FINANCIAL MANAGEMENT ASSIGNMENT

Name:- Raghvendra Sharma

Roll No.:- 22165
Q1. Explain payback period method of evaluating capital budgeting
proposals. What are its Advantages and Disadvantages?

ANS: The PBP technique is based on the idea of how much time is
needed by the project to generate cash flows sufficient to recover the
cost of investments. It can be also used as a criterion for acceptance or
rejection of projects in the case that the PBP is higher or lower certain
number of years previously defined and to differentiate between
projects (Afonso and Cunha, 2009). The PBP technique is commonly
used for evaluating the investments of capital budgeting in companies
for many reasons. Firstly, the technique is very easy to apply and
understand. Secondly, the technique enables the manager to measure
a risk of investment by examining how long it will take to recover the
cost of investment. Thirdly, it is comfortable with the desire of manager
in generating the liquidity. This issue is linked with pecking-order theory
where the managers try to use methods that create immediate
liquidity. Fourthly, the technique is used by small and medium
companies because it is simple and easy to understand by owners of
these companies where the small-medium businesses typically do not
engage in long-term planning. The payback method is not a true
measure of the profitability of an investment. The Payback Period
has been dismissed as misleading and worthless by most writers on capital
budgeting at the same time that businessmen continue to utilise this concept. The
payback period refers to the length of time it takes to recover
the cost of an investment. The desirability of an investment is
directly related to its payback period. Shorter paybacks mean
more attractive investments. Investors and managers use the
payback period to make quick judgments on their investments.
The concept of the payback period is generally used in financial
and capital budgeting. But it has also been used to determine
the cost savings of energy efficiency technology. As an example
it can be used by homeowners and businesses to calculate the
return on the energy efficient technologies such as solar panels
and insulation, as well as maintenance and upgrades. The
payback period, though, disregards the time value of money. It
is determined by counting the number of years it takes to
recover the funds invested. For example, if it takes five years to
recover the cost of the investment, the payback period is five
years. While payback periods are useful in financial and capital
budgeting, it has applications in other industries. Some analysts
favor the payback method for its simplicity. Others like to use it
as an additional point of reference in a capital budgeting
decision framework. The payback period does not account for
what happens after payback, ignoring the overall profitability of
an investment. When net annual cash inflow is even (i.e., same
cash flow every period), the payback period of the project can
be computed by applying the simple formula given below:
FORMULA:
Payback period = Investment required/net annual cash inflow
Example The ABC company is planning to purchase a machine known as
machine X. Machine X would cost RS.25,000 and would have a useful
life of 10 years with zero salvage value. The expected annual cash
inflow of the machine is RS.10,000. Compute payback period of
machine X and conclude whether or not the machine would be
purchased if the maximum desired payback period of ABC company is 3
years. Solution Since the annual cash inflow is even in this project, we
can simply divide the initial investment by the annual cash inflow to
compute the payback period. It is shown below: Payback period =
RS.25,000/RS.10,000

=2.5

Advantages: 1. The payback period is useful from a risk

analysis perspective, since it gives a quick picture of the length
of time that the initial investment will be at risk. If you were to
analyze a prospective investment using the payback method,
you would tend to accept those investments having rapid
payback periods and reject those having longer ones. It tends to
be more useful in industries where investments become
obsolete very quickly, and where a full return of the initial
investment is therefore a serious concern. 2. An investment
project with a short payback period promises the quick inflow
of cash. It is therefore, a useful capital budgeting method for
cash poor firms. 3. A project with short payback period can
improve the liquidity position of the business quickly. The
payback period is important for the firms for which liquidity is
very important.

