Evaluation of Investment Proposals - 7 Methods - Financial Management

11/10/2018 Evaluation of Investment Proposals: 7 Methods | Financial Management
Business Management Ideas
Evaluation of
Investment
Proposals: 7
Methods |
Financial
Management
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The following points highlight the top

seven methods used for evaluating the
investment proposals by a company.
The methods are: 1. Payback Period
Method 2. Accounting Rate of Return
Method 3. Net Present Value Method 4.
Internal Rate of Return Method 5.
Profitability Index Method 6.
Discounted Payback Period Method 7.
Adjusted Present Value Method.
1. Payback Period Method:
The payback period is usually expressed

in years, which it takes the cash inflows
from a capital investment project to
equal the cash outflows. The method
recognizes the recovery of original
capital invested in a project. At payback
period the cash inflows from a project
http://www.businessmanagementideas.com/investment/proposals-investment/evaluation-of-investment-proposals-7-methods-financial-management/… 1/34
will be equal to the project’s cash

outflows.
This method specifies the recovery time,

by accumulation of the cash inflows
(inclusive of depreciation) year by year
until the cash inflows equal to the
amount of the original investment. The
length of time this process takes gives
the ‘payback period’ for the project. In
simple terms it can be defined as the
number of years required to recover the
cost of the investment.
In case of capital rationing situations, a

company is compelled to invest in
projects having shortest payback period.
When deciding between two or more
competing projects the usual decision is
to accept the one with the shortest
payback. Payback is commonly used as a
first screening method. This method
recognizes the recovery of the original
capital invested in a project.
ADVERTISEMENTS:
Merits:
The merits of payback period

method are as follows:
1. It is simple to apply, easy to

understand and of particular
importance to business which lack the
appropriate skills necessary for more
sophisticated techniques.
2. In case of capital rationing, a

company is compelled to invest in
projects having shortest payback period.
ADVERTISEMENTS:
3. This method is most suitable when

the future is very uncertain. The shorter
the payback period, the less risky is the
project. Therefore, it can be considered
as an indicator of risk.
4. This method gives an indication to the

prospective investors specifying when
their funds are likely to be repaid.
5. Ranking projects according to their

ability to repay quickly may be useful to
firms when experiencing liquidity
constraints. They will need to exercise
careful control over cash requirements.
6. It does not involve assumptions about

future interest rates.
ADVERTISEMENTS:
Demerits:
The payback period method

suffers from the following
drawbacks:
1. It does not indicate whether an

investment should be accepted or
rejected, unless the payback period is
compared with an arbitrary managerial
target.
2. The method ignores cash generation

beyond the payback period and this can
be seen more a measure of liquidity than
of profitability.
ADVERTISEMENTS:
3. It fails to take into account the timing

of returns and the cost of capital. It fails
to consider the whole life time of a
project. It is based on a negative
approach and gives reduced importance
to the going concern concept and
stresses on the return of capital invested
rather than on the profits occurring
from the venture.
4. The traditional payback approach

does not consider the salvage value of an
investment. It fails to determine the
payback period required in order to
recover the initial outlay if things go
wrong. The bailout payback method
concentrates on this abandonment
alternative.
5. This method makes no attempt to

measure a percentage return on the
capital invested and is often used in
conjunction with other methods.
6. The projects with long payback

periods are characteristically those
involved in long-term planning, and
which determine an enterprise’s future.
However, they may not yield their
highest returns for a number of years
and the result is payback method biased
against the very investments that are
most important to long-term.
Problem 1:
The project involves a total initial

expenditure of Rs.2,00,000 and it is
estimated to generate future cash inflow
of Rs.30,000, Rs.38,000, Rs.25,000,
Rs.22,000, Rs.36,000, Rs.40,000,
Rs.40,000, Rs.28,000, Rs.24,000 and
Rs.24,000 in its last year.
Solution:
Calculation of Payback Period:
In six years, Rs. 1,91,000 are recovered.
... Payback period = 6 years + Rs.

