FINANCIAL ANALYTICS

Unit 3
Capital Budgeting Techniques: Payback Period, Accounting Rate of Return,
Net Present Value, Internal Rate of Return, Profitability Index, Decision Tree,
Cash Flow in Capital Budgeting, Cost of Capital, Advance Capital Budgeting
Techniques, Adjusted Present Value Approach, Competing Project Risk using
Spreadsheets.

Introduction
Indian economy is growing at 9% per annum. New lines of business such as retailing
investment, investment advisory services and private banking are emerging. All such
businesses involve investment decisions. These investment decisions that corporates
take are known as capital budgeting decisions. Such decisions help corporates reap the
benefits arising out of the emerging business opportunities.
Capital budgeting decisions involve evaluation of specific investment proposals.
Here the word “capital” refers to the operating assets used in production of goods or
rendering of services. Budgeting involves formulating a plan of the expected cash flows
during the future period.
Capital budgeting is a blue-print of planned investments in operating assets. Therefore,
capital budgeting is the process of evaluating the profitability of the projects under
consideration and deciding on the proposal to be included in the capital budget for
implementation.
Capital budgeting decisions involve investment of current funds in anticipation
of cash flows occurring over a series of years in future. All these decisions are strategic
because they change the profile of the organisations.

Capital Budgeting Techniques

The methods of appraising an investment proposal can be grouped into

1. Traditional methods.
2. Modern methods.
 Traditional methods are:
o Payback method
o Accounting rate of return
 Modern techniques are:
o Net present value
o Internal rate of return
o Modified internal rate of return
o Profitability index

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Traditional techniques
Traditional methods are of two types – payback method and accounting rate of return.
Payback method
Payback period is defined as the length of time required to recover the initial cash out lay.

Evaluation of payback period:

Merits
 Simple in concept and application
 Emphasis is on recovery of initial cash outlay. Pay-back period is the best method for
evaluation of projects with very high uncertainty
 With respect to accept or reject criterion, pay back method favours a project which is
less than or equal to the standard pay back set by the management. In this
process early cash flows get due recognition than later cash flows. Therefore,
pay-back period could be used as a tool to deal with the ranking of projects on the
basis of risk criterion
 For firms with short-age funds this is preferred because it measures liquidity of the
project

Demerits
 Pay-back period ignores time value of money.
 It does not consider the cash flows that occur after the pay-back period.
 It does not measure the profitability of the project.
 It does not throw any light on the firm’s liquidity position but just tells about the
ability of the project to return the cash out lay originally made.
 Project selected on the basis of pay back criterion may be in conflict with the
wealth maximisation goal of the firm.

Accept or reject criteria

 If projects are mutually exclusive, select the project which has the least pay-
back period
 In respect of other projects, select the project which have pay-back period less
than or equal to the standard pay back stipulated by the management

Pay-back formula

Year Prior to full recovery + Balance of initial out lay to be recovered

Of initial out lay at the beginning of the year in which full Re covery takes place

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Cash in f low of the year in w hichf ull recovery takes place

Accounting rate of return

Accounting rate of return (ARR) measures the profitability of investment
(project) using information taken from financial statements:

ARR = Average income / Average investment

ARR = Average of post tax operating profit / Average investment

Merits of accounting rate of return

 It is based on accounting information
 Simple to understand
 It considers the profits of entire economic life of the project
 Since it is based on accounting information, the business executives familiar with the
accounting information understand it

Demerits of accounting rate of return

 ARR is based on accounting income not on cash flows, as the cash flow approach
is considered superior to accounting information based approach
 ARR does not consider the time value of money
 Different investment proposals which require different amounts of investment may
have the same accounting rate of return. The ARR fails to differentiate projects on the
basis of the amount required for investment
 ARR is based on the investment required for the project. There are many
approaches for the calculation of denominator of average investment. Existence of
more than one basis for arriving at the denominator of average investment may result
in adoption of many arbitrary bases
Due to this the reliability of ARR as a technique of appraisal is reduced when two
projects with the same ARR but with differing investment amounts are to be evaluated.

