5th Year student, Hidayatullah National Law University, Raipur, (C.G.)
*Corresponding Author E-mail: ankitakashyap.hnlu@gmail.com
ABSTRACT:
Any investment decision depends upon the decision rule that is applied
under circumstances. However, the decision rule itself considers following
inputs: cash flows, project life and discounting factor.
The effectiveness of the decision rule depends on how these three
factors have been properly assessed. Estimation of cash flows requires immense
understanding of the project before it is implemented; particularly macro and
micro view of the economy, polity and the company. Project life is very
important, otherwise it will change the entire perspective of the project. So
great care is required to be observed for estimating the project life. Cost of
capital is being considered as discounting factor which has undergone a change
over the years. Cost of capital has different connotations in different
economic philosophies. Particularly, India has undergone a change in its
economic ideology from a closed- economy to open-economy. Hence determination
of cost of capital would carry greatest impact on the investment evaluation.
In this paper, we are going to analyse the
time value of money. We study how investors and borrowers interact to value
investments and determine interest rates on loans and fixed income securities.
Interest is paid by borrowers to lenders for the use of lenders’ money. The
level of interest charged is typically stated as a percentage of the principal
(the amount of the loan). When a loan matures, the principal must be repaid
along with any unpaid accumulated interest. In a free market economy, interest
rates are determined jointly by the supply of and demand for money. Thus,
lenders will usually attempt to impose as high an interest rate as possible on
the money they lend; borrowers will attempt to obtain the use of money at the
lowest interest rates available to them. Competition among borrowers and
competition among lenders will tend to lead interest rates toward some
competitive level. Factors affecting the levels of interest rates will do so by
affecting supply and demand conditions for money. Among these factors are
inflation rates, loan risks, investor inter-temporal monetary preferences (how
much individuals and institutions prefer to have money now rather than have to
wait for it), government policies, and the administrative costs of extending
credit.
KEY WORDS: Financial Decisions, Capital budgeting,
Cash Flows, Time-value of Money.
Capital budgeting is commonly referred to as a
fixed- asset management, when integrated with the financial manager’s goal of
attaining proper combinations of assets (i.e. optimal asset mix ) fixed assets
assume a great deal of significance . Fixed assets are also frequency termed as
the ‘earning assets’ of the firm since they usually generate large returns. 1
Such return is contrary to the limited earning
power of and returns from short term assets.
It is the decision –making process by which the
firms evaluate the purchase of major fixed assets. It involves firm’s decision
to invest its current funds for addition, disposition, modification and
replacement of long-term or fixed assets. Capital budgeting decision involve
the entire process of decision making relating to acquisition of long-term
assets whose returns are expected to arise over a period beyond one year,
planning and control of capital expenditures is a major decision area in any organisation. Its basic features can be summarised
as follows2:
(i) It has the
potentially of making large anticipated profits
(ii) It involves a
high degree of risk
(iii) It involves a
relatively long-term period between the initial outlay and the anticipated
return.
Capital budgeting has five
principles that play a crucial role in the allocation of money and the process
of capital budgeting. The five principles are; (1) decisions are based on
cash flows, not accounting income, (2) cash flows are based on opportunity
cost, (3) The timing of cash flows are important, (4) cash flows are analyzed
on an after tax basis, (5) financing costs are reflected on project’s required
rate of return.
1.3. Kinds of Capital Budgeting
Decisions
Since capital budgeting includes
the process of generating, evaluating, selecting and following up on capital
expenditure alternatives, allocation of financial resources should be made by
the firm to its new investment projects in the most efficient manner.3
A firm may adopt the following three types of capital budgeting decisions:
(i) Mutually Exclusive Projects
It
means if a firm accepts one project, it may rule out the necessity for other,
i.e. the alternatives are mutually exclusive and only one is to be chosen.
(ii)
Accept-
Reject Decisions
The
proposals which yield a higher rate of return in comparison with a certain rate
of return or cost of capital are accepted and naturally, the others are
rejected. For example, if the minimum acceptable return from a project is say
10%, after tax and an investment proposal which shows a return of 12%, may be
accepted and another project which gives a return of 8% only may be rejected.
In
other words, using Net Present Value Method Criterion an investment opportunity
will be accepted if NPV>0, or,
the same will be rejected if NPV< 0.
That
is, all independent projects are accepted under this criterion. It is to be noted
that independent projects are those which do not compete with one another, i.e.
the acceptance of one precludes the acceptance of other. At the same time,
those projects which will satisfy the minimum investment criterion should be
taken into consideration.
