FREE online courses on Investment Appraisal - Investment Appraisal - Investment Appraisal - Methods And Considerations - Non-discounting Methods

 

Urgency

 

According to this criteria, projects which are deemed to be more urgent get priority over projects, which are regarded as less urgent.

 

The problem with this criterion is: How can the degree of urgency be determined? In certain situations, of course, it may not be difficult to identify highly urgent investments. For example, some minor equipment may have to be replaced immediately due to failure, to ensure continuity of production. Non-replacement of such equipment may mean considerable losses arising from stoppage in production. It may be futile in such a case to go into detailed analysis and delay decision.

 

In view of these limitations of the urgency criterion, we suggest that in general it should not be used for investment decision-making. In exceptional cases, where genuine urgency exists, it may be used provided investment outlays are not significant.

 

Payback Period

 

Payback period is the most widely used technique and can be defined as the number of years required to recover the cost of the investment. This is easy to calculate, but is often calculated before tax, and always after accounting depreciation. By definition, the payback period ignores income beyond this period, and it can thus be seen to be more as a measure of liquidity than of profitability.

 

The payback period is the length of time required to recover the initial cash outlay on the project. For example, if a project involves a cash outlay of Rs 6,00,000 and generates cash inflows of Rs 1,00,000, Rs 1,50,000, Rs 1,50,000 and Rs 2,00,000 in the first, second, third and fourth years respectively, it payback period is four years because the sum of cash inflows during four years is equal to the initial outlay. When the annual cash inflow is a constant sum, the payback period is simply the initial outlay divided by the annual cash inflow. For example, a project which has an initial cash outlay of Rs 10,00,000 and constant annual cash inflow of Rs 3,00,000 has a payback period of Rs. 10,00,000/Rs 3,00,000 = 3.1/3 years.

 

According the payback criteria, the shorter the payback period, the more desirable the project. Firms using this criterion, generally specify the maximum acceptable payback period. If this is n years, projects with a payback period of n years or less are deemed worthwhile, and projects with a payback period exceeding n years are considered unworthy.

 

Projects with long payback periods are characteristically those involved in long range planning, and which determine a firm's future. However, they may not yield their highest returns for a number of years and the result is that the payback method is biased against the very investments that are most important to long-term success.

Evaluation

 

A widely used investment criterion, the payback period seems to offer the following advantages.

• It is simple, both in concept and application. It does not use complex concepts and tedious calculations and has few hidden assumptions.
• It is a rough and ready method for dealing with risk. It favors projects which generate substantial cash inflows in earlier years and discriminates against projects, which bring substantial cash inflows in later years but not in earlier years. Now, if risk tends to increase with futurity - in general, this may be true – the payback criterion may be helpful in weeding out risky projects.
• Since it emphasizes earlier cash inflows, it may be a sensible criterion when the firm is pressed with problems of liquidity.
• The limitations of the payback criteria, however, are very serious:
• It fails to consider the time value of money. Cash inflows, in the payback calculation, are simply added without suitable discounting. This violates the most basic principle of financial analysis which stipulates that cash flows occurring at different points of time can be added or subtracted only after suitable compounding / discounting.
• It ignores cash flows beyond the payback period. This leads to discrimination against projects, which generate substantial cash inflows in later years. To illustrate, consider the cash flows of two projects, A and B :

Year             Cash flow of A                  Cash flow of B

0                  -1,00,000                                   -1,00,000

1                  50,000                                       20,000

2                  30,000                                       20,000

3                  20,000                                       20,000

4                  10,000                                       40,000

5                  10,000                                       50,000

6                  60,000

 

The payback criteria prefers A, which has a payback period of 3 years, in comparison to B, which has a payback period of 4 years, even though B has very substantial cash inflows in years 5 and 6.

• Since the payback period is a measure of a projects' capital recovery, it may divert attention from profitability. Payback has harshly, but not unfairly, been described as the "fish bait test since effectively it concentrates on the recovery of the bait (the capital outlay) paying not attention to the size of the fish (the ultimate profitability), if any."
• Though it measures a project's liquidity, it does not indicate the liquidity position of the firm as a whole, which is more important.

 

Accounting Rate Of Return

 

The accounting rate of return, also referred to as the average rate of return or the simple rate, is a measure of profitability which relates income to investment, both measured in accounting terms. Since income and investment can be measured variously, there can be a very large number of measures for accounting rate of return.

 

The measures that are employed commonly in practice are:

                Average income after tax

        A :   -------------------------------

                     Initial investment

                  Average income after tax

        B :      -------------------------

                    Average investment

       

                  Average income after tax but before interest

        C :      ------------------------------------------------------

                                  Initial investment

       

                  Average income after tax but before interest

        D :     ------------------------------------------------------

                            Average investment

       

                  Average income before income and taxes

        E :      ---------------------------------------------------

                            Initial investment

                  Average income before income and taxes

        F :      ---------------------------------------------------

                            Average investment

                   Total income after tax but before depreciation - Initial investment

        G :     --------------------------------------------------- 

                            Initial investment x Years

 

This method is superior to the payback period, but is fundamentally unsound. While it does take account of the earnings over the entire economic life of a project, it fails to take account of the time value of money. This weakness is made worse by the failure to specify adequately the relative attractiveness of alternative proposals. It is biased against short term projects in the same way that payback is biased against longer term ones.

