Capital Budgeting Analysis Using IRR, NPV And Payback Period

Methods of Capital Budgeting Analysis

Question:

Describe about the Critical Evaluation of Techniques, Application of Technique and Estimating the cost of Capital?

Royal Airways is listed on local Stock Exchange. It is considering a proposal known as project GAMMA. This project has to be discussed at the finance meeting. In this project we have done some analysis on certain methods of Capital Budgeting like IRR, NPV, Pay Back Period, etc. we have selected Net Present Value for evaluating our project. We select Net Present Value method to evaluate the project because it considers time value of money. There are certain disadvantages of Net Present Value but the factors present in our project does not lead to any such situation that attracts disadvantages.

There are many tools through with which we can analyze the feasibility of any capital budgeting project. At a glance these are as follows

1. Internal Rate of Return
2. Net Present Value
3. Pay Back Period
4. Discounted Payback Period
5. Accounting Rate of Return
   

These are explained in detail as follows

1. Internal Rate of Return

Under this method the exact rate at which the present value of all cash inflows will be equal to the present value of all cash outflows. Here the NPV is zero. When we evaluate the project in terms of IRR then we can say that that project will be preferred which has higher IRR as compared to the project which have lower IRR. As the one which has higher will yield the amount invested in less time than the one which has lower IRR as it will return the amount invested in more time. It is also known as ERR (Economic Rate of Return). This rate helps in comparing the earnings of two entities. This is also called as discounted cash flow rate of return. When we look from the view point of loan it is also called as effective interest rate. It is also known as annualized effective compounded return rate. IRR is a measure of efficiency, quality, or yield of an investment. This is in contrast with the net present value, which is an indicator of the value or magnitude of an investment. Every company has its own Internal Rate of Return which is also known as minimum acceptable rate of return or cost of capital. When we evaluate the project in terms of IRR then we can say that that project will be preferred which has higher IRR as compared to the project which have lower IRR. As the one which has higher will yield the amount invested in less time than the one which has lower IRR as it will return the amount invested in more time. The other use of IRR is comparison of capital projects. The example we can relate to expanding versus extension. The company can either purchase a new plant or it can increase the capacity of the existing plant. For this purpose IRR can be used. In order for a project to get accepted the Internal Rate of Return calculated should be more than the company’s cost of capital. In case if more than one project have IRR more than the company’s cost of capital than that project will be selected which has a higher Internal Rate of Return. Further IRR is helpful in evaluating whether to buyback or not. If a company allocates a substantial amount to a stock buyback, the analysis must show that the company’s own stock is a better investment (has a higher IRR) than any other use of the funds for other capital projects, or than any acquisition candidate at current market prices

Internal Rate of Return (IRR)

2. Net Present Value

It is a method where we compare two mutually exclusive projects and find out which of them is better. We prefer that project which has higher Net Present Value. It is the difference between two things

1. The present value of cash inflows discounted at ko i.e. cost of capital
2. The present value of all cash outflows discounted at ko i.e. cost of capital

This helps in analyzing the profitability of a project. The best advantage of NPV is that it utilizes time value of money which means that a dollar earned today will not be as worthy as a dollar earned tomorrow or in future. Either its value will increase or decrease depending upon the economic condition of a country to which the currency belongs. The only difficulty with this method is to identify or calculate the discount rate. This calculation is subjective. Many things are required to be considered

The rate which is used to discount future cash flows to the present value is a key aspect of this process.

The weighted average cost of capital is the one which is most often used. But many researchers believe that it is better to use a discount rate which is much higher as it will be able to adjust the risk, opportunity cost and certain other factors like duration, etc. A variable discount rate with higher rates applied to cash flows occurring further along the time span might be used to reflect the yield curve premium for long-term debt.

The better approach of calculating discount rate is the CAPM model. It is known as Capita Asset Pricing Model. This is a model that shows relationship between two things. One is risk and the other is other is expected return in the mindset of the investors. This model helps in pricing securities. Here the approach is to compensate the investor in two forms. One is the time value of money and the other is the risk they take by investing in the company. The time value of money has a denotation risk free rate. This is the one that compensate the investors. One can say it is an opportunity cost, the cost of next best alternative forgone. This rate is calculated by using a risk factor known as beta. Basically beta helps a company in comparing results with the other firms in the market. It is the expected return that an investor expects from the market. It consists of certain terms such as Rf which is known as risk free rate, Rm which is known as Risk premium and b which is known as Beta.