(iii)
Capital
Rationing Decision
Capital
rationing is normally applied to situations where the supply of funds to the
firm is limited in some way. As such, the term covers many different situations
ranging from that where the borrowings and lending rates faced by the firm
differ to that where the funds available for investments are strictly limited.
4
In
other words, it occurs when a firm has more acceptable proposals than it can
finance. At this point, the firm ranks the projects from highest to lowest
priority and as such, a cut-off point is considered.
Naturally,
those proposals which are above the cut-off point will be accepted and those
which are below the cut-off point are rejected, i.e. ranking is necessary to
choose the best alternatives.5
1.4 Capital Budgeting Techniques
Money has time value. 6 A rupee today is more valuable
than a year hence. It is on this concept “the time value of money” is based.
The recognition of the time value of money and risk is extremely vital in
financial decision making. Most financial decisions such as the purchase of
assets or procurement of funds, affect the firm’s cash flows in different time
periods. For example, if a fixed asset is purchased, it will require an
immediate cash outlay and will generate cash flows during many future periods.
Similarly if the firm borrows funds from a bank or from any other source, it
receives cash and commits an obligation to pay interest and repay principal in
future periods. 7
The firm may also raise funds by issuing equity shares. The firm’s
cash balance will increase at the time shares are issued, but as the firm pays
dividends in future, the outflow of cash will occur. Sound decision-making
requires that the cash flows which a firm is expected to give up over period
should be logically comparable. In fact, the absolute cash flows which differ
in timing and risk are not directly comparable. Cash flows become logically
comparable when they are appropriately adjusted for their differences in timing
and risk. The recognition of the time value of money and risk is extremely
vital in financial decision-making. If the timing and risk of cash flows is not
considered, the firm may make decisions which may allow it to miss its
objective of maximising the owner’s welfare. The
welfare of owners would be maximised when Net Present
Value is created from making a financial decision. It is thus, time value
concept which is important for financial decisions.8
Thus, we conclude that time value of money is central to the
concept of finance. It recognizes that the value of money is different at
different points of time. Since money can be put to productive use, its value
is different depending upon when it is received or paid. In simpler terms, the
value of a certain amount of money today is more valuable than its value
tomorrow. It is not because of the uncertainty involved with time but purely on
account of timing. The difference in the value of money today and tomorrow is
referred as time value of money.9
Money has time value because of the following reasons:
1. Risk and Uncertainty: Future is always uncertain and
risky. Outflow of cash is in our control as payments to parties are made by us.
There is no certainty for future cash inflows. A cash inflow is dependent out
on our Creditor, Bank etc. As an individual or firm is not certain about future
cash receipts, it prefers receiving cash now.
2. Inflation: In an inflationary economy, the
money received today, has more purchasing power than the money to be received
in future. In other words, a rupee today represents a greater real purchasing
power than a rupee a year hence.
3. Consumption: Individuals generally prefer
current consumption to future consumption.
4. Investment opportunities: An investor can profitably
employ a rupee received today, to give him a higher value to be received
tomorrow or after a certain period of time. Thus, the fundamental principle
behind the concept of time value of money is that, a sum of money received
today, is worth more than if the same is received after a certain period of
time.
For example, if an individual is given an alternative either to
receive Rs.10,000 now or after one year, he will prefer Rs.10,000 now. This is
because, today, he may be in a position to purchase more goods with this money
than what he is going to get for the same amount after one year. Thus, time
value of money is a vital consideration in making financial decision. Let us
take some examples:
EXAMPLE 1: A project needs an initial investment o Rs. 1,00,000.
It is expected to give a return of Rs. 20,000 per annum at the end of each
year, for six years. The project thus involves a cash outflow of Rs. 1,00,000
in the ‘zero year’ and cash inflows of Rs. 20,000 per year, for six years. In
order to decide, whether to accept or reject the project, it is necessary that
the Present Value of cash inflows received annually for six years is
ascertained and compared with the initial investment of Rs. 1,00,000.
The firm will accept the project only when the Present Value of
cash inflows at the desired rate of interest exceeds the initial investment or atleast equals the initial investment of Rs. 1, 00,000.
EXAMPLE 2: A firm has to choose between two projects. One involves
an outlay of Rs. 10 lakhs with a return of 12% from
the first year onwards, for ten years. The other requires an investment of Rs.
10 lakhs with a return of 14% per annum for 15 years
commencing with the beginning of the sixth year of the project.
