I’m gonna introduce to you, the capital budgeting techniques. Capital Budgeting Techniques
The following are the four common capital budgeting techniques or methods that we use.
First, payback period.
It means how long it takes for us to earn back the initial cost, the shorter the better.
Second, net present value, NPV.
NPV calculates the value of future cash flows in today’s dollars.
It helps assess the profitability of an investment or project. Positive NPV indicates a potentially good investment.
Third, internal rate of return, IRR.
IRR is a measure of the profitability of an investment. It represents the rate at which an investment breaks even.
Fourth, profitability index, PI.
PI is used to evaluate the attractiveness of an investment by comparing its potential
returns to its initial cost.
A PI greater than 1 indicates a potentially profitable investment.
Among these four techniques, the payback period doesn’t rely on the discounted cash flow
technique, while the other three techniques—NPV, IRR and PI—are based on the capitalization
of cash flows, which involves using the discounted cash flow technique.
Calculating NPV, IRR and PI may require the use of a financial calculator.
First, let’s talk about payback period. Payback Period
You don’t need a financial calculator as it’s just a straightforward calculation.
The payback period means how long it takes to get our money back.
That’s the number of years required to recover a project’s cost. Project cost is what we call the initial investment or initial outlay.
Your answer will be in years. How many years it takes to recover a project’s cost. Let’s take an example.
Look at the timeline, let say, initially you invest $500k in one project.
After paying $500k at year 0, afterwards, every year you will earn back $150k for eight
years.
To calculate the payback period, we can apply a simple formula.
Taking initial investment over annual cash flow, you will get the payback period.
This formula is applicable only when you receive the same amount of cashflows every year. For the calculation, we take 500k over 150k, you will get 3.33 years.
This means after investing $500k, it takes 3.33 years to earn back the initial cost.
Payback Period: Mixed Stream Cash Flow
Next, if we have a mixed stream cash flow, payback period can be calculated by adding
project’s cash inflows to its cost until the cumulative cash flow for the project turns
positive.
In other words, annual cash flow is accumulated until the initial investment is recovered. Let’s take an example.
You have $45k invested in year 0, and then year 1 you’ll receive $28k, year 2, $12k,
year 3 to year 5, $10k each.
So how to calculate the payback period? Let’s look at the answer.
First, how to get two years? We just have to do a simple calculation here.
First year $28k plus second year $12k, you’ll get a total of $40k.
That’s how you get 2 years. Third year is $10k, but we only need to recover another $5k. $5k is calculated by taking $45k
minus $40k.
Then, $5k over $10k, you’ll get 0.5 year.
2 years plus 0.5 year, you’ll get a payback period of 2.5 years.
Payback Period: Decision Rule
Whether to accept or reject the project?
Let’s look at the decision rule.
Cut-off is the maximum period that the company management can accept, and it is set by the
company management.
If the payback period is less than the cut-off, we’ll accept the project.
If the payback period is more than the cut-off, then we’ll reject the project.
If our senior management had set a cut-off of 4 years for the projects, what would be
our decision?
It depends on whether they are independent projects or mutually exclusive projects.
If they are independent projects, then we can accept both projects.
Refer back to the previous examples, payback periods of the projects are 3.33 years and
2.5 years, so both are acceptable as their payback periods are less than the cut-off
4 years.
If they are mutually exclusive projects, then we have to select the project with the shortest
payback period, that’s the project with 2.5 years payback period.
Next, let’s talk about the strengths and weaknesses of using payback period.
Payback Period: Strengths & Weaknesses
First, payback period provides an indication of a project’s risk and liquidity.
Payback will tell you how long it takes to earn back your own money.
That’s how risky and how liquid the project is.
Second, it’s easy to calculate and understand the concept of payback period. However, payback period is subject to some weaknesses due to its simplicity.
First, it ignores the time value of money. When calculating the payback period, we assume that the money received in year 1 is equivalent
to the money received in year 2, meaning we do not consider the time factor.
Second, it ignores cashflows occurring after the payback period.
For the calculation of payback, we only care about how long it takes to recover the initial
cost, but we don’t care about how much money you will receive after the payback period.
Third, do this