Disadvantages: 1. It does not consider the useful life of the

assets and inflow of cash after payback period. For example, If
two projects, project A and project B require an initial
investment of RS.5,000. Project A generates an annual cash
inflow of RS.1,000 for 5 years whereas project B generates a
cash inflow of RS.1,000 for 7 years. It is clear that the project B
is more profitable than project A. But according to payback
method, both the projects are equally desirable because both
have a payback period of 5 years (RS.5,000/RS.1,000). If an
asset’s useful life expires immediately after it pays back the
initial investment, then there is no opportunity to generate
additional cash flows. The payback method does not
incorporate any assumption regarding asset life span. 8 2.
Additional cash flows. The concept does not consider the
presence of any additional cash flows that may arise from an
investment in the periods after full payback has been achieved.
3.Cash flow complexity. The formula is too simplistic to
account for the multitude of cash flows that actually arise with
a capital investment. For example, cash investments may be
required at several stages, such as cash outlays for periodic
upgrades. Also, cash outflows may change significantly over
time, varying with customer demand and the amount of
competition. 4.Profitability. The payback method focuses
solely upon the time required to pay back the initial
investment; it does not track the ultimate profitability of a
project at all. Thus, the method may indicate that a project
having a short payback but with no overall profitability is a
better investment than a project requiring a long-term payback
but having substantial long-term profitability. 5.Time value of
money. The method does not take into account the time value
of money, where cash generated in later periods is worth less
than cash earned in the current period. A variation on the
payback period formula, known as the discounted payback
formula, eliminates this concern by incorporating the time
value of money into the calculation. Other capital budgeting
analysis methods that include the time value of money are the
net present value method and the internal rate of return.
6.Individual asset orientation. Many fixed asset purchases are
designed to improve the efficiency of a single operation, which
is completely useless if there is a process bottleneck located
downstream from that operation that restricts the ability of the
business to generate more output. The payback period formula
does not account for the output of the entire system, only a
specific operation. Thus, its use is more at the tactical level
than at the strategic level.
The management of ABC company wants to reduce its labor
cost by installing a new machine. Two types of machines are
available in the market – machine X and machine Y. Machine X
would cost RS.18,000 where as machine Y would cost
RS.15,000. Both the machines can reduce annual labor cost by
RS.3,000. Which is the best machine to purchase according to
payback method? Solution: Payback period of machine X:
RS.18,000/RS.3,000 = 6 years Payback period of machine y:
RS.15,000/RS.3,000 = 5 years According to payback method,
machine Y is more desirable than machine X because it has a
shorter payback period than machine X.

