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Capital Budgeting Techniques – Independent and Mutually Exclusive Projects

Understanding of classification of capital budgeting projects plays a crucial role while analyzing viability of projects.

A Project whose cash flows have no impact on the acceptance or rejection of other projects is termed as Independent Project. Thus, all such Projects which meet this criterion should be accepted.

A set of projects from which at most one will be accepted is termed as Mutually Exclusive Projects. In mutually exclusive projects, cash flows of one project can be adversely affected by the acceptance of the other project. In mutually exclusive projects, all projects are to accomplish the same task. Therefore, such projects cannot be undertaken simultaneously. Hence, while choosing among Mutually Exclusive Projects, more than one project may satisfy the Capital Budgeting criterion. However, only one project can be accepted. Which project should be accepted depends on different factors like initial investment, time period required for completion, strategic importance of the project, etc. usually the project which adds more value to the business in the long run will be selected. Continue reading…

Internal Rate Of Return And Mutually Exclusive Projects……. What’s the Concern?

While considering the mutually exclusive projects, IRR technique can be misleading. Investment projects are said to be mutually exclusive if only one project could be accepted and others would have to be rejected.

NPV and IRR methods for project evaluation leads to conflicting results under following conditions:

1. The pattern of cash inflows plays an important role in project evaluation while using IRR method. i.e. The cash flows of one project may increase over time, while those of others may decrease and vice versa. The major drawback with the IRR method is that for mutually exclusive projects, it can give contradictory investment decision when compared with NPV.

Consider the following example.

In the above example A and B are mutually exclusive projects. Both projects require an initial outlay of $ 1,000,000.00 but the pattern of cash inflows is different.  Cash inflows for Project A are increasing over the period of time while for Project B these are declining. IRR decision rule leads to select Project A as Project A IRR>Project B IRR. But decision on the basis of NPV evaluation implies that project B is more viable. Thus on the basis of mere IRR the company may select less profitable project. Continue reading…

Capital Structure and Cash Flows

On one hand, operations of the company may help in forecasting of future cash flows but in addition to this, future cash inflows and out flows can also be accessed through company capital structure. A corporation may use different combinations of equity, debt, or mixture of securities to finance its assets which is termed as Capital Structure. Company’s capital structure is basically the composition of its liabilities i.e. how much the company owes to its share holders and how much to its creditors.

Stake holders can easily judge the management’s mind-set, strategy of running business and business’s future prospects. A company’s value is affected by the capital structure it employs, therefore; while deciding capital structure, management has to consider different important factors like bankruptcy costs, agency costs, taxes, and information asymmetry.

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Cash Flow

Success of any business can be determined through its capacity to generate positive cash flows. Therefore, Cash inflow and outflow is considered as one of the most essential elements which gives us as idea about the continued existence of a business in future. Therefore, the stake-holders focus on two things while investing in business:  first, how does business generate funds and second, where does business invest those funds for generating more.

Objectives of a cash flow statement: Continue reading…

Profitability Index

Profitability index (PI) is the ratio of investment to payoff of a suggested project. It is a useful capital budgeting technique for grading projects because it measures the value created by per unit of investment made by the investor.

This technique is also known as profit investment ratio (PIR), benefit-cost ratio and value investment ratio (VIR).

The ratio is calculated as follows:

Profitability Index = Present Value of Future Cash Flows / Initial Investment

If project has positive NPV, then the PV of future cash flows must be higher than the initial investment. Thus the Profitability Index for a project with positive NPV is greater than 1 and less than 1 for a project with negative NPV. Continue reading…

Present Value of Multiple Cash Flows

We come across many cases where we have to determine the present value of series of multiple cash flows. There are two ways we can calculate present value of multiple cash flows. Either we discount back individual cash flow at a time, or we can just calculate the present values individually and add them up.

Example:

Suppose if we want $10,000 in one year and $15,000 more in two years. If we can earn 8% on this money, how much we need to invest today to exactly earn this much in the future? In other words, what is the present value of two cash flows at 8%. Continue reading…

Discounted Payback Period

One of the limitations in using payback period is that it does not take into account the time value of money. Thus, future cash inflows are not discounted or adjusted for debt/equity used to undertake the project , inflation, etc. However, the discounted payback period solves this problem. It considers the time value of money, it shows the breakeven after covering such costs. This technique is somewhat similar to payback period except that the expected future cash flows are discounted for computing payback period.