Net Present value indicates the amount of premium an investment adds to the project it means how much one gets over and above his investment. The only disadvantage of this method is that when we compare projects with different lives we cannot come to conclusion using this method. Under this method the focus is only on the difference between the inflow and the outflow. Both are discounted at cost of capital. A project that has a higher duration than the project which has a lesser duration is assumed to be same under this. Here a modified IRR is used. Further we assume that there is no new investment in between the project

If…	Result	Action to be taken
NPV > 0	The company should go with the project	The chances of acceptance of a project increases
NPV < 0	The company will incur losses by accepting such project	No need to accept the project
NPV = 0	The company will be indifferent	Use other techniques to evaluate the project such as IRR, Payback and Discounted Payback

Net Present Value (NPV)

 
3. Payback Period

This method is used under capital budgeting to evaluate the time period in which the amount invested will be recovered by the entity. One can say it as a breakeven point. Payback period is the time period within which an entity will recover its investment of its cash inflow. But the negative side of payback period is that it does not consider time value of money. For the purpose of decision making those projects are preferred that have a shorter payback period than those that have a higher payback period. The best part of it is that this method is easy to apply than all the other methods. The solution can be arrived quickly. It is very easy to understand irrespective of the field in which one is working.

4. Discounted Pay Back Period

The project takes years to implement. In between these years it may happen that the entity starts earnings that might result in cash inflows and these inflows reduce the amount of investment. Discounted Payback Period is the amount of time required to recover the cost of the investment made in the project. Here we add all positive discounted cash flows. The only advantage of Discounted Payback Period over payback period is that Discounted Payback Period considers time value of money whereas payback period does not consider time value of money. All those projects that have negative NPV will never have a Discounted Payback Period. Future cash flows are considered are discounted to time “zero.”

5. Accounting Rate of Return

This is the amount or rate of return an investor can expect based on his/her investment made on the company. It divides the average profits earned by the company with the initial investments in order to get the rate of return in the project. This helps any investor to make a comparison the profit potential for projects, products and investments. 

The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested (yearly). If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects.

ARR=Average Return during the period/Average Investment

Average Investment = Book value at the beginning of the year 1+ book value at the end of the useful life/2

We select Net Present Value method to evaluate the project because it considers time value of money. There are certain disadvantages of Net Present Value but the factors present in our project does not lead to any such situation that attracts disadvantages. The calculations are done as follows

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Receipt or Inflow
Total No. of Passengers	3300	3300	3300	3300	3300	3300
Fare per passenger	RM3,100.00	RM3,100.00	RM3,255.00	RM3,417.75	RM3,588.64	RM3,768.07
Total Receipt		RM10,230,000.00	RM10,741,500.00	RM11,278,575.00	RM11,842,503.75	RM12,434,628.94
Outflow or Expenditure
Depreciation	RM2,000,000.00	RM200,000.00	RM200,000.00	RM200,000.00	RM200,000.00	RM200,000.00
Refreshment Cost	RM8,000,000.00	RM8,000,000.00	RM8,400,000.00	RM8,820,000.00	RM9,261,000.00	RM9,724,050.00
Earnings Lost	RM90,000.00	RM90,000.00	RM94,500.00	RM99,225.00	RM104,186.25	RM109,395.56
Additional Cost	RM450,000.00	RM450,000.00	RM472,500.00	RM496,125.00	RM520,931.25	RM546,977.81
Maintenance Material	RM385,000.00	RM385,000.00	RM404,250.00	RM424,462.50	RM445,685.63	RM467,969.91
Cabin Crew Staff	RM160,000.00	RM160,000.00	RM168,000.00	RM176,400.00	RM185,220.00	RM194,481.00
Total Cost		RM9,285,000.00	RM9,739,250.00	RM10,216,212.50	RM10,717,023.13	RM11,242,874.28
Net Profit		RM945,000.00	RM1,002,250.00	RM1,062,362.50	RM1,125,480.63	RM1,191,754.66
Tax Rate		25%	25%	25%	25%	25%
Tax		RM236,250.00	RM250,562.50	RM265,590.63	RM281,370.16	RM297,938.66
Profit After Tax		RM708,750.00	RM751,687.50	RM796,771.88	RM844,110.47	RM893,815.99
Add: Depreciation		RM200,000.00	RM200,000.00	RM200,000.00	RM200,000.00	RM200,000.00
Cash profit After Tax		RM908,750.00	RM951,687.50	RM996,771.88	RM1,044,110.47	RM1,093,815.99