In order to make a choice between these two projects, it is
necessary to compare the cash outflows and the cash inflows resulting from the
project. In order to make a meaningful comparison, it is necessary that the two
variables are strictly comparable. It is possible only when the time element is
incorporated in the relevant calculations. This reflects the need for comparing
the cash flows arising at different points of time in decision-making.
The time value of the money may be computed in the following
circumstances:
(a) Future value of a single cash
flow
(b) Future value of an annuity
(c) Present value of a single cash
flow
(d) Present value of an annuity.
This is generally considered to be the best method for evaluating
the capital investment proposals. In case if this method cash inflows and cash
outflows associated with each project are first worked out. The present value
of these cash inflows and outflows in then calculated at the rate of return
acceptable to the management this rate of return is considered as the out-off
rate and is generally determined on the basis of cost of capital suitably
adjusted to allow for the risk element involved in the project. The working
capital is taken as cash out flow in the year the project starts commercial
production.
The net present value (NPV) is the difference between the total
present value of future cash inflows and the total present value of future cash
inflows and future cash outflows.
In case of ranking of mutually exclusive proposals, the proposal
with the highest positive NVP is given the top priority and the proposal with
the lowest positive NPV is assigned the lowest priority. The proposals with
negative NPV should be rejected. However, if NVP is ‘0’ then firm may be
indifferent between acceptance and rejection of the proposal. 10
PI is defined as the benefits (in present value terms) per rupee
invested in the proposal. This technique which is a variant of the NPV
technique, is also known as benefit-cost ratio, or present value index the PI
is based upon the basis concept of discounting the future cash flows and is
ascertained by comparing the present value of the future cash inflows with the
present value of the future cash outflows. The PI is calculated by dividing the
former by the latter.
3.3. Internal Rule of return (IRR)
This technique is also known as yield on investment, marginal
productivity of capital, marginal efficiency of capital, rate of return, and
time-adjusted rate of return and so on. It also considers the time value of
money by discounting the cash flow streams, like NPV. While computing the
required rate of return and finding out present value of cash flows-inflows as
well as outflows- are not considered. But the IRR depends entirely on the
initial outlay and the cash proceeds of the projects which are being evaluated
for acceptance or rejection. It is, therefore, appropriately referred to as internal
rate of return. The IRR is usually the rate of return that a project earns.
11
Internal rate of return is the rate at which the sum of discounted
cash inflows equals the sum of discounted cash outflows. In other words, it is
the rate which discounts the cash flows to zero. In other words, the internal
rate of return (IRR) is the discount rate that equates the NPV of an investment
opportunity with Rs.0 (because the present value of cash inflows equals the
initial investment). It is the compound annual rate of return that the firm
will earn if it invests in the project and receives the given cash inflows.12
3.4. Conflicts in results in NPV and IRR
NPV and IRR methods may give conflicting results in case of
mutually exclusive projects, i.e., projects where acceptance of one world
result in non-acceptance of the other such conflict of result may be due to any
one or more of the flowing reasons:
(i) The projects require different
cash outlays
(ii) The projects have unequal loves.
(iii) The projects have different
patterns of cash flows.
A comparison between the two may be attempted as follows:
(a) Advantage of IRR over NPV:
IRR may be considered superior to the NPV for the following
reasons :
(i) IRR gives percentage return
while the NPV gives absolute return.
(ii) For IRR, the availability of
required rate of return is not a pre-requisite while for NPV it is must.
(b) Advantage of NPV over IRR:
The NPV is said to have superiority over IRR for
i) NPV shows expected increase in
the wealth of the shareholders.
ii) NPV gives clear cut
accept-reject decision rule, while the IRR may give multiple results also.
iii) The NPV of different projects
are stabilizer while the IRR cannot be added.
iv) NPV gives better ranking as
compare to the IRR.
The NPV method and PI method will give same acceptance or
rejection decision when the projects are independent and there is capital
rationing because of the following reason:
(i) PI will be greater than one,
only when NPV will be positive i.e. (PI>1 when NPV +ve)
(ii) PI will be less than one, only
when NPV will be negative i.e. (PI<1 when NPV-ve)
Under this method, it is assumed that each cash inflow is
re-invested in another asset at a certain rate of return and calculating the
terminal value of net cash flows at the end of project life. In short, the NCF
and the outlay are compounded forward rather than backward by discounting which
is used by NPV method.
