4.1 Payback Period.pdf

CAPITAL BUDGETING Basics of Capital Budgeting techniques: Time Value of money- Compounding- Discounting- Future Value of single and multiple flows- Present Value of single and multiple Flows- Present Value of annuities Financial Appraisal of Projects– Payback Period, ARR- NPV, Benef...

CAPITAL BUDGETING Basics of Capital Budgeting techniques: Time Value of money- Compounding- Discounting- Future Value of single and multiple flows- Present Value of single and multiple Flows- Present Value of annuities Financial Appraisal of Projects– Payback Period, ARR- NPV, Benefit Cost Ratio, IRR (simple ratios).  Capital Budgeting Investment in long term projects/assets Generates cash flows over one or more years Capital Expenditure Also referred to as the Investment Outlay Initial cost of the project Capital Budgeting Capital Budgeting involves evaluation of (and decision about) projects. Which projects should be accepted? Here, our goal is to accept a project which maximizes the shareholder wealth. Benefits are worth more than the cost. The Capital Budgeting is based on forecasting Estimate future expected cash flows. Evaluate project based on the evaluation method Classification of Projects Mutually exclusive – accept one project only Independent – accept all profitable projects  Classification of Investment Project Proposals 1. New products or expansion of existing products 2. Replacement of existing equipment or buildings 3. Research and development 4. Exploration 5. Other (e.g., safety or pollution related) Estimating After-Tax Incremental Cash Flows Ignore sunk costs Include opportunity costs Include project-driven changes in working capital net of spontaneous changes in current liabilities Include effects of inflation Tax Considerations and Depreciation Depreciation represents the systematic allocation of the cost of a capital asset over a period of time for financial reporting purposes, tax purposes, or both. Depreciation is a noncash expense. Depreciable Basis = Cost of Asset + Capitalized Expenditures WHAT MUST BE CONSIDERED We need to know the following: Expected Cash Flows Investment outlay Operating cash Flow Terminal Cash Flow Risk of the Project appropriate Discount Rate for the Project Cash Flows Initial Cash Outlay - amount of capital spent to get project going. Cash Inflows - amount of operating revenue generated by the project over the period Initial Cash Outlay Initial Cash Outlay = Cost of Asset + Capitalized Expenditures – Subsidy Cost of Asset means acquisition cost of asset/project capitalized expenses are transportation, installation expenses and relevant capital expenses Cash Inflows/Operating cash inflows Sales Revenue XXXXX (-) Operating Expenses XXXX Profit/Earnings before Interest, Depreciation &Tax XXXX EBID&T/PBID&T (-) Interest XXX Profit/Earnings before Depreciation &Tax XXXX EBD&T/PBD&T (-) Depreciation XXX Profit/Earnings before Tax XXXX EBT/PBT (-) Tax XXX Profit/Earnings after Tax XXXX EAT/PAT (+) Depreciation XXX Cash in flow / cash flow after tax XXXX CFAT  A co considering a investment proposal costing Rs.10,00,000/-, estimated life of 5 years and estimated cash inflows for 5 years are Rs.4,50,000/- 5,25,000/-,6,60,000/- ,5,80,000/- and 3,50,000/-operating expenses are 40% of total revenue, interest for 5 years 1,00,000/-,80,000/-,60,000/-,40,000/- & 20,000/- , the tax rate is 40%, provide depreciation on fixed instalment method. PARTICULARS 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5 YEAR Total Revenue 4,90,000 5,25,000 6,60,000 5,80,000 3,50,000 (-) Operating Exp. 1,96,000 2,10,000 2,64,000 2,32,000 1,40,000 E/PBID&T 2,94,000 3,15,000 3,96,000 3,48,000 2,40,000 (-) Interest 1,00,000 80,000 60,000 40,000 20,000 E/PBD&T 1,94,000 2,35,000 3,36,000 3,08,000 2,20,000 (-) Depreciation 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000 E/PBTAD (-) 4,000 35,000 1,36,000 1,08,000 20,000 (-) Tax NIL 17,500 68,000 54,000 10,000 E/PAT (-) 4,000 17,500 68,000 54,000 10,000 (+) Depreciation 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000 Cash flow/Cash inflow/CFAT 2,00,000 2,17,500 2,68,000 2,54,000 2,10,000 CAPITAL BUDGETING TECHNIQUES DISCOUNTED CASH FLOW TRADITIONAL METHOD METHOD NET PRESENT VALUE METHOD(NPV) PAYBACK PERIOD METHOD PROFITABILITY INDEX METHOD(PI) AVERAGE RATE OF RETURN METHOD (ARR) (OR) ACCOUNTING RATE OF RETURN METHOD(ARR) INTERNAL RATE OF RETURNS METHOD(IRR)  PAYBACK PERIOD METHOD Definition: The Payback Period helps to determine the length of time required to recover the initial cash outlay in the project. Simply, it is the method used to calculate the time required to earn back the cost incurred in the investments through the successive cash inflows.  PAYBACK PERIOD METHOD The formula to calculate (i) When cash inflows are even Payback Period = Initial Outlay/Annual Cash Inflows(CFAT) Accept-Reject Criteria: The projects with the lesser payback are preferred. A co., in finalization of investment proposal, cost of Project Rs.10,20,000/-transportation Rs.80,000/- and installation charges Rs.1,50,000/-. Estimated life of the project 5years and standard payback period two and half year. Expected cash inflow per annum Rs.3,00,000/-. Suggest the management in implementation of the Project. Even cash inflows: Payback period = Cost of asset/ Annual cash inflow Cost of asset = cost + Transportation + Installation 10,20,000 + 80,000 + 1,50,000 = 12,50,000/- Payback period = 12,50,000/3,00,000 = 4.17 years Reject the proposal as the payback period is greater than standard payback period.  