The role of financial management in any corporation is to increase the firm value to the shareholders within the applicable legal framework. The crux of corporate finance, therefore, centers around achieving this goal by dealing with strategic financial issues associated therewith. This responsibility includes advising the corporation on the ways in which capital can be raised and managed, the kinds and nature of investments the firm should make, the quantum of profits to be returned to the shareholders in the form of dividends, and also on the possibilities of enhancing the firm value through merging with or acquiring another firm. (QuickMBA) One of the important functions of a corporate financial manager is to allocate the scarce capital resources of the firm among the various available investment options, and this process is generally referred to as capital budgeting. There are various techniques being used to evaluate a capital investment proposal, and the objective of all these techniques is to make a comparison of the costs to be incurred on a project and the likely benefits in financial terms from the project. One overriding rule of all capital budgeting evaluation techniques is to accept all projects for which the cost is lower than the benefits and reject all projects where the cost is more than the benefits. Usually, there are six criteria that are being used for capital project evaluations. They are:
- Payback period,
- Discounted payback period,
- Internal rate of return,
- Modified internal rate of return,
- Net present value,
- Profitability index,
- Capital Asset Pricing Model (CAPM) Descriptive notes on these methods are appended.
“The Payback Period is perhaps the simplest method of looking at one or more investment projects or ideas. The Payback Period method focuses on recovering the cost of investments. The Payback Period represents the amount of time that it takes for a capital budgeting project to recover its initial cost.” (12manage) The payback period is the ratio of the initial fixed investment over the annual cash flows for the recovery period. If the cash flows are an annuity, the total cost of investment is divided by the annual cash flow to arrive at the payback period. Alternatively, the cash flows can be subtracted from the total cost until the remainder becomes zero and the payback period determined accordingly. So long as the payback period is shorter, the project is considered a better project to invest in. In general, the firm’s workout some maximum allowable payback period and against which the investments are compared, and the capital investment decisions are taken.
There are certain shortcomings associated with the payback period method. In some cases, if the payback period calculated is less than some maximum acceptable payback period, the proposal is accepted. If the payback period calculated does not meet the maximum period fixed, the proposal will be rejected. The major shortcoming of the payback period is that it fails to consider cash flows occurring after the payback period. Consequently, it cannot be considered as a measure of profitability and is deceptive as such. In addition, this method does not take account of the magnitude or timing of cash flows during the payback period. It considers only the recovery period as a whole.
Despite the shortcomings, the payback method continues in use frequently as a supplement to other more sophisticated methods of capital project evaluations. This method offers only limited insight to the management into the risk and liquidity of a project. A firm that is cash poor may find this method useful in gauging the early recovery of funds invested. Since this method simply considers the cash flows and does not take into account the magnitude and timing of the expected value of these outcomes, this method cannot be considered as an adequate indicator of risk. When the firms use payback periods for project evaluations, they usually treat it as a constraint to be satisfied rather than as profitability to be maximized. (James C. Van Horne, 2004).
Discounted Payback Period
The discounted payback period is exactly similar to the payback period except that instead of the actual cash flows, the present values are used to calculate the payback period. It is to be noted that the discounted payback period is always longer than the regular payback period. Even the discounted payback period suffers from some shortcomings. Though this method takes into account the time value issue, it still does not consider the cash flows beyond the payback period. This may lead to the rejection of projects having larger cash flows outside the maximum payback period fixed for accepting the project. Therefore it is to be inferred that any measure of payback can lead the management to focus on the short-term gains at the expense of the larger profits that may occur during the long life of the project.
Internal Rate of Return (IRR)
In view of the shortcomings of the payback period method and the calculations of the average rate of return methods, it is felt that discounted cash flow methods provide a more objective basis for evaluating and selecting investment projects. This method takes into account both the magnitude and timing of expected cash flows in each period of a project’s life. The internal rate of return for a project can arrive as the discount rate that equates the present value of the expected cash inflows with the total amount of cash outflows in the form of investment.
The acceptance criterion generally employed with the internal rate of return method is to compare the internal rate of return with a required rate of return known as the cut-off or hurdle rate. If the internal rate of return (IRR) exceeds the required rate, the project can be treated as financially viable and can be accepted. If it does not, then the project is rejected. “Internal Rate of Return is the flip side of Present Net Value and is based on the same principles and the same math. NPV shows the value of a stream of future cash flows discounted back to the present by some percentage that represents the minimum desired rate of return, often your company’s cost of capital.” (Value-Based Management.net)
The IRR method is popular because it can easily be compared with the Weighted Average Cost of Capital (WACC). However, the method suffers from certain shortcomings, as the method assumes by implication that the cash flows are reinvested at the IRR. This assumption may not always hold well in all situations. The statistical method of comparing results by percentages may sometimes be misleading and may not reflect the true position. (James C. Van Horne, 2004).