9,000/Rs. 40,000 x 12 months = 6 years
3 months
2. Accounting Rate of Return

Method:
The accounting rate of return is also
known as ‘return on investment’ or
‘return on capital employed’ method
employing the normal accounting
technique to measure the increase in
profit expected to result from an
investment by expressing the net

accounting profit arising from the
investment as a percentage of that
capital investment. The method does
not take into consideration all the years
involved in the life of the project.
In this method, most often the

following formula is applied to
arrive at the accounting rate of
return:
Sometimes, initial investment is used in

place of average investment. Of the
various accounting rates of return on
different alternative proposals, the one
having highest rate of return is taken to
be the best investment proposal.
Merits:
The merits of accounting rate of

return method are as follows:
1. It is easy to calculate because it makes

use of readily available accounting
information.
2. It is not concerned with cash flows

but rather based upon profits which are
reported in annual accounts and sent to

shareholders.
3. Unlike payback period method, this

method does take into consideration all
the years involved in the life of a project.
4. Where a number of capital

investment proposals are being
considered, a quick decision can be
taken by use of ranking the investment
proposals.
5. If high profits are required, this is

certainly a way of achieving them.
Demerits:
The demerits of accounting rate of

return method are summarized as
follows:
1. It does not take into accounting time

value of money.
2. It fails to measure properly the rates

of return on a project even if the cash
flows are even over the project life.
3. It uses the straight line method of

depreciation. Once a change in method
of depreciation takes place, the method
will not be easy to use and will not work
practically.
4. This method fails to distinguish the

size of investment required for
individual projects. Competing
investment proposals with the same
accounting rate of return may require
different amounts of investment.
5. It is biased against short-term

projects in the same way that payback is
biased against longer-term ones.
6. Several concepts of investment are

used for working out accounting rates of
return.
7. The accounting rates of return does

not indicate whether an investment
should be accepted or rejected, unless
the rates of return is compared with the
arbitrary management target.
Problem 2:
A machine is available for purchase at a

cost of Rs.80,000. We expect it to have a
life of five years and to have a scrap
value of Rs.10,000 at the end of the five
year period.
We have estimated that it will

generate additional profits over its
life as follows:
These estimates are of profits before

depreciation. You are required to
calculate the return on capital
employed.
Solution:
Total profit before depreciation over the

life of the machine = Rs.1,10,000
... Average profit p.a. = Rs.1,10,000/5

years = Rs.22,000
Total depreciation over the life of the

machine = Rs.80,000 – Rs.10,000 =
Rs70,000
... Average depreciation p.a. =

Rs.70,000/5 years = RS.14,000
... Average annual profit after

depreciation = Rs.22,00 – Rs.14,000 =
Rs.8,000
Original investment required
... Accounting rate of return =

(Rs8,000/Rs.80,000) × 100 = 10%
Average investment = (Rs.80,000 +

Rs.10,000)/2 = Rs.45,000
Accounting rate of return =

(Rs.8,000/Rs.45,000) × 100 = 17.78%
http://www.businessmanagementideas.com/investment/proposals-investment/evaluation-of-investment-proposals-7-methods-financial-management… 10/34
3. Net Present Value Method:

The objective of the firm is to create
wealth by using existing and future
resources to produce goods and services.
To create wealth, inflows must exceed
the present value of all anticipated cash
outflows. Net present value (NPV) is
obtained by discounting all cash
outflows and inflows attributable to a
capital investment project by a chosen
percentage e.g., the entity’s weighted
average cost of capital.
The method discounts the net cash flows

from the investment by the minimum
required rate of return, and deducts the
initial investment to give the yield from
the funds invested. If yield is positive
the project is acceptable. If it is negative
the project in unable to pay for itself and
is thus unacceptable. The exercise
involved in calculating the present value
is known as ‘discounting and the factors
by which we have multiplied the cash
flows are known as the ‘discount
factors’.
Discount factor = 1/(1+r)n
Where, r = Rate of interest p.a.
n = number of years over which we are

