Showing posts with label Financial Management. Show all posts
Showing posts with label Financial Management. Show all posts
Payback Period Method
Relevant Facts
a. The Payback period doesn’t have decision rule like NPV (Net Present Value) & IRR (internal Rate of Return). This is just a liquidity measure.
b. Acceptance or rejection of the proposal totally depends on the specified timeframe in which company / individual wants their money back.
c. Payback period should not be used alone. It should be used alongside any one of the DCF (Discounted cash flow) techniques i.e. NPV (Net Present Value) or IRR (Internal Rate of Return).
How to calculate Payback Period?
Suppose, Initial cash outflow is $90,000 for two projects i.e. A & B
Cash inflows for subsequent years are mentioned below.
Calculate the cumulative cash inflow in a separate column & calculate it till the last inflow. Mark a year in which you find your initial investment is recovered.
Hence, it is clear from the table that
a. Payback period for Project A is 7 Years, Total cash inflow is $1,35,000
b. Payback period for Project B is 4 Years, Total cash inflow is $1,00,000
Now the question arises, which project to choose? Most of the people who prefer Payback Period method would suggest Project B but Project A can’t be ignored due to surplus cash inflow of $35,000 ($1, 35,000 - $1, 00,000). Hence it is suggested that one should use Payback Period method in combination of DCF methods and base their judgement by evaluating all aspects.
Advantages of Payback period method
1. It’s easy & simple to calculate.
2. It measures the liquidity aspect of the proposal. The project with Payback period of 3 years can be considered more liquid as compared to project with Payback period of 5 years.
Disadvantages of Payback period method
1. It ignores many cash inflows which happen after payback period. Hence, the projects which tend to generate larger cash inflow at later years get discriminated.
2. It ignores the salvage value & total economic life of the project.
3. Most importantly, it ignores the time value of money.
4. It doesn't account for the profitability figure out of a project. Long term profitability should not be ignored during selection of project.
Cash Flow Calculation - Capital Budgeting
Basic principles which should be kept in mind while calculating cash flows are mentioned below.
1. Incremental approach
While calculating cash flows, only those cash flows are considered which can be associated and attributed to adoption of a particular project. Finance manager should check for nature of expenses very wisely while evaluating proposals. Only incremental cash flows are considered for capital budgeting.
2. Financial cash flows
As cost of debt or equity is already considered in WACC (weighted average cost of capital) which is used for discounting cash flows, financial cash flows are ignored in order to avoid error of double counting,
3. Cash flows are considered on after tax basis. Tax savings is considered as an inflow.
4. Depreciation is added back to PAT as they are of non-cash nature and provides a tax shield i.e. reduction in tax liability. All non-cash items should be added back to PAT to arrive at cash inflows.
5. Sunk cost is ignored as these are not incremental.
Sunk costs are that cost which has already been incurred in past, prior to evaluation of proposals and is thus ignored as this doesn't have effect on present or future decisions. Example, if a company has piece of land acquired in past and is considering to set up a plant on that land, then this cost land acquisition in past is considered as sunk cost.
If a new land has to be acquired for this new project then the cash outflows should be considered in capital budgeting.
6. Opportunity costs are considered as they are sacrificed. Opportunity costs of a resource is its value in its best alternative usage.
7. Unless given otherwise, it is assumed that cash outflows are considered to have occurred in the beginning of the year and inflows to be occurred at the end of the year.
8. While evaluating replacement decision, savings in costs are always considered as inflows and that to on after tax basis.
Calculation
Cash inflows
PAT (Profit after tax) + Depreciation +Financial charge (1-tax rate) – Capital expenditure (if any) – Repairs (if any)
Where,
PAT is calculated as
Net sales revenue – Cost of goods sold – Selling, general & administration expenses – Depreciation – Interest – Taxes
Where,
Cost of goods sold is calculated as
Opening inventory + Purchases – Closing Inventory
Cash outflows
Cost of new plant + Installation expenses + Other capital expenditure + Additional working capital – Tax benefit on account of capital loss on sale of old plant (if any) – Salvage value of old plant + Tax liability on account of capital gain on sale of plant (if any)
Fig: Showing items which are excluded / included in the calculation of cash flows.
Most Popular Capital Budgeting Methods
If we talk about the global scenario,
Under non – discounted cash flow category: Payback period is the most popular technique used worldwide.
Under discounted cash flow category: NPV (Net present value) & IRR (Internal rate of return) are the most popular methods.
Please have a look at the chart which shows the ranks of capital budgeting techniques based upon preference of respondents on a scale of 0 (never) to 4 (always) in 4 countries such as USA, UK, Germany & France.
Source: As per report published by Graham & Harvey Surveys (2001) & Brownen, Dejong & Koedijk Survey report (2004)
Below mentioned findings were further highlighted by similar surveys.
1. In European countries, most of the companies prefer Payback period method for making capital budgeting decisions.
2. In USA, IRR is still the favourite while taking decisions. Thereafter, NPV & Payback period is considered.
3. Companies managed by MBA degree holders have a strong preference for discounted cash flow techniques such as NPV / IRR.
NPV vs IRR
Net Present Value – NPV
IRR Formula
Calculation of IRR (Internal Rate of Return) is bit tedious so i have tried to break the steps in simpler and easy to understandable form. For understanding IRR in detail, please refer to my separate post on this.
Internal Rate of Return - IRR
Internal Rate of Return is one of the most frequently discussed discounted cash flow technique in capital budgeting. This is one of the best tools for making investment decisions, especially important when you have two mutually exclusive projects. IRR is basically the discount rate at which present value of future after tax cash flows equals the total investment outlay. In other words, this is discount rate which produces a zero NPV (Net present value). Hence, at this rate, present value of cash inflows equals the present value of cash outflows.
Capital Budgeting
Before arriving at any decisions related to huge capital investment, every finance manager / analyst tries to evaluate the project on various parameters and at last selects between different available proposals / options. This process of evaluation of multiple proposals which has life of more than a year forms part of capital budgeting process. Thus it plays a vital role in decision making process and is generally used in decisions related to replacement & modernization of machinery, expansion of project and diversification of product line or services..
Assumptions
1) Capital rationing:
Managers / analyst start with the thought that there is no scarcity of funds and the firm isn't faced with capital rationing.
WACC - Weighted Average Cost of Capital
WACC stands for Weighted Average Cost of Capital. This is also referred as MCC (Marginal Cost of Capital). In simple words, this is generally the rate of return which is being required by business to earn for paying off all the obligations such as Loans, Creditors, Preference Shareholders and Equity Shareholders. In other words, WACC is the required rate of return which the investors demand for above average risk investment of a company.
Calculation
Generally, company raises capital from sources such as Debt, Equity and instruments which share the same characteristics of Debt and Equity. Most of the firms use more than one source of capital, so in order to get the overall cost of capital, we calculate WACC as follows:
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