Accept or reject criteria

 In any project which has an excess ARR, the minimum rate fixed by the
management is accepted.
 If actual ARR is less than the cut-off rate (minimum rate specified by the
management ) then that project is rejected.
 When projects are to be ranked for deciding on the allocation of capital on account

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 of the need for capital rationing, project with higher ARR are preferred to the ones
with lower ARR.

Net present value

Net present value (NPV) method recognises the time value of money. It correctly admits
that cash flows occurring at different time periods differ in value. Therefore, there is the
need to find out the present values of all cash flows. NPV method is the most widely used
technique among the DCF methods.
Steps involved in NPV method involve:
 Forecasting the cash flows, both inflows and outflows of the projects to be taken up
for execution
 Decisions on discount factor or interest factor. The appropriate discount rate is the
firm’s cost of capital or required rate of return expected by the investors
 Computation of the present value of cash inflows and outflows using the discount
factor selected
 Calculation of NPV by subtracting the PV of cash outflows from the present
value of cash inflows.
Accept or reject criteria
If NPV is positive, the project should be accepted. If NPV is negative the project
should be rejected.
Accept or reject criterion can be summarised as given below:
 NPV > Zero = accept
 NPV < Zero = reject
NPV method can be used to select between mutually exclusive projects by examining
whether incremental investment generates a positive net present value.

Merits of NPV method

 It takes into account the time value of money.
 It considers cash flows occurring over the entire life of the project.
 NPV method is consistent with the goal of maximising the net wealth of the company.
 It analyses the merits of relative capital investments.
 Since cost of capital of the firm is the hurdle rate, the NPV ensures that the project
generates profits from the investment made for it.

Demerits of NPV method

 Forecasting of cash flows is difficult as it involves dealing with the effect of
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 elements of uncertainties on operating activities of the firm.
 To decide on the discounting factor, there is the need to assess the investor’s
required rate of return. But it is not possible to compute the discount rate precisely.
 There are practical problems associated with the evaluation of projects with
unequal lives or under funds’ constraints
For ranking of projects under NPV approach, the project with the highest positive NPV
is preferred to that with a lower NPV.
Properties of the NPV
 NPVs are additive. If two projects A and B have NPV (A) and NPV (B) then by
additive rule the net present value of the combined investment is NPV (A + B)
 Intermediate cash inflows are reinvested at a rate of return equal to the cost of
capital.

Internal rate of return (IRR)

Internal rate of return (IRR) is the rate (i.e. discount rate) which makes the NPV of any
project equal to zero. IRR is the rate of interest which equates the PV of cash inflows
with the PV of cash outflows.
IRR is also called as yield on investment, managerial efficiency of capital, marginal
productivity of capital, rate of return and time adjusted rate of return. IRR is the rate
of return that a project earns.

Merits of IRR

 IRR takes into account the time value of money

 IRR calculates the rate of return of the project, taking into account the cash flows
over the entire life of the project.
 It gives a rate of return that reflects the profitability of the project.
 It is consistent with the goal of financial management i.e. maximisation of
net wealth of share holders
 IRR can be compared with the firm’s cost of capital.
 To calculate the NPV the discount rate normally used is cost of capital. But to
calculate IRR, there is no need to calculate and employ the cost of capital for
discounting because the project is evaluated at the rate of return generated by the
project. The rate of return is internal to the project.

Demerits of IRR
 IRR does not satisfy the additive principle.
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  Multiple rate of returns or absence of a unique rate of return in certain projects
will affect the utility of this technique as a tool of decision making in project evaluation.
 In project evaluation, the projects with the highest IRR are given preference to
the ones with low internal rates.
 Application of this criterion to mutually exclusive projects may lead under certain
situations to acceptance of projects of low profitability at the cost of high profitability
projects.
 IRR computation is quite tedious.
Accept or reject criteria
If the project’s internal rate of return is greater than the firm’s cost of capital, accept the
proposal, otherwise reject the proposal.