discounting.
Discounted cash flow is an evaluation of

the future net cash flows generated by a
capital project, by discounting them to
their present day value. The method is
considered better for evaluation of
investment proposal as this method
takes into account the time value of
money as well as, the stream of cash
flows over the whole life of the project.
The discounting technique converts cash
inflows and outflows for different years
into their respective values at the same
point of time, allows for the time value
of money.
Merits:
Conceptually sound, the net

present value criterion has
considerable merits:
1. It explicitly recognises the time value

of money.
2. It considers the cash flow stream in

its entirety.
3. It squares neatly with the financial

objective of maximization of the wealth
of stockholders. The net present value
represents the contribution to the
wealth of stockholders.
4. The net present value (NPV) of

various projects, measured as they are in
today’s rupees, can be added.
For example, the NPV of a package

consisting of two projects A and B,
will simply be the sum of NPV of
these projects individually:
NPV(A + B) = NPV(A) + NPV(B)
The additivity property of NPV ensures

that a poor project (one which has a
negative NPV) will not be accepted just
because it is combined with a good
project (which has a positive NPV).
5. A changing discount rate can be built

into NPV calculations by altering the
denominator. This feature becomes
important as this rate normally changes
because the longer the time span, the
lower is the value of money and the
higher is the discount rate.
6. This method is particularly useful for

the selection of mutually exclusive
projects.
Demerits:
The demerits of NPV method are

as follows:
1. It is difficult to calculate as well as

understand and use.
2. The ranking of projects on the NPV

dimension is influenced by the discount
rate – which is usually the firm’s cost of
capital. But cost of capital is quite a
difficult concept to understand and
measure in practice.
3. It may not give satisfactory answer

when the projects being compared
involve different amounts of investment.
The project with higher NPV may not be
desirable if it also requires a large
investment.
4. It may mislead when dealing with

alternative projects of limited funds
under the condition of unequal lives.
5. The NPV measures an absolute

measure, does not appear very
meaningful to businessmen who think
in terms of rate of return measures.
Problem 3:
A firm can invest Rs. 10,000 in a project

with a life of three years.
The projected cash inflows are:
Year 1 – Rs.4,000,
Year 2 – Rs.5,000 and
Year 3 – Rs.4,000.
The cost of capital is 10% p.a. should the

investment be made?
Solution:
Discount factors can be calculated based

on Rs.1 received in with ‘r’ rate of
interest in 3 years using 1/(1+r)n
In this article, the tables given at the end

of the book are used wherever possible.
Where a particular year or rate of
interest is not given in the tables,
students are advised to use the basic
discounting formula as given above.
Analysis:
Since the net present value is positive,

investment in the project can be made.
4. Internal Rate of Return Method:

Internal rate of return (IRR) is a
percentage discount rate used in capital
investment appraisals which brings the
cost of a project and its future cash
inflows into equality. It is the rate of
return which equates the present value

of anticipated net cash inflows with the
initial outlay. The IRR is also defined as
the rate at which the net present value is
zero.
The rate for computing IRR depends on

bank lending rate or opportunity cost of
funds to invest which is often called as
‘personal discounting rate’ or
‘accounting rate’. The test of profitability
of a project is the relationship between
the IRR (%) of the project and the
minimum acceptable rate of return (%).
The IRR can be stated in the form

of a ratio as shown below:
P.V. of Cash Inflows – P.V. of Cash

Outflows = Zero
The IRR is to be obtained by trial and

error method to ascertain the discount
rate at which the present values of total
cash inflows will be equal to the present
values of total cash outflows.
If the cash inflow is not uniform, then

IRR will have to be calculated by trial
and error method. In order to have an
approximate idea about such
discounting rate, it would be better to

find out the ‘factor’. The factor reflects
the same relationship of investment and
cash inflows as in case of payback
calculations.
F = I/C
Where, F = Factor to be located
I = Original Investment
C = Average cash inflow per year
In appraising the investment proposals,