Q2.Explain ARR method of Capital Budgeting along with

Advantages and Disadvantages.
ANS: The Average Rate of Return or ARR, measures the
profitability of the investments on the basis of the information
taken from the financial statements rather than the cash flows.
It is also called as Accounting Rate of Return. The term “average
rate of return” refers to the percentage rate of return that is
expected on an investment or asset vis-à-vis the initial
investment cost or average investment over the life of the
project. The ratio does not take into account the concept of
time value of money. ARR calculates the return, generated from
net income of the proposed CAPITAL INVESTMENT.
The accounting rate of return (ARR) is "not only a central feature of any
basic text on financial statement analysis but also figures commonly in the
evaluation by investment analysts of the financial performance of firms"
(Whittington 1988, 261). Notwithstanding the prominence given to this
financial ratio (Foster 1986, 77-79), many writers have warned that the
ARR lacks economic significance and can be a very misleading measure of
profitability. Fisher and McGowan (1983, 90), for example, conclude that
"there is no way in which one can look at accounting rates of return and
infer anything about relative economic profitability." In the same vein,
Rappaport (1986, 31) states flatly that the comparison of the ARR with the
cost of capital is "clearly like comparing apples with oranges." The
limitations of using ARRs to estimate the economic rate of return have
been discussed over the last 25 years; for example, Harcourt (1965),
Solomon (1966), Kay (1976), Fisher and McGowan (1983), Salamon
(1985), Edwards et al. (1987), and Brief and Lawson (1991). This research
has focused mainly on the question of whether the ARR is a good proxy for
the economic return and the literature contains virtually no discussion of
other ways in which the ARR might be used in financial analysis. An
important exception is Peasnell (1982b) who presents a common analytical
framework connecting conventional economic concepts of value and yield
and accounting models of profit and return. However, even here, the main
emphasis is on the relationship between accounting and economic rates of
return. This emphasis is quite evident in Peasnell's concluding comment
that "it is difficult to assign economic significance to accounting yields
except either (1) as surrogate measures of IRR or (2) when they are defined
in terms of entry- or exit-market prices" (379-80). A different slant on the
economic significance of ARRs is presented here where the focus is on the
use of the ARR in the valuation process, not in the determination of
profitability. The purpose is to show that an expression for an accounting-
based measure of discounted cash flows (DCF) can be derived in terms of
the ARR. Thus, quite apart from the question of whether or not the ARR is
an accurate estimate of the economic rate of return, this financial ratio has a
key role to play in the valuation process. The results have both analytical
and practical significance. On an analytical level, the derivations can be
viewed as basic "bookkeeping relationships" that are associated with a
double-entry system. On the more practical side, while the DCF techniques
currently used in practice "are largely accounting-based valuation
approaches" (DeAngelo 1990, 100), the use of accounting data in DCF
valuations is very indirect. Present practice is to "use historical accounting
relationships to forecast future earnings, from which future cash flows are
estimated" and, in addition, to estimate terminal values "from projections of
future earnings" (p. 100). However, instead of basing DCF valuations on
cash flows which are derived from accounting data, a more direct method
of analysis is to base the DCF valuations directly on accounting data.
Understanding how accounting data can be used in DCF analysis leads to a
greater appreciation of the general nature of accounting and provides a
compelling reason to give the ARR a more prominent place in financial
statement analysis.

How to calculate ARR?

The investing entity has to first work out the annual net
profit of the proposed investment. Net profit is the
money remaining after factoring in all expenses. It’s
calculated as Total Revenue – Total Expenses i
Total expenses include tax and depreciation if the
investment is a fixed asset.
Now, you have to divide the annual net profit by the
initial cost of the asset or investment. The calculation
will show a decimal, so multiply the result by 100 to see
the percentage return.
ARR formula is as follows:
ARR = average annual profit / average investment
Here’s an example of how to use the Accounting Rate of
Return formula in the real world. A Company wants to
invest in a new set of machinery for the business. The
machinery costs Rs.1500000 and would increase the
company’s annual revenue by Rs.300, 000, as well as the
company’s annual expenses on the machinery are Rs.10,
000. The machinery is estimated to have a useful life of
20 years, with no salvage value. So, the ARR calculation
is as follows:
Average annual profit = 300,000 – 10,000 = 290,000
Depreciation expense = 1500000 / 20 = 75000
True average annual profit = 290,000 – 75000 =
215000
ARR = 215000/ 1500000 = 0.14333 = 14.33%
Here, the company will receive a return of 14.33% which
is relatively good if it is better than the company’s other
options and it may go ahead with the investment.

Advantages of using Accounting rate of return:

1. The ARR concept is a familiar concept to return on
investment (ROI), or return on capital employed.
2. It is easier to calculate and simple to understand like
payback period.
3. It considers accounting concept of profit for
calculating rate of return. The accounting profit can be
readily calculated from the accounting records.
4. Total profits or savings over the entire period of
economic life of the project is estimated under ARR
method which gives clear picture of profitability from
the project.
5. It is a simple capital budgeting technique and is
widely used to provide a guide to how attractive an
investment project is

The drawbacks of using Accounting rate

of return:
1. This method is based on profits rather than cash flow.
Therefore it can be affected by non-cash items such as
the depreciation and bad debts when calculating
profits.
2. The change of methods for depreciation can lead to
different outcomes.
3. This technique does not adjust for the risk to longer
term forecasts.
4. This method ignores time factor. The profits are
earned as a 14.33% rate of return in 20 years may be
considered to be better than 8% rate of return for 5
years under ARR method. This is not proper because
longer the term of the project, greater is the risk
involved.
5. This method does not consider the external factors
which are also affecting the profitability of the project.