Evaluation

 

Traditionally as a popular investment appraisal criterion, the accounting rate of return has the following virtues:

• It is simple to calculate.
• It is based on accounting information which is readily available and familiar to businessmen.
• It considers benefits over the entire life of the project.
• Since it is based on accounting measures, which can be readily obtained from the financial accounting system of the firm, it facilitates post-auditing of capital expenditures.
• While income data for the entire life of the project is normally required for calculating the accounting rate of return one can make do even if complete income date is not available. For example, when due to indeterminacy of project life a complete forecast of income cannot be obtained, the accounting rate of return can be calculated on the basis of income for some typical year or income for the first three to five years.
• The shortcomings of the accounting rate of return criterion seem to be considerable:
• It is based upon accounting profit, not cash flow.
• It does not take into account the time value of money. To illustrate this point, consider two investment proposals X and Y, each requiring an outlay of Rs 1,00,000. Both the proposals have an expected life of four years after which their value would be nil. Relevant details of these proposals are given below:

 

Proposal x     

          Year    Book Value     Depreciation            Profit            Cash

                                                                                                after tax

          0        1,00,000        0                           0                  1,00,000

          1        75,000          25,000                    40,000          65,000

          2        52,000          25,000                    30,000          55,000

          3        50,000          25,000                    20,000          45,000

          4        0                  25,000                    10,000          35,000

 

Proposal y

          Year    Book Value     Depreciation            Profit            Cash

                                                                                                after tax

          0        (1,00,000)     0                           0                  (1,00,000)

          1        70,000          25,000                    10,000          35,000

          2        50,000          25,000                    20,000          45,000

          3        25,000          25,000                    30,000          55,000

          4        0                  25,000                    40,000          65,000

 

Both the proposals, with an accounting rate of return (measure A) of 50% look alike from the accounting rate of return point of view, though project X, because it provides benefits earlier, is much more desirable. While the payback period criterion gives no weight to more distant benefits, the accounting rate of return criteria seems to give them too much weight.

• There are, as we have seen, numerous measures of accounting rate of return. This can create controversy, confusion and more confusion, and problems in interpretation.
• Accounting income (whatever particular measure of income we choose) is not uniquely defined because it is influenced by the methods of depreciation, inventory valuation, and allocation of certain costs. Working with the same basic accounting data, different accountants are likely to produce different income figures. A similar problem, though less severe, exists with respect to investment.
• The argument that the accounting rate of return measure facilitates post-auditing of capital expenditure is not very valid. The financial accounting system of a firm is designed to report events with respect to accounting periods and for profit centers but not for individual investment.

 

Debt Service Coverage Ratio

 

Financial institutions, which provide the bulk of long-term finance for industrial projects, evaluate the financial viability of a project primarily in terms of the internal rate of return and the debt service coverage ratio.

 

Debt service coverage ratio (DSCR) is defined as

                                               

where PAT_i = Profit after tax for year i

              D_i   = depreciation for year i

              I_i     = interest on long-term loans of financial institutions for year i

             LRI_i = loan repayment instalment for year i.

                n   = period over which the loan has be repaid.

 

Looking at the debt service coverage ratio we find the numerator consists of a mixture of post-tax and pre-tax figures  (profit after tax is a post tax figure and interest is a pre-tax figure).  Likewise, the denominator consists of mixture of post-tax and pre-tax figures (loan repayment installation is a post-tax figure and interest is a pre-tax figure).  It is difficult to interpret a ratio, which is based on a mixture of post-tax and pre-tax figures. In view of this difficulty, we suggest two alternatives:          

 

Alternative 1:

                     Earnings before depreciation interest and taxes

 DSCR =        ----------------------------------------------------------

                          Interest + Loan repayment installment

                                            ---------------------------------------

                                                   1 - Tax rate

Alternative 2:      

                    Profit after tax + Depreciation

DSCR =         -------------------------------------

                     Loan repayment installment

 

While alternative 1 is based on pre-tax figures, alternative 2 is based on post-tax figures.  There is one more difference.  Alternative 1, assumes that the interest and loan repayment obligations are of the same order and focuses on the ability of the firm to  meet these obligations jointly. Alternative 2 assumes that the interest burden is of a higher priority, and focuses on the ability of the firm to meet the principal repayment obligation, once the interest obligation is fully met.

 

These traditional methods of investment appraisal are misleading to a dangerous extent. A means of measuring cash that allows for the importance of time is needed. This is provided by the discounting methods of appraisal, of which there are basically two methods, both of which meet the objections to the payback period and the average rate of return methods.