IRR is compared with the desired rate of
return or weighted average cost of
capital, to ascertain whether the project
can be accepted or not. IRR is also called
as ‘cut off rate’ for accepting the
investment proposals.
Merits:
The merits of IRR method are as

follows:
1. It considers the time value of money.
2. It takes into account the total cash

inflows and cash outflows.
3. It is easier to understand. For

example, if told that IRR of an
investment is 20% as against the desired

return on an investment is Rs.15,396.
Demerits:
The demerits of IRR method are

given below:
1. It does not use the concept of desired

rate of return, whereas it provides the
rate of return which is indicative of the
profitability of investment proposal.
2. It involves tedious calculations, based

on trial and error method.
3. It produces multiple rates which can

be confusing.
4. Projects selected based on higher IRR

may not be profitable.
5. Unless the life of the project can be

accurately estimated, assessment of cash
flows cannot be correctly made.
6. Single discount rate ignores the

varying future interest rates.
Problem 4:
A company has to select one of the

following two projects:
Using the internal rate of return

method, suggest which project is
preferable.
Solution:
Average cash inflows of Project A =

Rs.14, 000/4years = Rs.3, 500
Factor in case of Project A =

11,000/3,500 = 3.14
Average cash inflows of Project B =

Rs.14, 000/4 years = Rs.3, 500
Factor in case of Project B =

10,000/3,500 = 2.86
The factor thus calculated will be located

in table given at the end of the book on
the line representing number of years
corresponding to estimated useful life of
the asset. This would give the expected
rate of return to be applied for
discounting the cash inflows in finding
the internal rate of return.
In case of Project A, the rate comes to

10% while in case of Project B it comes
to 15%.
The present value at 10% comes to

Rs.11,272. The initial investment is
Rs.11,000. Internal rate of return may

be taken approximately at 10%. In case
more exactness is required another trial
rate which is slightly higher than 10%
(since at this rate the present value is
more than initial investment) may be
taken.
Taking a rate of 12%, the following

results would emerge
The internal rate of return is thus more

than 10% but less than 12%.
The exact rate may be calculated

as follows:
Since present value at 15% comes only to

Rs.8,662. The initial investment is
Rs.10,000. Therefore, a lower rate of
discount should be taken. Taking a rate
of 10% the following will be the result.
The present value at 10% comes to

Rs.10,067 which is more or less equal to
the initial investment. Hence, the
internal rate of return may be taken as
10%. In order to have more exactness to
internal rate of return, can be
interpolated as done in case of Project

‘A’.
Analysis:
Thus, internal rate of return in case of

project A’ is higher as compared to
Project B. Hence, Project A is preferable.
NPV and IRR: Reasons for

Conflict:
Both the NPV and the IRR methods are

widely used for evaluation of projects,
specially when the assessment is done
by large organizations and the projects
are large-scale. Both methods seek to
assist management in their capital
budgeting decisions.
The two methods may differ in the

discounting rates applied to cash flows
and in some basic assumptions on
reinvestment of generated funds.
Besides these, there are other points
which lie at the root of the conflict
between the two methods of evaluation.
The reasons for conflict between

the NPV and the IRR methods are
mainly as under:
1. NPV ranking depends on the discount

rate used. Assuming the IRR for a
project is 12%, then for a rate of
discount greater than 12% no
contradiction arises. However, if the
discount rate used is less than 12%, the
two methods of evaluation will give
different rankings for the same project.
2. IRR expresses the result as a

percentage rather than in money terms.
Comparison of percentages may
sometimes be misleading.
3. The implicit assumption of NPV is

that cash flows from the project will be
re-invested at the cost of capital.
4. Majority of the projects produce

conventional cash flows, that is initial
cash outflows followed by inflows in the
subsequent years. If in the later years
there are more number of net outflows,
multiple IRRs will be produced.
Problem 5:
The NPV, IRR and other details of