By using Net Present value we see the following results

Year	Cash Flow After Tax	PVF @ 11.64%	Discounted PVF
1	RM908,750.00	RM0.90	RM814,000.36
2	RM951,687.50	RM0.80	RM763,580.29
3	RM996,771.88	RM0.72	RM716,368.19
4	RM1,044,110.47	RM0.64	RM672,151.45
5	RM1,093,815.99	RM0.58	RM630,732.38
		Net Present value	RM3,596,832.67

Cost of capital

It is basically the cost that has to be paid by an entity for financing a business. It mainly depends on the modes of financing used. In case if the whole entity is financed through just equity capital then the cost of capital is the cost of equity. As equity shareholders cannot demand right in the profits. The cost of capital is the dividend that is paid to them every year. It changes every year if the company has profits that are volatile. In case if the entity is financed through debt or loan then the cost of debt is the cost of capital. It is the interest that is paid to the debt holders. But in case if the company has a mixture of equity and debt then we use the term weighted average cost of capital and not cost of capital. It is also known as hurdle rate that the entity must ensure before it can generate value. This is more widely used in capital budgeting process.

Weighted Average Cost of Capital (WACC)

Cost of capital is a cost of entity’s funds. We look to it from the point of view of the investor. The investor’s expect a minimum return on their investment. This is used for evaluating capital budgeting decisions. In order for an investment to be attractive the expected return on its capital must be greater than the cost of capital of the company. This is the minimum return that is expected by an investor when he/she/it invests in the entity. One can term it as a bench mark that has to be met for any project. Cost of capital consists of two things.

1. Cost of debt: These are loans borrowed from outside institutions and debentures. The company pays interest in the form of cost of debt. The cost of debt is calculated by taking a risk free bond as a base which has duration similar to the debt raised by an entity. A premium is added depending upon the risk class. The rate is than discounted by tax rate as the interest is a tax deductible item. So the entity gets the benefit of tax savings on it. The formula is written as (Risk free rate + credit risk rate)(1-Tax rate).

2. Cost of equity: The dividend that is paid to them every year. The formula is shown as follows

Cost of equity = Risk free rate of return + Premium expected for risk
Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of return) where Beta= sensitivity to movements in the relevant market

Es=Rf+Bs(Rm-Rf)

Where

Es= The expected return on security

Rf= the expected risk free return on the market

Bs=the beta or the sensitivity to the market risk

Rm= the market return

(Rm-Rf)= risk premium

The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds.

The computation of cost of capital for the company is done as follow. We see that the growth rate is 8% and this will continue till perpetuity. Here we will calculate the cost of equity from Capital Asset Pricing Model

CAPM

This is a model that shows relationship between two things. One is risk and the other is other is expected return in the mindset of the investors. This model helps in pricing securities. Here the approach is to compensate the investor in two forms. One is the time value of money and the other is the risk they take by investing in the company. The time value of money has a denotation risk free rate. This is the one that compensate the investors. One can say it is an opportunity cost, the cost of next best alternative forgone. This rate is calculated by using a risk factor known as beta. Basically beta helps a company in comparing results with the other firms in the market. It is the expected return that an investor expects from the market. It consists of certain terms such as Rf which is known as risk free rate, Rm which is known as Risk premium and b which is known as Beta.

