Everyone in this world yearns for more and more and unlimited money because money is the only thing that has got the power to purchase any or all other things. If ample funds are with everyone, there is no need to make any selection as one would be able to purchase all things or will be able to invest in all available opportunities, etc. But it is not so in real life. The scarcest resource is probably the financial resource with any person as everyone has to earn it and everyone has got limited earning capacity. This makes life difficult as one has to decide upon the priorities and make selections every now and then. The same is the case with organizations.
Organizations too have scarce financial resources. Whenever there are investment opportunities or a number of projects available for persuasion, there is a need to appraise them and select according to pre-decided selection criteria. It is not possible for any firm to invest in all the projects and it is even more important to know whether the project is going to be profitable or not. Suppose there is n number of projects available for investment than first of all the organization will shortlist those projects which are profitable, using predefined criteria for the purpose, like projects having a specific return on investment, etc. This will reduce the number of projects to be analyzed further.
The projects need to be analyzed from three dimensions.
- Amount required for investment.
- Tenure of project
- Return from the project
Various projects have different durations and the amount required as initial investment also varies. Of course, returns from projects are also not the same. Finding a tradeoff between these three is the real challenge for any organization, in order to select the best project. Keeping in view all these three dimensions, there are a number of techniques used by the organizations. Non discounted and discounted cash flow techniques are also the techniques applied by the organizations to appraise and rank the projects. Organizations also use these techniques as yardsticks to check whether specific projects qualify for investment or not.
For example, an organization may decide that it will not at all consider those projects which have a payback period of more than five years or which do not have positive net present value etc. organizations devote a lot of time and efforts in the exercise of the selection of feasible projects as their future depends on the success of these projects. The projects demand a commitment of large amounts of funds and their benefits are reaped by the organizations over a number of future years. Usually, these types of decisions are irretrievable and these also affect the risk profile of the organization.
It also depends on the type of project and how it is going to contribute to the success of the organization. Whether the project is related or not, with the current business of the organization, it is technology-based or some new product or service is being launched or it is the expansion of present capacities, these are some critical issues that will affect the fate of the organization. To deal with the selection process, the organizations resort to various methods and techniques and non-discounted and discounted cash flow techniques are also very popular project appraisal techniques followed by the organizations to narrow down on feasible and profitable projects.
If the organizations had more than sufficient funds for all projects or all investment opportunities that come their way, there would have been no need to appraise any project but in real life, financial resources are limited and it becomes imperative to appraise all projects from the viewpoint of their financial viability. It is the scarcity of budgetary assets that the associations can’t seek after all undertakings and in this manner the associations need to choose the most suitable project out of the numerous accessible ones. All ventures, in the race of getting chosen, don’t have the same necessities of speculation sums and same money inflows.
Even the life span of various projects are also different. In case of investment opportunities, the maturity date varies from project to project. Thus, to appraise and compare different projects, the organizations use a number of methods and techniques, as per their yardsticks. Some of these techniques are really simple to understand and apply while others are technical, requiring certain knowledge of apprising. This process of evaluating cash flows for different stimulated time is also sometimes known as part of the capital budgeting process. It is understood that with the passage of time, the purchasing power of money is eroded and hence the amount supposed to be received in future needs to be adjusted for such reduction.
The required rate of return the organization wants to earn on its projects is referred to as its discounting rate. It is very much clear here that the non-discounted cash flow techniques of project appraisal do not consider the time value of money. These techniques presume that the value of money today will also remain the same in the future, as well. In practice, it is not so, as there is an impact of inflation and other economic factors and the value of money is less on a future date, in comparison to what it is today.
Project appraisal Non-Discounted Cash Flow (NDCF) techniques are really simple to understand project appraisal. Least calculations involved in these techniques and are easy to apply in practice. By the term non-discounted, it is meant that the time value of money has not been considered i. e. the present value and the future value of money is being treated as the same. The cash inflows or even the future cash outflows are not being brought at par with their present value.
Since time immemorial, the criterion to analyze the investment opportunity is to find out the time period in which the invested amount is recovered. There used to be no consideration for the time value of money. They are found out from simple traditional methods of payback.
Discounted Cash Flow techniques are an edge over Non-Discounted Cash flows techniques of project appraisal as these consider the time value of money.
Before landing into Discounted techniques, let us first understand the concept of discounting.
Concept of discounting
If suppose Rs 100 are invested today @ 10% for one year, the amount to be received after one year is Rs 110. If it is known that Rs 110 will be received after one year and if the organization wants to know the amount that can be invested today at 10% required rate of return, the answer is Rs 100. In other words, one can say that Rs 100 is the present value of Rs 110 expected to be received after one year @ 10% rate of return and Rs 110 is the future value of Rs 100 being invested today, for one year @ 10% rate of return. To reach the present value from the future value, the future value is to be multiplied by a discounting factor. For investment for one year duration @ 10%, this factor is 0.909. This is arrived at by dividing 1 by (1+0.1). Similarly, discounting factors for another rate of interest for different years can be calculated.
Now, as the concept of discounting is clear, let us discuss Discounted Cash Flow techniques of project appraisal.
Discounted Cash Flow techniques of project appraisal.
Basically, there are four techniques
- Adjusted payback period
- Net present value
- Profitability index or benefit-cost ratio
- Internal rate of return.
The organizations need capital funds for n number of reasons like an expansion of present capacities, diversification from present business, replacement of heavy machines or equipment with an objective of modernization and these may be sometimes emergency investments. New business ventures are also tried by organizations. For all such purposes, capital investments are needed. A peculiar feature of capital projects is that these are irreversible and due to this very reason it becomes crucial that these projects are analyzed from the viewpoint of financial viability. Any organization considering capital investment projects is actually committing its scarce financial resources and moreover, these financial resources are competing for various mutually exclusive investment opportunities. It is considerable here that capital investment projects convert current assets into fixed assets and the features of both these types of assets are different, the main difference being long term commitment of funds in fixed assets.
These investments further affect the profitability of the organization as it may be possible that during the initial years some projects fail to generate any revenue. All projects which seem financially viable initially may not be worth taking up for consideration for investment. For the purpose of selecting projects for investment, organizations apply many techniques, in order to let the projects jump the cut off criteria and attain some rank in the process of selection. Non-Discounted techniques do not discount the cash flows as these do not consider the time value of money. These are simple to understand and apply but the results provided by these techniques can be misleading.
Discounted techniques are a step ahead as these consider the time value of money by discounting the future cash flows by the required rate of return, to arrive at the present value of such future cash flows. This provides a refined picture of the cash streams of the projects and also guides the organization about the worth of the project as on the present date. Also, it makes the comparison of cash outflows and inflows more effective as all the cash flows are now considered on the same date. This makes usage of discounted techniques more relevant for the organizations engaged in the Project evaluation process.