Project A and Project B are given
below:
Which project do you suggest?
Solution:
If a choice has to be made between

Project A and Project B because they are
operationally mutually exclusive, the
project chosen will depend upon the
appraisal method used, because
conflicting ranking will occur. Project B
would be preferred based on NPV
method, despite offering a lower
percentage return on average, it involves
investment of an extra Rs.11,000 – the
return on which is sufficient to generate
a further profit surplus (i.e., an increase
in the NPV) when discounted at 10%.
Differential cash flows of Project A and

Project B
Analysis:
Using IRR, Project A would be chosen

because it provides a differential return
in excess of the minimum required
return. But with the simple observation
of IRR between two projects. Project A
will be selected because of its higher IRR
of 23%.
5. Profitability Index Method:
It is a method of assessing capital

expenditure opportunities in the
profitability index. The profitability
index (PI) is the present value of an
anticipated future cash inflows divided
by the initial outlay The only difference
between the net present value method
and profitability index method is that
when using the NPV technique the
initial outlay is deducted from the
present value of anticipated cash
inflows, whereas with the profitability
index approach the initial outlay is used
as a divisor.
In general terms, a project is acceptable

if its profitability index value is greater
than 1. Clearly, a project offering a
profitability index greater than 1 must
also offer a net present value which is
positive. When more than one project
proposals are evaluated, for selection of
one among them, the project with
higher profitability index will be
selected.
Mathematically, PI (profitability
index) can be expressed as
follows:
This method is also called ‘benefit-cost

ratio’ or ‘desirability ratio’ method.
Limitations:
The limitations of profitability

index method are as follows:
1. Profitability index cannot be used in

capital rationing problems where
projects are indivisible. Once a single
large project with high NPV is selected,
the possibility of accepting several small
projects which together may have higher
NPV than the single project, is excluded.
2. Sometimes the project with lower

profitability index may have to be
selected if it generates cash flows in the
earlier years, which can be used for
setting up of another project to increase
the overall NPV.
Problem 6:
The NPV and profitability index of

project A and project B are given
below:
Which project can be selected based on

the above data?
Solution:
According to the NPV method, Project A

would be preferred, whereas according
to profitability index Project B would be
preferred. Although PI method is based
on NPV, it is a better evaluation
technique than NPV in a situation of
capital rationing.
6. Discounted Payback Period

Method:
In this method the cash flows involved

in a project are discounted back to
present value terms as discussed above.
The cash inflows are then directly
compared to the original investment in
order to identify the period taken to
payback the original investment in
present values terms.
This method overcomes one of the main

objections to the original payback
method, in that it now fully allows for
the timing of the cash flows, but it still
does not take into account those cash
flows which occur subsequent to the
payback period and which may be
substantial.
The method is a variation of payback

period method, which can be used if
DCF methods are employed. This is
calculated in much the same way as the
payback, except that the cash flows

accumulated are the base year value
cash flows which have been discounted
at the discount rate used in the NPV
method (i.e., the required return on
investment).
Thus, in addition to the recovery of cash

investment, the cost of financing the
investment during the time that part of
the investment remains unrecovered is
also provided for. It thus, unlike the
ordinary payback method, ensures the
achievement of at least the minimum
required return, as long as nothing
untoward happens after the payback
period.
Problem 7:
Geeta Ltd. is implementing a project

with an initial capital outlay of Rs.
7,600.
Its cash inflows are as follows:
The expected rate of return on the

capital invested is 12% p.a. Calculate the
discounted payback period of the
project.
Computation of present value of

cash flows:
Computation of Present Value of

Cash Flows
Analysis:
The discounted payback period of the

project is 3 years i.e., the discounted
cash inflows for the first three years (i.e.,
Rs.5,358 + Rs.1,594 + Rs.712) is
equivalent to the initial capital outlay of
Rs.7,600.
7. Adjusted Present Value Method:

In the evaluation of capital budgeting
proposals, the first step is to estimate
the expected cash outflow and inflow of
the project. Such estimates are made
over economic life of the project and
present values of future cash flows are
reckoned. While calculation of present
values of the future cash flows,
otherwise called discounted cash flows,
weighted average cost of capital (WACC)
is considered as a rate for discounting
the cash flows.
In NPV method, cash flows are

discounted at WACC rate, and if the
present value of cash inflow is higher
than the present value of cash outflow,
the project can be accepted. The rate of

discounted return in the project with the
initial outlay is calculated. Under IRR
method this rate is the IRR of the
project and it is then compared with
WACC figure. If WACC of the project is
lower than IRR, the project is accepted
and vice versa.
Under adjusted present value (APV)

approach, the project is splitted into
various strategic components. The cash
flow estimates of the project are first
discounted at the cost of equity, and a
base-case present value is arrived at as if
the project is all-equity financed.
After that, the financial side effects are

analyzed one by one and duly valued.
For example, if the debt is proposed to
be used as a component of capital, then
positive impact of tax shield is added to
the base-case present values. Likewise,
different aspects in cost of financing like
capital investment subsidy, flotation
costs of public issue/rights issue,
administrative cost of equity/debt funds
are analyzed separately and a composite
position arrived at.
The APV method is considered

improvement over WACC method for
the reason that by splitting the overall
decision into logical pieces and

attributing financial values to it, aid the
management in correct valuation of the
project’s viability. But this approach lays
more emphasis on financial risk
ignoring the business risk.
Under WACC approach, all flows are

post-tax and the discount rate is also
post-tax. Thus the benefit of tax shield
will get discounted at the WACC. On the
other hand, under APV approach, the
tax shields are discounted back at the
cost of debt.
Related Articles:
Determination of Cash Flow: 7 Methods |

Firm | Financial Management
Evaluating Capital Budgeting Decisions: 8
Techniques | Financial Management
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Business Management Ideas

The following points highlight the top

1. Payback Period Method:

The payback period is usually expressed

will be equal to the project’s cash

This method specifies the recovery time,

In case of capital rationing situations, a

The merits of payback period

1. It is simple to apply, easy to

2. In case of capital rationing, a

3. This method is most suitable when

4. This method gives an indication to the

5. Ranking projects according to their

6. It does not involve assumptions about

The payback period method

1. It does not indicate whether an

2. The method ignores cash generation

3. It fails to take into account the timing

4. The traditional payback approach

5. This method makes no attempt to

6. The projects with long payback

The project involves a total initial

Calculation of Payback Period:

In six years, Rs. 1,91,000 are recovered.

... Payback period = 6 years + Rs.

2. Accounting Rate of Return

investment by expressing the net

In this method, most often the

Sometimes, initial investment is used in

The merits of accounting rate of

1. It is easy to calculate because it makes

2. It is not concerned with cash flows

reported in annual accounts and sent to

3. Unlike payback period method, this

4. Where a number of capital

5. If high profits are required, this is

The demerits of accounting rate of

1. It does not take into accounting time

2. It fails to measure properly the rates

3. It uses the straight line method of

4. This method fails to distinguish the

5. It is biased against short-term

6. Several concepts of investment are

7. The accounting rates of return does

A machine is available for purchase at a

We have estimated that it will

These estimates are of profits before

Total profit before depreciation over the

... Average profit p.a. = Rs.1,10,000/5

Total depreciation over the life of the

... Average depreciation p.a. =

... Average annual profit after

Original investment required

... Accounting rate of return =

Average investment = (Rs.80,000 +

Accounting rate of return =

3. Net Present Value Method:

The method discounts the net cash flows

Discount factor = 1/(1+r)n

Where, r = Rate of interest p.a.

n = number of years over which we are

Discounted cash flow is an evaluation of