Modified Internal Rate of Return (MIRR)
Modified internal rate of return (MIRR) is a variation in the method of calculating IRR. This method assumes that the cash generated out of a project is reinvested at the cost of the capital of the firm. The cost of capital is usually assumed to be the WACC to the firm. This method is considered preferable to the normal IRR method because (i) any series of cash flows has a MIRR and (ii) the MIRR takes into account the rate at which the cash generated out of the project is reinvested and to this extent, this method is more scientific than the trial and error method being followed in the IRR method. If the returns generated at the end of the life of the project is taken into account, including the cash generated by the project and reinvested elsewhere, then it may become difficult for the IRR to equal the total cash generated out of the project including the re-investments. If IRR has to equal this, then the returns from the project must also be invested in the same rate as IRR. But this proposition seems to highly unrealistic and hence this method suffers a basic drawback. MIRR method also suffers from the other shortcomings of IRR method and relying on MIRR may lead to a wrong choice among mutually exclusive investment opportunities. (Moneyterms).
Net Present Value (NPV)
“The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.” (Investopedia) Like the IRR method, net present value (NPV) method is also a discounted cash flow approach to capital budgeting and project evaluation. In the NPV method, all the cash inflows are discounted to present value using the required rate of return. If the sum of these discounted cash flows is zero or more, then the proposal becomes acceptable; if not, the proposal is rejected. Another way to express the acceptance criterion of the method is to say that the project will be accepted if the present value of the cash flows exceeds the present value of the cash outflows.
The rationale behind the acceptance criterion is the same as that of the IRR. If the required rate of return is the rate the investors expect the firm to earn on the investment proposal and the firm accepts a proposal with a net present value greater than zero, the market price of the stock should rise.
The profitability index or the benefit/cost ratio of a project is the present value of the future cash inflows over the initial cash outlay. As long as the profitability index is greater than 1, the investment proposal is acceptable. Because of the similarity in calculations, for any given project, the NPV and profitability index give the same acceptance/rejection signals. If a choice is to be made between mutually exclusive projects, the NPV method is preferable since it expresses the economic contributions from the project in absolute terms. In contrast to this, the profitability index expresses only the relative profitability. (James C. Van Horne, 2004).
Capital Asset Pricing Model (CAPM)
This model developed by William F. Sharpe and John Lintner for the valuation of a security. This method has been adopted for the valuation of shares of a firm by many analysts due to its simplicity and the real world applicability. Basically, this method takes into account the relationship between the risk and expected return from each security. This model assumes that based on the behavior of the risk-averse investor, there is implied an equilibrium relationship between risk and expected return from the prospective investments planned by the investor. In the market equilibrium, a security will be expected to provide a return commensurate with the risk which is inherent to the security and hence becomes unavoidable. This risk is the one that cannot be avoided by diversifying the investment portfolio. The greater the unavoidable risk associated with a security, the greater is the return that will be expected by the investor from any particular security. The relationship between expected return and unavoidable risks and the valuation of securities that follows is the essence of the CAPM model. (James C. Van Horne, 2004) This model has several assumptions for its offering the proper results. The method also has a lot of important consequences. “CAPM implies that investing in individual stocks is pointless, because you can duplicate the reward and risk characteristics of any security just by using the right mix of cash with the appropriate asset class”. (Moneychimp).
Popularity and Practice of Different Valuation Methods
Graham and Harvey (2001), out of the survey conducted by them into the practice of project valuation methods, report that most of the firms use present value techniques to evaluate new projects in addition to the payback period. The firms prefer to use company-wide discount rates instead of project-specific discount rates for evaluating the projects. The survey results also indicate that the size of the firm happens to be one important factor that influences the practice of corporate finance. For instance fairly larger size firms are using NPV techniques and Capital Asset Pricing Model than the smaller size firms. The smaller firms are used to evaluate their projects using the payback period method. It is also observed in the study that a majority of the large firms have a tighter debt-equity ratio as compared to smaller firms.
If the role of management is assumed to work towards increasing the shareholder value, it would be helpful for the managers to predict in advance the impact of their financial decisions. By adopting any of the above capital project evaluation methods, the managers would be able to provide effective financial decisions; of course, subject to the considerations of the size of the firms, amount of investments, and the shortcomings of each of the methods described.
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Graham, J.R. & Harvey, C.R, The theory and practice of corporate finance: evidence from the field, Journal of Financial Economics 60, 2001, pp.187-243.
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