Capital Budgeting decisions (Part Four)
This feature is a continuation of an earlier publication on how managers could effectively strategise and manage complex investment decisions to ensure profitability of their respective firms. Discussions in the previous write-up ended on some capital budgeting methods.
Advertisement
Discounted Cash Pay Back (DPB)
The discounted cash payback method is used to measure the stream of cash flows discounted at the opportunity cost of funds of the project.
Weston and Copeland (1992) define the method as the “number of years required for the sum of the cash flows discounted at k, the cost of capital, equal the present value of the initial outlay” (p. 307). Similarly, Brigham and Ehrhardt (2008) define it as the “number of years required to recover the investment from discounted net cash flows” (393). The discounted cash flows for Project E are illustrated in Table 3.
Table 3: Discounted Cash Payback for Project E
Cash Flows
Year Cash Flows E x PVF @ 10% = Present Value
0 $(1,500) 1.000 $(1,500.00) $(1,500.00)
1 150 0.909 136.35 (1,363.65)
2 300 0.826 247.80 (1,115.85)
3 450 0.751 337.95 (777.90)
4 600 0.683 409.80 (368.10)
5 1,875 0.621 1,164.38 796.28
The statistics in Table 3 indicate the firm’s discounted cash flows into the business equal its initial investment in the project in year four ($-1,500 + $150 + $300 + $450 + $600 = $-1,500 + $1,500 = $0); the discounted cash payback period is between four and five years. The exact discounted cash payback period for the project is 4.46 years:
Payback = Number of years preceding complete recovery + (Cost not recovered at start of year ÷ Cash flow recorded in the year of complete recovery)
= 4 + [($ 368.10 ÷ $796.28)
= 4 + 0.46
= 4.46 years
The discounted cash payback method addresses a major problem identified with the cash payback method, that is, failure to consider time value of money. Under the discounted payback method, the time value of money is given a serious consideration. The discounted method helps firms to effectively measure their liquidity and riskiness in the short- and long-term. In spite of the merits enumerated above, the discounted cash payback method is saddled with some shortcomings. Notable among these is its inability to consider cash flows that occur after the payback period. We observe Project E’s largest cash inflow is recorded in year five, after the discounted cash payback period.
Net Present Value (NPV)
The net present value (NPV) technique is financial experts’ response to the setbacks identified with the payback and ARR techniques in the project selection process. The NPV is one of the discounted cash flow (DCF) methods used in projects evaluation. To compute the NPV, we discount the present value of the investment cash flows at the opportunity cost of funds, and subtract the initial investment capital. A firm would have to reject a project with a negative net present value and accept the one with a positive net present value. When comparing mutually exclusive projects, it is essential to select the one with the highest NPV. The formula for the net present value is provided in Equation 7.
Where:
CFt = Net cash flow in time period t
I0 = Initial investment capital
k = Opportunity cost of capital
n = Number of years for the project
The opportunity cost of funds for the projects presented in Table 1 is assumed to be 10 per cent. On this note, we determine the NPV for Project H as follows.
Year Cash Flow x PVF @ 10% = Present Value
0 $(1,500) 1.000 $(1,500.00)
1 0 0.909 0.00
2 0 0.826 0.00
3 450 0.751 337.95
4 1,050 0.683 717.15
5 1,950 0.621 1,210.95
NPV = $ 766.05
Table 4: Computation of NPV for Project H
The net present values (NPVs) for the four projects are enumerated below.
• Project E, NPV = $796.28
• Project F, NPV = $778.80
• Project G, NPV = $(610.95)
• Project H, NPV = $766.05
Recall that managers would select the mutually exclusive project with the highest NPV among the alternatives. This implies Project E would be the preferred choice among the four projects; it depicts the greatest net present value. If the four projects were independent rather than mutually exclusive, managers would select Projects E, F, and H. Project G would be rejected because it has a negative net present value. There is no distinction between the net present value of the project and maximization of shareowners’ wealth. This implies they are the same.
Merits of the NPV: The NPV is the method that exhibits all the four essential features required in the selection of the appropriate technique for projects. That is, it considers all the stream of cash flow during the life of the project, it discounts cash flows at the market determined cost of capital, and it helps in the selection of the best mutually exclusive project among alternatives, and adheres to the value additivity principle. A project with a zero net present value implies it generates enough cash flows to pay initial capital, pay creditors, and to pay dividends and capital gains to shareowners. These attributes make the NPV the most important capital budgeting technique:
A zero net present value project is one which earns a fair return to compensate both debt holders and equity holders, each according to the returns [he or she expects for the risk assumed]. A positive NPV project earns more than the required rate of return, and equity holders receive all excess cash flows because debt holders have a fixed claim on the firm. Consequently, equity holders’ wealth increases by exactly the NPV of the project. It is this direct link between [shareowners’] wealth and the NPV definition that makes the net present value criterion so important in decision making. (Weston and Copeland, 1992, p. 311)
There is a correlation between net present value and economic value added (EVA): the discounted economic value added equals the net present value of the project. The implication is the acceptance of projects with positive NPVs should result in positive economic value added, and market value added (MVA). The MVA is defined as the difference between the book value of the company and its market value. The NPV is unrivaled in the choice of appropriate capital budgeting technique for firms’ projects.