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Factors Influencing Plant Location – Production and Operations Management
Capital Budgeting
Capital budgeting is the process of allocating available funds to different investment possibilities.
The questions that capital budgeting addresses itself to are:
1. Is it wise to invest a certain amount of funds in a particular project or not?
2. If investment funds are limited or if the investment opportunities are mutually exclusive, how can we establish priorities, or choose between the different viable investment possibilities?
These are the real-life problems faced during the formulation or feasibility studies of projects requiring capital investment.
CRITERIA FOR APPRAISAL OF INVESTMENT OPPORTUNITIES
Payback Period
It is the duration in which the investment will be recovered totally, by the net returns of the project invested in.
Let us consider the following example where the revenues (gross) and the operating costs in different periods of a project are as given in Table 6.1.
The payback period for this example will be 4 years. Within 4 years, the initial investment will be recovered by means of the net returns to this project. If this period of recovery (4 years) is acceptable to the management, the project will be approved for making an investment.
The same calculations could be summarised in terms of the following expression. The payback period is the value of n which satisfies the following equation:
Merits and Demerits of Payback Period
1. One shortcoming of this criterion is that it overlooks the net incomes made available by the project after the payback period.
2. Another drawback of this criterion is that the value of money is assumed to be the same over the different years of the payback period. This is obviously wrong, since the value of one rupee available today is not the same as the value of the same rupee received the next year.
3. The merit of the payback method lies in its implicit coverage of risk. The user of the payback period criterion may not be sure about the revenues and costs of the project in the long-term future.
Net Present Value
As mentioned earlier, the value of one rupee available today is not the same as the value of the same rupee received a year later. This is so because, had we received the rupee today we could have invested the same in a project, or in a bank and earned the interest.
Let us say the return or interest was 10%. Then, receiving one rupee today is as good as receiving Rs. 1.10 a year later; it is as good as receiving Rs. 1.21 two years later, and so on. It implies the revenues and costs generated or incurred for the future years of a project have to be discounted by the appropriate cost of the money. It is not inflation that we are talking about, but rather the interest or return on capital which we would normally expect of our investments. This normally expected return on capital is called cost of capital. The revenues and costs should be discounted by this expected return on capital which is necessary for the firm or organisation. The values of the future net incomes discounted by the cost of capital are called net present values (NPVs).
Where i is the cost of capital; the other notations remain the same as earlier.
Some have defined the cost of capital as the weighted arithmetical average of the cost of various sources of financing employed by the Arm. To obtain the cost of capital of the Arm, one needs to know:
(i) the cost of different sources of financing employed by the Arm (debt, equity, etc.);
(ii) the weights that should be applied to the cost of different sources of financing in calculating the weighted average.
The determination of the cost of capital is difficult, but it is certainly not impossible.
The obvious advantage of the NPV criterion is that the income and cost streams for the future are brought to a common basis and this gives us a measure of the absolute value of profits to be gained by investment in a project.
Internal Rate of Return (IRR)
The Internal Rate of Return is that rate of discount that equates the initial investment in the project with the future net income stream. Mathematically, it is expressed as given below:
The IRR criterion for project acceptance, under theoretically infinite funds is: accept all projects which have an IRR greater than the cost of capital.
The procedure in applying this criterion is
(ii) Assume different values of the discount rate, i.
(iii) For each value of the discount rate, find if the equation given above balances.
(iv) That discount rate for which the equation fits, is the Internal Rate of Return.
Merits and Demerits of IRR
IRR criterion is often preferred since it involves minimal use of a given cost of capital (which is controversial conceptually and is difficult to arrive at). Although it does away with the cost of capital assumptions, it still has certain drawbacks:
1. It is cumbersome in calculation.
2. For mutually exclusive and in cases of capital rationing, IRR is not the best criterion to be used.
3. IRR is only a figure reflecting the rate of return or the efficiency in the use of the capital; or, in other words, it does not consider the size or amount of outlay involved in the project.
Profitability index (PI)
This is the ratio of the net present value of the future benefits minus costs divided by the initial investment.
The project is accepted if the profitability index is greater than unity and the funds are unlimited. Those projects whose profitability index is equal to or less than unity are rejected.
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