 | 15,750 |
5 | 0.328 | 60,000 | 19,680 | 0.269 | 16,140 |
Total present value of inflows | 74,290 |
| 65,057 | ||
Total present value of outflow | 70,000 |
| 70,000 | ||
Net Present Value | 4,290 |
| -4,930 | ||
4290
25 + ----------- x (30-25)
4290 –(-4930)
Year | Discount Factor 35% | Project-Y | |||
Cash Flows | Present Value | Factor @40% | Present Value | ||
1 | 0.741 | 50,000 | 37,050 | 0.714 | 35,700 |
2 | 0.549 | 40,000 | 21,960 | 0.510 | 20,400 |
3 | 0.406 | 20,000 | 8,120 | 0.364 | 7,280 |
4 | 0.301 | 10,000 | 3,010 | 0.260 | 2,600 |
5 | 0.221 | 10,000 | 2,230 | 0.186 | 1,860 |
Total present value of inflows | 72,370 |
| 67,840 | ||
Total present value of outflow | 70,000 |
| 70,000 | ||
Net Present Value | 2,370 |
| -2,160 | ||
2370
35 + ----------- x (40-35)
2370 –(-2160)
Merits:
It consider the time value of money
It takes into account the cash flows over the entire useful life of the asset.
It is inconformity with the firm’s objective of maximum owner’s welfare.
Demerits:
It is very difficult to understand and use.
It involves a very complicated computational work.
It may not give unique answer in all situations.
Probability Index Method (PI)
The method is also called benefit cost ration. This method is obtained a slight modification of the NPV method. In case of NPV the present value of cash out flows are profitability index (PI), the present value of cash inflows are divide by the present value of cash out flows, while NPV is a absolute measure, the PI is a relative measure.
It the PI is more than one (>1), the proposal is accepted else rejected. If there are more than one investment proposal with the more than one PI the one with the highest PI will be selected. This method is more useful incase of projects with different cash outlays cash outlays and hence is superior to the NPV method.
The formula for PI is
A choice is to be made between the two competing proposals which require an equal investment of Rs50,000/- and are expected to generate net cash flows as under
Year | Project-A | Project-B |
1 | 25,000 | 10,000 |
2 | 15,000 | 12,000 |
3 | 10,000 | 18,000 |
4 | Nil | 25,000 |
5 | 12,000 | 8,000 |
6 | 6,000 | 4,000 |
Cost of capital of the company is 10%. The following are the present factor at 10% P.A. Which proposal should be selected using PI method? Suggest the best project.
Interpretation:Since project B has the highest PI than Project A, hence project B should be accepted.
Year | Discount Factor | Project-A | Project-B | ||
Cash Flows | Present Value | Cash Flows | Present Value | ||
1 | 0.909 | 25,000 | 22,725 | 10,000 | 9,090 |
2 | 0.826 | 15,000 | 12,390 | 12,000 | 9,912 |
3 | 0.751 | 10,000 | 7,510 | 18,000 | 13,518 |
4 | 0.683 | Nil | Nil | 25,000 | 17,075 |
5 | 0.620 | 12,000 | 7,452 | 8,000 | 4,968 |
6 | 0.564 | 6,000 | 3,384 | 4,000 | 2,256 |
Total present value of inflows (A) | 53,461 |
| 56,819 | ||
Total present value of outflow (B) | 50,000 |
| 50,000 | ||
Profitability Index (A/B) | 1.06 |
| 1.13 | ||
Merits:
It requires less computational work then IRR method
It helps to accept / reject investment proposal on the basis of value of the index.
It is useful to rank the proposals on the basis of the highest/lowest value of the index.
It is useful to tank the proposals on the basis of the highest/lowest value of the index.
It takes into consideration the entire stream of cash flows generated during the useful life of the asset.
Demerits:
It is very difficult to understand the analytical part of the decision on the basis of probability index.