6.3 Methods Of Capital Budgeting Decision (Rate and Profit or Loss Sharing Ratio Comparison)

 

The three main capital budgeting tools usually performed are NPV, IRR and Payback period. In more detail definition,    

1.      NPV (Net present value) is the difference between cash outflow and cash inflow’s present values over a period of time. A present value of a time period is the multiplication between present value factor (PV = 1/(1+r)ⁿ, r = rate of return, n = periods) and total cash in or out of that period. And the net present value is the sum of all available periods. Positive NPV means that, in present dollars, anticipated costs are less than projected earnings. In other words, Positive NPV indicates profitable investments and Negative NPV indicates unprofitable ones (Fernando, 2021).

2.      IRR (Internal rate of return) is a used metric for financial analysis to do the estimation of potential investment’s profitability. In a discounted analysis of cash flows, it is a rate of discount making the NPV of all cash flows as follows, (Fernando, 2021).

In general, higher IRR means better investment based on the definition to make total NPV quickly go to zero (Ganti, 2021). General excel formula to calculate the IRR can be written as : =IRR(Total cash at year 0: Total cash at year n, initial guess value)

3.      Payback period is the required amount of time for the investment cost recovery. In other words, it is the time for the investment to reach the Break Even Point (BEP) (Kagan, 2021). In the technical excel sheet, the calculation uses the fact that the payback period is the time at exactly zero cumulative cash flow. If the cash flow data show no zero cumulative cash flows then we can use the linear regression technique to find the linear equation between two points consisting of the last negative and the first positive cumulative cash flows. In detail, the required payback period is the year on the x axis where cumulative cash flow is exactly zero at the y axis.   

 

The best and the least information can be based on the critics to the above theories. The critics to the net present value (NPV) and (Internal rate of return) IRR which are closely related to the TVM (Time value of Money) are as follow :

1.    Due to the above  present value factor in relation to the future value, the theory of NPV closely related to disconto theory let money rely on the time period. Adiawarman in (Ilyas, 2017) mentioned The TVM concept is intervention to the biological concept in economy, making money as a biological cell which can grow by itself using the formula : Pb = Po (1+g)^t, where Pb is growing cell, Po is initial cell, g is growing factor and t is time. The adopted financial formula is FV = PV(1+r)^n . The critic is that money can not be made similar with biological cell since it’s spread must only be generated to be as an exchange to the goods and service transaction and money must not be made as commodities.

2.    Time value of money (TVM) is defined as “a dollar today is worth more than a dollar in the future because to get a return a dollar today can be invested”. This means TVM always predicts positive return, while in contradiction,  Adiwarman in (Ilyas, 2017) said this definition is not accurate since every investment always has probability to get negative, positive or even no return. 

3.    The IRR (Internal Rate of Return) and NPV using the required rate of return introduce the concept of rate which is in contradiction with the concept of profit/loss sharing due to the fact that all investments and businesses have profit or loss probabilities.

In conclusion the last concept of payback period and even the NPV and IRR becomes the least information if the present cash flow data are sourced from the required rate of return and becomes the best information if the present cash flow data are sourced from the profit or loss sharing ratio (Ruminta,2020). 

Additional Note :  Considering the unstable value of money, further available choices of more stable concepts of capital budgeting analysis are using golds such as those in the Hamdi’s model (Gold Value Method (GVM), Gold Index (GI) and Investible Surplus Method (ISM) ) (Hamdi at all , 2021)     

References 

Fernando, J. (2021, October 13). Net present value (NPV). Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/n/npv.asp.  

Fernando, J. (2021, October 13). Internal Rate of Return (IRR). Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/i/irr.asp.  

Ganti, A. (2021, October 13). Internal Rate of Return (IRR) rule. Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/i/internal-rate-of-return-rule.asp.  

Kagan, J. (2021, October 13). What is the payback period? Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/p/paybackperiod.asp.  

Ilyas, R. (2017). Time value of money Dalam Perspektif Hukum islam. AL-'ADALAH, 14(1), 157. https://doi.org/10.24042/adalah.v14i1.1991

Ruminta, D. (2020, April 1). Analisis Perbandingan Perhitungan Kelayakan finansial Konvensional Dan syariah. Jurnal ECODEMICA. Retrieved October 15, 2021, from https://ejournal.bsi.ac.id/ejurnal/index.php/ecodemica/article/view/7603. 

Agustin, H., Azmi, N., Armis, & Asril. (2021). Analisis Pengembangan usaha nenas Sakinah Berdasarkan Aspek Keuangan konvensional dan syariah (Hamdi’s method). Jurnal Tabarru': Islamic Banking and Finance, 4(1), 219–230. https://doi.org/10.25299/jtb.2021.vol4(1).6749