M.K.G and Finance

DIFFERENT TECHNIQUES USED IN CAPITAL BUDGETING

Net Present Value (NPV)

Net present value is one of the most reliable measure used in capital budgeting. It is the present value of net cash inflows generated by a project less the initial investment on the project. The use of discounted cash inflows means that net present value accounts for time value of money. Before calculating NPV, a target rate of return is set which is used to discount the net cash inflows from a project.

Calculation Methods and Formulas

The major component of NPV is the present value of net cash inflows which may be even (i.e. equal cash inflows in different periods) or uneven (i.e. different cash flows in different periods). Where net cash inflows are even, present value can be easily calculated by using the present value formula of annuity. However if net cash inflows are uneven we need to calculate the present value of each individual cash inflow separately.

PAYBACK PERIOD

Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques.

The formula to calculate payback period of a project depends on whether the cash flow per period from the project is even or uneven. In case the cash flow per period are even, the formula to calculate payback period is:

Payback Period = Initial Investment / Cash Inflow per Period

Discounted Payback Period

One of the major disadvantages of simple payback period is that it ignores the time value of money. To counter this limitation, an alternative procedure called discounted payback period may be followed, which accounts for time value of money by discounting the cash inflows of the project.

Accounting Rate of Return (ARR)


Accounting rate of return or simple rate of return is the ratio of the estimated accounting profit of a project to its average investment. It is an investment appraisal technique. ARR ignores the time value of money.
Formula
Accounting Rate of Return is calculated as follows:

ARR = Average Accounting Profit / Initial Investment


Internal Rate of Return (IRR)

Internal rate of return (IRR) is the discount rate at which the net present value of an investment becomes zero. In other words, IRR is the discount rate which equates the present value of the future cash flows of an investment with the initial investment. It is one of the several measures used for investment appraisal.

Profitability IndeX

Profitability index is an investment appraisal technique calculated by dividing the present value of future cash flows of a project by the initial investment required for the project.

DEPRECIATION AND ITS METHODS

Confused about depreciation on fixed assets? Depreciation is simply the calculation of wear and tear on assets and is reported annually on your financial statements and utilized as a business expense when submitting tax returns. Learn the most common methods used here.

About This Business Expense

Depreciation is the reduction in the book value of an asset due to usage over a period of time. In other words, it is the reduction in the economic usefulness of the asset, or the calculation of wear and tear that may have occurred to the asset. This is also done to report the actual value to tax authorities.

The present value of the asset, i.e., after deducting the depreciation amount, is then recorded in the accounting books. To calculate, one needs to take into account the economic life and the expected value or scrap value of the asset after its use in the business is over.

The calculation is a non-cash expense that is estimated or forecasted. This process occurs at the end of the financial year and the amount is shown in both the balance sheet and the income and loss statement. Here we discuss the different types of depreciation methods and how to calculate them.

Straight Line Method

This is the simplest, and most commonly used, form of depreciation calculation and refers to reduction of the value as per a constant rate. The depreciation value is calculated by taking the original, purchase, or historical price, less the scrap (or salvage) value, and dividing it by the useful years or the number of years that the asset would be in use in the business. The rate of depreciation remains constant as a fixed expense throughout the years. This depreciation method is useful for those assets in which the usage remains uniform or consistent. Unfortunately, it does not take into account the fact that all assets do not deteriorate equally.

An example would be an alignment machine purchased for a body shop for $100,000. The straight line calculation is as follows:

Cost of Alignment Machine - $100,000

See the complete Bright Hub Guide to Balance Sheet Basics »
Less Salvage Costs – ($10,000)

Subtotal - $90,000

Years of Useful Life – 5

5 Years of Useful Life Divided by $90,000 = $18,000

So, for the first year, the alignment machine depreciation using the straight line method is $18,000 and the value on the accounting books at year end is $100,000 (purchase price) minus the depreciation ($18,000) = $82,000.

The straight line depreciation method continues until the useful life (5 years) .

Reducing Balance Method

The reducing balance method allows you to consider a certain depreciation percentage to depreciate the alignment machine rate annually. This method takes into consideration an accelerated rate of depreciation. This is useful for those assets in which a higher value is lost during the beginning years of usage. The only flaw of this method is it does not take into account the scrap or residual value of the asset. In addition, most tax professionals will tell you the reducing balance method should be used for fixed assets where useful life is only three years and upon the fourth year, the straight line depreciation method should be implemented (check with your tax professional to be sure). Below is an example of the declining balance method based on five years for our same alignment machine using 37 percent each year.

MACRS Method

The Modified Accelerated Cost Recovery System (MACRS) is widely used in the depreciation of land, buildings or equipment owned and used 100 percent by the company. MACRS is almost always utilized when depreciating assets for tax purposes to enjoy the expense of each depreciated item. In the Bright Hub article, MARCS Depreciation Formula: Explanation and Examples, you'll find great tips on how to use this method to help your business reap the tax benefits offered by this type of depreciation method.

The Internal Revenue Service offers Form 4562 along with detailed instructions on the best way to utilize the MACRS method. You can download the form and instructions here. It you're unsure on how to best utilize the MACRS method, ask your tax professional for help.

Unit of Production Method

This method refers to an association between the asset’s ability to do work during its useful life and the decline in the worth of the asset. Unfortunately, this depreciation method does not take into account the expected years of the asset but takes into account the measurable units of use. The units could be anything, including number of items produced or hours used for machinery, number of miles traveled by vehicles, etc. Thus, it is calculated by the actual usage of the asset.

Again using our alignment machine and assuming the machine can do 15 alignments in one year (365 days):

Depreciation cost equals original purchase price less salvage value. ($100,000 - $10,000 = $90,000).

Deprecation per item/unit equals depreciable costs divided by the number of total items or units. ($90,000 / 5,475 units - 16.44%).

Depreciation - $90,000 * 16.44% = $14,796 per year.

DEPRECIATION

Buildings, machinery, equipment, furniture, fixtures, computers, outdoor lighting, parking lots, cars, and trucks are examples of assets that will last for more than one year, but will not last indefinitely. During each accounting period (year, quarter, month, etc.) a portion of the cost of these assets is being used up. The portion being used up is reported as Depreciation Expense on the income statement. In effect depreciation is the transfer of a portion of the asset's cost from the balance sheet to the income statement during each year of the asset's life.

The calculation and reporting of depreciation is based upon two accounting principles:
Cost principle. This principle requires that the Depreciation Expense reported on the income statement, and the asset amount that is reported on the balance sheet, should be based on the historical (original) cost of the asset. (The amounts should not be based on the cost to replace the asset, or on the current market value of the asset, etc.)
Matching principle. This principle requires that the asset's cost be allocated to Depreciation Expense over the life of the asset. In effect the cost of the asset is divided up with some of the cost being reported on each of the income statements issued during the life of the asset. By assigning a portion of the asset's cost to various income statements, the accountant is matching a portion of the asset's cost with each period in which the asset is used. Hopefully this also means that the asset's cost is being matched with the revenues earned by using the asset.

There are several depreciation methods allowed for achieving the matching principle. The depreciation methods can be grouped into two categories: straight-line depreciation and accelerated depreciation.

The assets mentioned above are often referred to as fixed assets, plant assets, depreciable assets, constructed assets, and property, plant and equipment. It is important to note that the asset land is not depreciated, because land is assumed to last indefinitely.