PAYBACK PERIOD METHOD The formula to calculate (ii) When cash inflows are not even(CFAT) (a) Construct a cumulative cash inflow (b) In cumulative cash inflow where it is equaling to initial outlay of cash – corresponding year is Payback period Accept-Reject Criteria: The projects with the lesser payback are preferred. A co., in finalization of investment proposal, cost of Project Rs.10,20,000/-transportation Rs.80,000/- and installation charges Rs.1,50,000/-. Estimated life of the project 5years and standard payback period two and half year. Expected cash inflow per annum 1st year Rs.3,50,000/- 2nd year Rs.4,50,000/- 3rd year Rs.4,50,000/- 4th year Rs.4,00,000/- 5th year Rs.3,00,000/-. Suggest the management in implementation of the Project. Not Even cash inflows Cost of asset = cost + Transportation + Installation 10,20,000 + 80,000 + 1,50,000 = 12,50,000/- years Cash inflow Cumulative cash inflow 1 year 3,50,000 3,50,000 2 year 4,50,000 8,00,000 3 year 4,50,000 12,50,000 4 year 4,00,000 16,50,000 5 year 3,00,000 19,50,000 Reject the proposal as the payback period is greater than standard payback period. A co., finalizing a capital out lay of a project ,help the management in decision making using the payback period method Cost o f project CFAT – 1 YEAR CFAT – 2 YEAR CFAT – 3 YEAR CFAT – 4 YEAR 1,00,000 PROJECT - A 40,000/- 30,000/ 20,000/ 10,000/ 1,00,000 PROJECT - B 10,000/ 20,000/ 30,000/ 40,000/ CALCULATIION OF PAYBACK PERIOD YEAR PROJECT – A PROJECT – B CASH INFLOW CUMULATIVE CASH INFLOW CASH INFLOW CUMULATIVE CASH INFLOW 1 YEAR 40,000 40,000 10,000 10,000 2 YEAR 30,000 70,000 20,000 30,000 3 YEAR 20,000 90,000 30,000 60,000 4 YEAR 10,000 100,000 40,000 100,000 As the payback period of both the Project is 4th Year, the Project ’A’ is repaying more comparing to Project ‘B’ in earlier years, hence Project ‘A’ is accepted A co., finalizing a capital out lay of a project ,help the management in decision making using the payback period method Cost o f project CFAT – 1 YEAR CFAT – 2 YEAR CFAT – 3 YEAR CFAT – 4 YEAR 1,00,000 PROJECT - A 40,000/- 30,000/ 20,000/ 10,000/ 1,00,000 PROJECT - B 10,000/ 20,000/ 30,000/ 40,000/ CALCULATIION OF PAYBACK PERIOD YEAR PROJECT – A PROJECT – B CASH INFLOW CUMULATIVE CASH INFLOW CASH INFLOW CUMULATIVE CASH INFLOW 1 YEAR 40,000 40,000 10,000 10,000 2 YEAR 30,000 70,000 20,000 30,000 3 YEAR 20,000 90,000 30,000 60,000 4 YEAR 10,000 100,000 40,000 100,000 As the payback period of both the Project is 4th Year, the Project ’A’ is repaying more comparing to Project ‘B’ in earlier years, hence Project ‘A’ is accepted  PAYBACK PERIOD METHOD The formula to calculate (iii) When cash inflows are not even and cumulative cash inflow is not equal to Initial Outlay of cash - then ( it will falls between two years) where it is nearer to cash out lay that year plus proportionate period of succeeding period – in recovering reaming cash outlay Accept-Reject Criteria: The projects with the lesser payback are preferred.  A co., finalizing a capital out lay of a project ,help the management in decision making using the payback period method Cost o f project CFAT – 1 YEAR CFAT – 2 YEAR CFAT – 3 YEAR CFAT – 4 YEAR 1,00,000 PROJECT - A 40,000/- 50,000/ 40,000/ 30,000/ 1,00,000 PROJECT - B 30,000/ 50,000/ 50,000/ 40,000/ CALCULATIION OF PAYBACK PERIOD YEAR PROJECT – A PROJECT – B CASH INFLOW CUMULATIVE CASH INFLOW CASH INFLOW CUMULATIVE CASH INFLOW 1 YEAR 40,000 40,000 30,000 30,000 2 YEAR 50,000 90,000 50,000 80,000 3 YEAR 40,000 130,000 50,000 130,000 4 YEAR 30,000 160,000 40,000 170,000 Previous year +( cost of the project – amount recovered up to previous year) Payback Period = Amount available in succeeding year Project ‘A’ Project ‘B’ Payback Period =2rd Year + (100,000-90,000/40,000) Payback Period =3rd Year + (100,000-80,000/50,000) Payback Period = 2.25 Years Payback Period = 2.4 Years Accept Project ‘A’ & Reject Project ‘B’  PAYBACK PERIOD METHOD Merits of Payback Period It is very simple to calculate and easy to understand. This method is helpful to analyze risk, i.e. to determine how long the investments will be at risk. It is beneficial for the industries where the investments become obsolete very quickly. It measures the liquidity of the projects.  PAYBACK PERIOD METHOD Demerits of Payback Period The major drawback of this method is that it ignores the Time Value of Money. It does not take into consideration the cash flows that occur after the payback period. It does not show the liquidity position of the company, but only tells the ability of a project to return the initial outlay. It does not measure the profitability of the entire project since it only focuses on the time required to recover the initial investment cost. This method does not consider the life-span of investment, what if the life of an asset gets over very much before the initial investment cost is realized. Thus, the payback period is the simplest method to assess the risk associated with the investment and the time required to get the initial outlay recovered.