Continuous availability of surplus cash inflows from business operations is the symbol of a successful entrepreneur. This motivates him to expand business operations, carry out replacement of old and obsolete plants and machinery or equipment and modernise the production process. It also encourages him to incur long-term commitments by way of capital expenditure. But before making any long-term investment the entrepreneur has to decide whether such investment is worthwhile/ whether it will increase profitability or strain the cash position/ whether alternative use of capital could be more rewarding/ and the criteria he must follow to take correct investment decision.There are several investment evaluating criteria which a small entrepreneur may follow viz. (i) pay-back criterion (ii) rate of return (iii) discounted cash flow or internal rate of return method; and (iv) net present value criterion.
For different type of investments/ equipment, different methods are to be selected. For example, if theproposed investment is to be made in the asset which is subject to rapid technological or innovational changes with higher rate of obsolescence requiring early recovery of investment outlay, the best method is "pay-back" criterion.
The shortest pay-back period represents less risk and more certainty of repayment. For example, if a machine is offered for Rs 5,000 with an estimated economic life of 10 years and savings of Rs 1,000 a year before depreciation then pay-back period will be five years (i.e. 5,000 + 5 = 1,160). If estimated annual earnings are not equal in all these five years and are Rs 1,500, Rs 1,800, Rs 1,100, Rs 1,000 and Rs 900 = 5,800 for the first year to fifth year then an average annual cash flow could be derived as (5,800 + 5 = 1160). Now the pay-back period will be 5,000 + 1160 = 4.31 i.e. 4 years, three months and 15 days.
In instant illustration, the economic life of the machine is 10 years i.e. more than the pay-back period. In that case the proposal should be acceptable. If theeconomic life and the pay-back period are the same, the proposal is not worth accepting. This is a thumb of rule criteria and does not take into consideration the time value of money. For this purpose, it is necessary to discount the cash flows at the appropriate discount rate and add up the present values of cash flows. If this sum is more than the total outlay the proposal should be acceptable.
From the data given in this example, cash flow should be discounted at 10% to get these results (See graph). The present value of cash inflow from investment is more than the cost outlay; the pay-back period is also shorter than the economic life of the machine. The proposal should be acceptable to the concern.
The second criterion is the rate of return based on unadjusted return on investment for establishing desirability of an investment proposal. The rate of return can be arrived at by dividing the average net income (after tax and depreciation) by the original cost of investment. Taking the data from theabove example, the rate of return is 1000 + 5000 x 100 = 20% or 1160 + 500 x 100 = 23.20. The rate of return (R/R) is compared to minimum cut-off rate; if the R/R is higher than the cut-off rate, the investment proposal is acceptable. However, this criterion is not reliable as it does not take into account time value of money.
This drawback can be overcome by using the internal rate of return (IRR) criterion. In this method the rate of return for an investment is determined by finding the discount rate that exactly equates the present value of cash inflows (expected during the life of the asset) with the capital outlay required to produce inflows. In other words IRR is that rate at which the total sum of present values of all inflows is equal to the present values of current investment i.e. outflow. This method is also known as discounted cash flow technique for evaluation of investment proposals.
Another method available for the small business entrepreneur for evaluating investment decision is the NetPresent Value method which is more reliable in terms of time value of money in measuring desirability of investment. NPV method prevails over IRR method in two circumstances viz. (i) when IRR method fails where multiple rate of return exist (ii) NPV method is good where own funds are invested by the entrepreneur because IRR method is good only when borrowed funds are used by entrepreneur.
The IRR method suggests that the borrower should not pay more interest on borrowed moneys then IRR. Borrowed fund investment will yield only IRR whereas payment of interest on borrowed money will be higher than IRR. As such the entrepreneur would incur heavy losses as the cost of borrowed funds is not covered. The NPV method ignores the above shortcoming. The entrepreneur should use the NPV method where two or more investment proposals are being compared.
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