Modified Internal Rate of Return (MIRR)

Modified internal rate of return (MIRR) is a distinct improvement over the IRR.
Managers find IRR intuitively more appealing than the rupees of NPV because IRR is
expressed on a percentage rate of return. MIRR modifies IRR. MIRR is a better indicator
of relative profitability of the projects.

To calculate PVC, the discount rate used is the cost of capital. To calculate the terminal
value, the future value factor is based on the cost of capital
MIRR is obtained on solving the following equation.
n
PV of costs = TV/ (1 + MRR)

Superiority of MIRR over IRR

 MIRR assumes that cash flows from the project are reinvested at the cost of capital.
The IRR assumes that the cash flows from the project are reinvested at the projects own
IRR. Since reinvestment at the cost of capital is considered realistic and correct, the MIRR
measures the project’s true profitability
 MIRR does not have the problem of multiple rates which we come across in IRR

Profitability Index
Profitability index is also known as benefit cost ratio. Profitability index is the ratio of the
present value of cash inflows to initial cash outlay. The discount factor based on the
required rate of return is used to discount the cash inflows.
P1= Present value of cash inflows / initial cash outlay

Accept or reject criteria

 Accept the project if PI is greater than 1

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 Reject the project if PI is less than 1
If profitability index is 1 then the management may accept the project because the sum of
the present value of cash inflows is equal to the sum of present value of cash outflows.
It neither adds nor reduces the existing wealth of the company.

Merits of PI
 It takes into account the time value of money
 It is consistent with the principle of maximisation of share holders wealth
 It measures the relative profitability

Demerits of PI

 Estimation of cash flows and discount rate cannot be done accurately

with certainty
 A conflict may arise between NPV and profitability index if a choice between
mutually exclusive projects has to be made.

Cost of Different Sources of Finance

The various sources of finance and their costs are explained in this section.
Cost of debentures
The cost of debenture is the discount rate which equates the net proceeds from issue of
debentures to the expected cash outflows.

The expected cash outflows relate to the interest and principal repayments.
I(1  T )  F  P  / n
Kd =
(F  P ) / 2

Where Kd is post tax cost of debenture capital,

I is the annual interest payment per unit of debenture, T is
the corporate tax rate,
F is the redemption price per debenture,
P is the net amount realised per debenture, n is maturity period.

Cost of Term Loans

Term loans are loans taken from banks or financial institutions for a specified
number of years at a pre-determined interest rate. The cost of term loans is equal to the
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interest rate multiplied by 1-tax rate. The interest is multiplied by 1-tax rate as interest on
term loans is also taxed.

Kt = I (1—T)
Where I is interest, T is tax rate

Cost of Preference Capital

The cost of preference share Kp is the discount rate which equates the proceeds from
preference capital issue to the dividend and principal repayments. It is expressed as:

Kp = (D + {(F – P) / n} / ((F + P) / 2)
Where Kp is the cost of preference capital,
D is the preference dividend per share payable, F is the redemption price,
P is the net proceeds per share,
n is the maturity period.

Cost of Equity Capital

Equity shareholders do not have a fixed rate of return on their investment. There is no
legal requirement (unlike in the case of loans or debentures where the rates are governed
by the deed) to pay regular dividends to them.

Measuring the rate of return to equity holders is a difficult and complex exercise.

There are many approaches for estimating return – the dividend forecast approach,
capital asset pricing approach, realised yield approach etc. According to dividend
forecast approach, the intrinsic value of an equity share is the sum of present values of
dividends associated with it.

Ke = (D1/Pe) + g

This equation is modified from the equation, Pe= {D1/Ke-g}.

Dividends cannot be accurately forecasted as they may sometimes be nil or have a

constant growth or sometime have supernormal growth periods.

Is Equity Capital free of cost?

Some people are of the opinion that equity capital is free of cost as a company is
not legally bound to pay dividends and also as the rate of equity dividend is not fixed like
preference dividends. This is not a correct view as equity shareholders buy shares with the
expectation of dividends and capital appreciation. Dividends enhance the market value
of shares and therefore equity capital is not free of cost.