The Cash flows are discounted at Weighted Average Cost of Capital i.e. 11.64%. this is calculated as follows

Calculation of cost of debt

Particulars	$
Rate	12%
Term of debt	15 years
Redemption Value	$1,153.72
Face value	$1,000.00
Interest	$120.00
Tax	25%
After tax interest	$90.00
Kd	7.40%

Calculation of Cost of Preferred Stock

Particulars	$
Dividend	$10.00
Market price	$111.10
Kp	9.00%

Calculation of Equity Stock

Particulars	$
Market Price	$50.00
Do(Last Dividend)	$4.19
Growth Rate	5%
Next Dividend	$4.40
Ke	13.80%
Ke as per CAPM
Risk Free Rate	7%
Beta	1.2
Risk Premium	6%
Ke	14.20%

Calculation of Weighted Average Cost of Capital

WACC	%	Weight	Weighted Average
Ke	14.2	0.6	8.52
Kp	9	0.1	0.9
Kd	7.4	0.3	2.22
WACC			11.64%

Notes forming part of calculations

1. There are certain costs which are irrelevant and are ignored in calculations. These are known to be sunk cost. Under Capital Budgeting, those costs which are already incurred are known as sunk cost and are not relevant for the project. An outflow that has already been done and there are no chances that the cost incurred will be. There is a difference between sunk cost and other cost, future costs that a business has to incur. The examples of these are inventory costs or R&D expenses. These costs have no relation with future. They are independent cost. Market research cost RM 250000 and the cost of retrenched employee is sunk cost.

2. The remaining costs are relevant cost. One can say all the variable cost that differ from project to project is relevant cost.

3. Depreciation comes into picture when the tax rate is given as the entity can get the benefit of tax savings on depreciation.

Conclusion

The company can go with NPV method. We see that the NPV is positive. It is RM 3596833. So Royal Airways should go with the project. But while undertaking the project it should consider certain assumptions. These earnings or the net inflow received during the year are not invested in the current project and are set aside. The company should also continue beyond five years. The company should scarp the machine after five years and it should purchase a new one and should continue with the project. The return on this project for all five years is approimately 30% which is relly a handful investment. Further the inflows of all the years should be again invested when earned as it will earn the company more profit. It can invest in fixed deposits also. The project is feasible and viable.

References

Investing Answer, 2014, “Capital Asset Pricing Model”, viewed on 23^rd January 2015, available at https://www.investinganswers.com/financial-dictionary/stock-valuation/capital-asset-pricing-model-capm-1125

Investing Answer, 2014, “Internal Rate of Return”, viewed on 23^rd January 2015, available at https://www.investinganswers.com/financial-dictionary/investing/internal-rate-return-irr-2130

Business Dictionary, (ND), “Net Present Value”, viewed on 23^rd January 2015, available at https://www.businessdictionary.com/definition/net-present-value-NPV.html

Accounting Explained, (ND), “Net Present Value”, viewed on 23^rd January 2015, available at https://accountingexplained.com/managerial/capital-budgeting/npv

Accounting Explained, (ND), “Accounting Rate of Return”, viewed on 23^rd January 2015, available at https://accountingexplained.com/managerial/capital-budgeting/arr

Accounting tools, 2013, “What is Accounting Rate of Return”, viewed on 23^rd January 2015, available at https://www.accountingtools.com/questions-and-answers/what-is-the-accounting-rate-of-return.html

Eugene F. Fama and Kenneth R. French, 2004, “The Capital Asset Pricing Model Theory and Evidence” viewed on 23^rd January 2015, available at https://pubs.aeaweb.org/doi/pdfplus/10.1257/0895330042162430

Karl Sigman, 2005, “Capital Asset Pricing Model” viewed on 23^rd January 2015, available at https://www.columbia.edu/~ks20/FE-Notes/4700-07-Notes-CAPM.pdf

Richard Pike and Bill Neale, (ND), “Corporate Finance and Investment”, viewed on 23^rd January 2015, available at https://sg3-attach.ymail.com/in.f1926.mail.yahoo.com/ya/securedownload?m=YaDownload&mid=2_0_0_1_9758132_ADSvCmoAABJxVKT3oQK7OJ6%2F0s4&fid=Inbox&pid=2&clean=0&appid=YahooMailNeo&cred=xK98USpXnckug2cOxUSs4sSQvFwV_PBE2I3jQHhBrOy0wsTzej1XbyhS&ts=1420307041&partner=ymail&sig=y_d47MDYmbi5RbHRPHEvYg–