Discounted payback period is how long an investment’s cash flows, discounted at project’s cost of capital, will take to cover the initial cost of the project. In this approach, the PV of future cash inflows are cumulated up to time they cover the initial cost of the project. Discounted payback period is generally higher than payback period because it is money you will get in the future and will be less valuable than money today. Continue reading…

Internal Rate of Return

Internal Rate of Return is another important technique used in Capital Budgeting Analysis to access the viability of an investment proposal. This is considered to be most important alternative to Net Present Value (NPV). IRR is “The Discount rate at which the costs of investment equal to the benefits of the investment. Or in other words IRR is the Required Rate that equates the NPV of an investment zero.

NPV and IRR methods will always result identical accept/reject decisions for independent projects. The reason is that whenever NPV is positive , IRR must exceed Cost of Capital. However this is not true in case of mutually exclusive projects. Continue reading…

Payback Period

Payback period is the first formal and basic capital budgeting technique used to assess the viability of the project. It is defined as the time period required for the investment’s returns to cover its cost. Payback period is easy to apply and easy to understand technique; therefore, widely used by investors. Continue reading…

Capital Budgeting Process 

Evaluation of Capital budgeting project involves six steps:

• First, the cost of that particular project must be known.
• Second, estimates the expected cash out flows from the project, including residual value of the asset at the end of its useful life.  
• Third, riskiness of the cash flows must be estimated. This requires information about the probability distribution of the cash outflows.
• Based on project’s riskiness, Management find outs the cost of capital at which the cash out flows should be discounted.
• Next determine the present value of expected cash flows. Continue reading…

How To Use Financial Calculator?

Financial calculator is considered as easiest and less time consuming tool for computation of basic as well as advance financial analysis techniques. A financial calculator is an ordinary calculator featuring few advanced and complex financial formulas so it can compute things like present value etc. financial calculator are really helpful as they handle lot of the computation at their back-end. But one still have to understand the problem as the calculator just does some of the arithmetic and that is all.

Financial calculators are commonly used for determining loan payments but there are many other uses of financial calculators that don’t involve loan payments and interest rates. Continue reading…

How to Calculate Net Present Value using Excel:

The calculation of net present value is useful when a business has to identify a viable investment opportunity. There are many ways to calculate the NPV. The simplest way is:                 

By Use of NPV function in Excel:

The NPV function consists of the following arguments:

=NPV (Rate, FCF ₁, FCF ₂………… FCF _n)

This function gives the NPV of an investment based on a discount rate and a series on cash outflows (future payments) and cash inflows (income).  

                              
The calculation of NPV is based on expected future cash flows of a project. For example, if cash flows occur at the beginning of the period, the first value should be added to the NPV result, should not include in the values arguments.

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Net Present Value 

Net Present Value measures the difference between present value of future cash inflows generated by a project and cash outflows during a specific period of time. With a help of net present value we can figure out an investment that is expected to generate positive cash flows. 

In order to calculate net present value (NPV), we first estimate the expected future cash flows from a project under consideration. The next step is to calculate the present value of these cash flows by applying the discounted cash flow (DCF) valuation procedures. Once we have the estimated figures then we will estimate NPV as the difference between present value of cash inflows and the cost of investment.  Continue reading…

Importance of Capital Budgeting Decisions

Capital budgeting is a process used to determine whether a firm’s proposed investments or projects are worth undertaking or not. The process of allocating budget for fixed investment opportunities is crucial because they are generally long lived and not easily reversed once they are made. So we can say that this is a strategic asset allocation process and management needs to use capital budgeting techniques to determine which project will yield more return over a period of time.

The question arises why capital budgeting decisions are critical? The foremost importance is that the capital is a limited resource which is true of any form of capital, whether it is raised through debt or equity. The firms always face the constraint of capital rationing. Continue reading…

Capital Budgeting and Financial Management

Businesses look for opportunities that increase their share holders’ value. In capital budgeting, the managers try to figure out investment opportunities that are worth more to the business than they cost to acquire. Ideally, firms should peruse all such projects that have good potential to increase the business worth. Since the available amount of capital at any given time is limited; therefore, it restricts the management to pick out only certain projects by using capital budgeting techniques in order to determine which project has potential to yield the most return over an applicable period of time.  Continue reading…