Acceptance Rule:
From the foregoing discussion it becomes clear that if the value
of the total compounded re-invested cash flows is greater than the present
value of outflow, i.e. if NCF have a higher terminal value in comparison with
the outlay, the project is accepted and vice-versa.
The accept-reject rule can, thus, be formulated as under:
(1) If there is a single project:
Accept the project if the terminal value (TV) is positive,
(2) If there are mutually exclusive projects: The project will be
more profitable which has highest positive terminal value (TV).
It can also be stated that if TV is positive, accept the project
and if TV is negative, reject the project. It should be remembered that TV
method is similar to NPV method. The only difference is that in case of former,
values are compounded while in case of latter, values are discounted, of
course, both of them will present the same result provided the rate is same.
Public investment is an important potential contributor to
economic growth and achievement of social development objectives. In addition
to the level of investment and the sectoral
allocation, the capital budgeting process is an important determinant of the
quality of investment projects and their implementation.
In this paper, two types of capital budgeting techniques under the
assumption of certainty as well as uncertainty have been discussed,
highlighting their relative strengths and weaknesses. The investment decision
made by managers will determine a number of significant issues like the cash
flows generated by the company, the dividends paid out by the company, the
market value of the company, the survival of the company etc. Many managers
talk about the “gut feel”, or special expertise, that enables them to say a
project should be undertaken even though it does not appear to have a positive
NPV. It is difficult to quantify their value, so the “gut feel” approach is
often simply to “guesstimate” that the project is profitable and then to go
ahead with it. In fact, the use of capital budgeting techniques allow for much
more informed judgments with the caution that their application does become
more problematic in a period of rapid technological and economic change. In
such a situation, some form of computer based simulation approach may well
turn-out to be of great practical use. Though there are other flexible
techniques but it cannot replace the standard capital budgeting techniques (eg. NPV) rather it expands on and improves the insights of
strategic valuation. However, virtually all capital budgeting methods are
analyzed by computer, so it is easy to calculate and list all the decision
measures, because each one provides decision makers with a somewhat different
piece of relevant information.
By analysing the above chapters
discussed in this paper, we can conclude the following:
1. For a given rate of return, we
can determine the value at some point in the future of an investment made today
by calculating the future value of that investment.
2. We can determine the current
worth of a future cash flow or series of cash flows for a given ;rate of return
by calculating the present value of the cash flow(s) involved.
The fundamental concepts of finance are on the one hand investors
who seek a good return on invested capital and on the other firms that are
looking for capital and are prepared to pay for it. The highly-developed
capital markets match up these two groups with a wide variety of financial
instruments that meet the needs of market participants.
Common sense tells us that “money today is worth more than money
tomorrow” and worth substantially more than the same amount of money to be
received in 1 or 5 years from now. We can make a rational calculation of the
value today by using the present value formula. The present value formula is
just a rearrangement of the future value formula that enables us to compute the
effect of compounding interest over several time periods.
REFERENCES:
1.
http://mathworld.wolfram.com/capitalbudgeting.html
2.
Chandra Prasanna,
Financial Management (Theory & Practice), 6th ed., Tata Mcgraw-Hill
Publishing Co. Ltd., pg. 350-351
3.
McMENAMIN JIM,
Financial Management (An Introduction), OXFORD University Press, pg. 408-409.
4.
http://en.wikipedia.org/w/index.php?title=financedecision(finance_theory)&oldid=572074510
5.
http://newbusinessplaybook.com/corpratedecision/4301389
6.
Time impacts the value of money by an
individual. For example, a dollar received today is of more value than a dollar
received at some future point in time. This difference in value is equalized by
the use of an interest rate.
7.
http://en.wikipedia.org/w/index.php?title=time
value of money (finance_theory)&podid=872034902
8. http://baselineeducation.blogspot.co.uk/2012/time,money
and finance management.html
9.
Khan M Y and Jain P K, Financial
management(5th Ed.), Tata McGraw-Hill Publishing Company Limited, pg. 12.15
10.
Van Horne, J.C., Financial Management
and Policy, Prentice-Hall of India, 1974, p.74
11.
Jain
P K & Khan M Y, Financial Management (4th ed),Tata
McGraw-Hill Publishing Company Ltd, pg 10.26
12.
Gitman
Lawrence J., Principles of Managerial Finance,10th ed., PEARSON Education, pg.
403
Received on 25.01.2014 Modified on 09.02.2014
Accepted on 17.02.2014 © A&V Publication all right reserved
Asian J. Management 5(1):
January–March, 2014 page 106-110