In most business firms, there are more than one investment proposals for a capital projects than the firm is able and willing to finance. But due to the scarcity of resources, the management to select the most profitable proposal. As we know that the ultimate goal of financial management is the worth maximization of its owners, hence, in order to achieve this object, the management must select those projects which deserve first priority in terms of their profitability.
Here arises the problem of ranking these projects. For ranking these projects many methods have been evolved. The various methods criteria most commonly used for evaluating capital investment proposals are unsophisticated techniques and sophisticated techniques.
Different Methods of Ranking Investment Proposals
First four are included the former group while the discounted cash flow techniques are called sophisticated technique of capital budgeting. They are :
(1) Degree of Urgency Method
(2) First-year’s Performance Method
(3) Payback Period Method
(4) Rate of Return Method
(5) Discounted Cash flow Techniques
1. Degree of Urgency Method – it is subjective method of ranking the projects. Some projects are needed at one while some others may be postponed to future. Those projects that cannot be postponed and are needed at once are undertaken first. For example, if there is a breakdown in production process due to loss of any component, the management takes decision at once to buy the available one to avoid the delay.
2. First Year’s Performance – According to this method, the investment projects are evaluated on the basis of their impact on revenues and expenses in the first year. If the increased revenue from added sales, or the savings in the expenses relating from the improve technique or equipment, exceed all the added expenses including interest and depreciation, the investment is accepted, otherwise it is rejected. This method is simple but not much popular. The main limitation of this method is this that is takes into account only the first year’s results and subsequent revenues are ignored. It also ignores the time value of money, hence this method is not popular.
3. Payback Period Method – This method is popularly known as pay off, pay-out, recoupment period method also. It gives the number of years in which the total investment in a particular capital expenditure pays back itself.
This method is base-d on the principle that every capital expenditure pays itself back over a number of years. It means that it generates income within a certain period. When the total earnings (or net cash-inflow) from investment equals the total outlay, that period is the payback period of the capital investment. An investment project is adopted so long as it pays for itself within a specified period of time-say 5 years or less. This standard of recoupment period is settled by the management taking into account a number of considerations. While there is a comparison between two or more projects, the lesser the number of payback years, the project will be acceptable.
The formulae for the payback period calculation is simple. First of all, net-cash-inflow is determined. Then we divide the initial cost (or any value we wish to recover) by the annual cash-inflows and the resulting quotient is
the payback period. As per formulae
Formula to calculate Payback period
Payback period = Original Investment/Annual Cash -inflow
If annual cash-inflows are uneven, then the calculation of payback period takes a cumulative form. We accumulate the annual cash-inflows till the recovery of investment and as soon this amount is recovered, it is the
expected number of payback periods (years). An asset or capital expenditure that pays back itself early comparatively is to be preferred.
4. Accounting Rate of Return Method – It is also an important method. This method is known as Accounting Rate of Return Method. Financial Statement Method or Un-adjusted Rate of Return Method also. According to this method, capital projects are ranked in order of earnings. Projects which yield the highest earnings are selected and others are ruled out. Accounting Rate of Return Method is sub-divided into many others like ARR or Average Rate of Return Method, Earning per unit, average investment etc.
5. Discount Cash-flows Techniques: Another method of computing expected rates of return is the present value method. The method is popularly known as Discounted Cash-flow Method also. This method involves calculating the present value of the cash benefits discounted at a rate equal to the firm’s cost of capital. In other words, the present value of an investment is the maximum amount a firm could pay for the opportunity of making the investment without being financially worse off. Discount Cash-flows Techniques is divided into many others, like IRR, NPV, terminal value method, etc.
The financial executive compares the present values with the cost of the proposal. If the present value is greater than the net investment, the proposal should be accepted. Conversely, if the present value is smaller than the net investment, the return is less than the cost of financing. Making the investment in this case will cause a financial loss to the firm. There are four methods to judge the profitability of different proposals on the basis of this technique