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Cost of Retained Earnings
A company‘s earnings can be reinvested in full to fuel the ever-increasing demand of
company‘s fund requirements or they may be paid off to equity holders in full or they may be
partly held back and invested and partly paid off. These decisions are taken keeping in mind
the company‘s growth stages.
High growth companies may reinvest the entire earnings to grow more, companies with
no growth opportunities return the funds earned to their owners and companies with
constant growth invest a little and return the rest. Shareholders of companies with
high growth prospects utilising funds for reinvestment activities have to be compensated
for parting with their earnings.

Therefore the cost of retained earnings is the same as the cost of shareholders‘ expected
return from the firm‘s ordinary shares. So, Kr = Ke

Capital Asset Pricing Model Approach

This model establishes a relationship between the required rate of return of a security
and its systematic risks expressed as ―β‖. According to this model,

Ke = Rf + β (Rm — Rf)

Where Ke is the rate of return on share, Rf

is the risk free rate of return,
β is the beta of security,
Rm is return on market portfolio

The CAPM model is based on some assumptions, some of which are:

 Investors are risk-averse.
 Investors make their investment decisions on a single-period horizon.
 Transaction costs are low and therefore can be ignored. This translates to assets being
bought and sold in any quantity desired. The only considerations that matter are the price
and amount of money at the investor‘s disposal.
 All investors agree on the nature of return and risk associated with each investment.
Earnings Price Ratio Approach
Under the case of earnings price ratio approach, the cost of equity can be calculated as:
Ke = E1/P
Where E1 = expected EPS per one year
P = current market price per share
E1 is calculated by multiplying the present EPS with (1 + Growth rate).

Cost of Retained Earnings and Cost of External Equity

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As we have just learnt that if retained earnings are reinvested in business for growth
activities, the shareholders expect the same amount of returns and therefore
Ke=Kr
However, it should be borne in mind by the policy makers that floating of a new issue and
people subscribing to the new issue will involve huge amounts of money towards floating
costs which need not be incurred if retained earnings are utilised towards funding activities. From
the dividend capitalisation model, the following model can be used for calculating cost of
external equity.
Ke = {D1/P0(1—f)} + g
Where, Ke is the cost of external equity,
D1 is the dividend expected at the end of year 1, P0 is the current market price per share,
g is the constant growth rate of dividends,
f is the floatation costs as a % of current market price

The following formula can be used as an approximation:

K‘e = Ke/(1—f)

Where K‘e is the cost of external equity,

Ke is the rate of return required by equity holders, f is the floatation cost.

Key Point

Dividends cannot be accurately forecasted as they might sometimes become nil or

have a constant growth or sometimes have supernormal growth periods.

Weighted Average Cost of Capital

In the previous section, we have calculated the cost of each component in the overall capital of
the company. The term cost of capital refers to the overall composite cost of capital or the
weighted average cost of each specific type of fund. The purpose of using weighted average is
to consider each component in proportion of their contribution to the total fund available.
Use of weighted average is preferable to simple average method for the reason that firms do not
procure funds equally from various sources and therefore simple average method is not used.
The following steps are involved to calculate the WACC

Step I: Calculate the cost of each specific source of fund, that of debt, equity, preference
capital and term loans.
Step II: Determine the weights associated with each source.
Step III: Multiply the cost of each source by the appropriate weights.
Step IV: WACC = W e Ke + W r Kr + W p Kp + W d Kd + W t Kt

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Assignment of weights
Weights can be assigned based on any of the following methods
 The book value of the sources of the funds in capital structure
 Present market value of funds in the capital structure and
 Adoption of finance planned for capital budget for the next period
As per the book value approach, weights assigned would be equal to each source‘s proportion in
the overall funds. The book value method is preferable. The market value approach uses the
market values of each source and the disadvantage in this method is that these values
change very frequently.

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