Example of ARR Imagine there is a project that has an initial

investment value of Rs. 250,000. And, it is expected to generate
revenue for the forthcoming five years. Jotted down below are the
details: Initial investment: Rs. 250,000 Expected revenue every year:
Rs. 70,000 Time period: 5 years ARR calculation: Rs. 70,000 (annual
revenue) / Rs. 250,000 (initial cost) ARR = .28 or 28% (.28 * 100).

Q3. If given a choice between NPV and IRR which would

you choose and why?
ANS: NPV: popularly known as Net present value. This is the
difference between the present value of cash inflows and
cash outflows.

· If you are investing in certain investments or projects if

it produces positive NPV or NPV>0 then you can accept that
project.

· And in case of negative NPV or NPV<0, you should not

accept the project.

Now there are some advantages and disadvantages:

Advantages:
1. It helps you to maximize your wealth as it will show your
returns greater than its cost of capital or not.

2. It takes into consideration both before & after cash flow

over the life span of a project.

3. It considers all discount rates that may exist at different

point of time while discounting back our cashflows.

Disadvantages:

1. Calculating Appropriate discount rate is difficult.

2. It will not give accurate decision if two or more projects

are of unequal life.

3. It doesn’t provide accurate answer at what period of

time you will achieve positive NPV.
IRR: also referred as “yield to redemption or yield per
annum. The internal rate of return for an investment project
is the effective rate of interest that equates the present value
of inflows and outflows. Higher IRR represents a more
profitable project.

However, IRR need not be positive. Zero return implies

investor receives no return on investment. If the project has
only cash inflows then the IRR is infinity.

Now when IRR> cost of capital, then NPV will be positive

When IRR< cost of capital, NPV will be negative.

Advantages:
· This approach is mostly used by financial managers as it
is expressed in percentage form so it is easy for them to
compare to the required cost of capital.

· IRR method gives you the advantage of knowing the

actual returns of the money which you invested today.

Disadvantages:

· If an analyst is evaluating two projects, both of which

share a common discount rate, predictable cash flows, equal
risk, and a shorter time horizon, IRR will probably work. The
catch is that discount rates usually change substantially over
time. Thus, IRR will not be effective.

· IRR is the discount rate that makes a project break even.

If market conditions change over the years, this project can
have two or more IRR. (we will justify with the example).
Now let’s see which method is better and why:

We have seen the advantages and disadvantages of both the

methods. But NPV is much better as compared to IRR.

1. IRR assumes the single discount rate which will not be

case in reality. For example, return on 1- year Treasury bills
is varied between 1% - 12% in last 20 years. Now this
problem is easily solved by NPV method as it discounts back
the future cashflows at different discount rates easily.

2. IRR can be more than one also which will not only make
confusion but also make analysis difficult. For ex:

If the project has cash flows of -$50,000 in year one (initial

capital outlay), returns of $115,000 in year two and costs of
$66,000 in year three because the marketing department
needed to revise the look of the project. Then the IRR are
two i.e 10% and 20%
3. IRR can be negative too which is difficult to interpret,
whereas in case of NPV if it is negative it surely means
Deficit and positive implies profitability in the project.

4. Positive NPV indicates addition to shareholder’s wealth

and negative NPV implies vice-versa. But this thumb rule
will not applicable in case of IRR.

So, why is the IRR method still commonly used in capital

budgeting? Its because of its reporting simplicity. The NPV
method is inherently complex and requires assumptions at
each stage. The result is simple, but for any project that is
long-term, that has multiple cash flows at different discount
rates, or that has uncertain cash flows - in fact, for almost
any project at all - simple IRR isn't good for much more than
presentation value.
REFRENCES:
Q1. Economicsdiscussion.net , accaglobal.com
Q2.Cleartax , accountlearning
Q3. FINCASH.COM,
Semanticsscholor.org