Subject: Commerce

Class: M. Com 1st Semester

Name of the Paper: Financial Management
Paper: Second
Titled: Investment Evaluation Criteria
Key Words: Investment, Techniques, capital Budgeting, Criteria.
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content is authentic and best as per my knowledge.
Dr. Manish Kumar Singh
Department of Commerce
Dr. Vibhuti Narayan Singh Campus Mahatma Gandhi
Kashi Vidyapith
Gangapur, Varanasi
Email: - singhmanishcom@gmail.com
 Discussed Contents

Method /
Technique of
Capital
Budgeting
1.Payback period
Method
2.Accounting Rate of NPV and IRR
Objective Conclusion References Questions
Return Method (ARR). Comparison
3.Net Present Value
Method (NPV)
4.Internal Rate of
Return (IRR)
5.Profitability Index
(PI)
Objective:
The objective of this E-content is to make the students learn about various methods of capital
budgeting along with their merits and demerits.

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.
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. 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.
• Payback period = Cash outlay (investment) / Annual cash inflow

Example

Project A Project B
Cost 1,00,000 1,00,000
Expected
future cash
flow Payback period of project B is shorter than A.
Year 1 50,000 1,00,000 Hence, project B will be selected.
Year 2 50,000 5,000
Year 3 1,10,000 5,000
Year 4 None None
TOTAL 2,10,000 1,10,000
Payback 2 years 1 year
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. 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.
• ARR= Average income/Average Investment

Discounted cash flow method

• The discounted cash flow technique calculates the cash inflow and outflow through the life of an asset. These
are then discounted through a discounting factor. The discounted cash inflows and outflows are then
compared. This technique takes into account the interest factor and the return after the payback period.

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.
The equation for the net present value, assuming that all cash outflows are made in the initial year (tg), will be:

Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost of the investment proposal
and n is the expected life of the proposal. It should be noted that the cost of capital, K, is assumed to be known,
otherwise the net present, value cannot be known.
NPV = PVB – PVC
where,
PVB = Present value of benefits
PVC = Present value of Costs
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. It can be determined by solving the following equation:

If IRR > WACC then the project is profitable.

If IRR > k = accept
If IR < k = reject

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 A
 PI = NPV (benefits) / NPV (Costs)
All projects with PI > 1.0 are accepted.
Differences Between NPV and IRR:
Under the NPV approach, the present value can be calculated by discounting a project’s future cash flow at predefined
rates known as cut off rates. However, under the IRR approach, cash flow is discounted at suitable rates using a trial and
error method that equates to a present value. The present value is calculated to an amount equal to the investment
made. If IRR is the preferred method, the discount rate is often not predetermined as would be the case with NPV.
NPV takes cognizance of the value of capital cost or the market rate of interest. It obtains the amount that should be
invested in a project in order to recover projected earnings at current market rates from the amount invested.
On the other hand, the IRR approach doesn’t look at the prevailing rate of interest on the market, and its purpose is to
find the maximum rates of interest that will encourage earnings to be made from the invested amount.
NPV’s presumption is that intermediate cash flow is reinvested at cut-off rate while under the IRR approach, an
intermediate cash flow is invested at the prevailing internal rate of return. The results from NPV show some similarities
to the figures obtained from IRR under a similar set of conditions, while both methods offer contradicting results in
cases where the circumstances are different.
NPV’s predefined cut-off rates are quite reliable compared to IRR when it comes to ranking more than two project
proposals.
Similarities of Outcomes under NPV and IRR
Both methods show comparable results regarding “accept or reject” decisions where independent investment
project proposals are concerned. In this case, the two proposals don’t compete, and they are accepted or rejected
based on the minimum rate of return on the market.
Conventional proposals often involve a cash outflow during the initial stage and are usually followed by a number
of cash inflows. Such similarities arise during the process of decision-making. With NPV, proposals are usually
accepted if they have a net positive value, while IRR is often accepted if the resulting IRR has a higher value
compared to the existing cut off rate. Projects with a positive net present value also show a higher internal rate of
return greater than the base value.
Conflicts Between NPV and IRR:
In the case of mutually exclusive projects that are competing such that acceptance of either blocks acceptance
of the remaining one, NPV and IRR often give contradicting results. NPV may lead the project manager or the
engineer to accept one project proposal while the internal rate of return may show the other as the most
favourable. Such a kind of conflict arises due to a number of problems.
For one, conflicting results arise because of substantial differences in the amount of capital outlay of the
project proposals under evaluation. Sometimes, the conflict arises due to issues of differences in cash flow
timing and patterns of the project proposals or differences in the expected service period of the proposed
projects.
When faced by difficult situations and a choice must be made between two competing projects, it is best to
choose a project with a larger positive net value by using cut-off rate or a fitting cost of capital.
The reason the two abovementioned options works is because a company’s objective is maximizing its
shareholder’s wealth, and the best way to do that is choosing a project that comes with the highest net
present value. Such a project exerts a positive effect on the price of shares and the wealth of shareholders.
So, NPV is much more reliable when compared to IRR and is the best approach when ranking projects that are
mutually exclusive. Actually, NPV is considered the best criterion when ranking investments.
Conclusion:
Capital budgeting decisions relate to long term asset which are in operation and yield return
over a period of time. They, therefore, involve current outlays in return for series of
anticipated flow of future benefits.
References:
1. Khan M.Y Jain PK, Financial Management Mc Graw Hill Education.
2. Pandey I.M Financial Management, Vikas Publication.
3. https://www.edupristine.com/blog/capital-budgeting-techniques
4. https://corporatefinanceinstitute.com/resources/knowledge/valuation/npv-vs-irr/

Questions:
1. What are the different methods of capital budgeting or investment evaluation criteria?
2. What are the differences between NPV and IRR methods?
3. What are the similarities between NPV and IRR methods?