Capital Budgeting

Decisions
Accepting projects that yields a return higher
than the hurdle rate
Capital Budgeting Decisions
Capital budgeting decisions relate to selection of
a long-term asset or investment proposal or
course of action that generally involves use of
 funds today but generate regular and recurring
benefits in future.
❑ Benefit
may be in the form of increased revenue or
reduced cost
❑ Capital budgeting decisions could
relate to: – Additions
– Modifications
– Replacements
– Disposals
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Capital Budgeting Decision Process

Decisions involved in capital budgeting

projects:
1. Estimate costs and benefits from the
project
2. Convert these costs and benefits to a
single figure
3. Compare this against a predetermined
amount, rate or time period
 4. Make a choice
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Assumptions in Capital Budgeting

1. All cash flows take place at the end of the time period
2. No change in the risk i.e. size and timing of cash flow
are known with certainty
3. Perfect capital markets

4. Projects are infinitely divisible but exhibit decreasing

return to scale
5. Cash flows are in independent of each other overtime
and other investment decisions
6. Rational decision parties
 7. It is a well-behaved project or conventional cash flow
projects

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Problems involved in Capital Budgeting

1. Estimating future costs – both initial

and operating
2. Forecasting of benefits

3. Determination of cost of capital or

required rate of return
4. Treatment of time element – economic
life of project

5. Treatment of risk element

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Cost – Benefit measurement

❑ Profit
is not a theoretical superior basis of
measurement
❑ Cash Flow is considered to be the superior
 basis of measurement
– Is not affected by the
Accounting conventions –
Objective and verifiable
❑ Cash Flow models can also be taken at
different levels of
analysis –
– Operating Free Cash Flow
– Free Cash Flow to
Equity Narain
Proforma Cash Flow Statement
1. Cash flow from operations
Profit before tax
+

Depreciation &
other non-cash
items + Interest & other non-operating
items - Income tax paid
- Increase in Working Capital
2.Cash flow from
investing
 Cash paid to
acquire Fixed
Asset
Cash received for disposing Fixed
Asset 3. Cash flow
from financing
Interest/Dividend paid
Capital funds raised
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Cash Flows of the Project

 ❑ Incremental Operating Cash Flows After Tax ❑
Only the cash flows which are incremental in nature
and directly attributable to the project are relevant ❑
Net of tax effect – tax liability or tax shield ❑
Depreciation & Amortisation – non cash items but
affects taxes
❑ Indirect overheads – ignore if not affected by the
project
❑ Effect on other projects – consider with the projects
flows

❑ Opportunity costs – consider with the project flows

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Cash Flows of the Project
❑ Financial

charges – ignore in the project flows –

Investment & Financing decisions are considered
separately
– Avoids double counting
as these charges are
reflected in the hurdle rate
❑ Changes in working capital – consider with
 the project flows
– Only

changes are considered

– Need arise because account books are
kept on accrual basis
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Cash flow computation

With the help of following projected Income Statement,
calculate the cash inflow:
Net Sales Revenue 475000 Cost of goods sold 200000 General
expenses 100000 Depreciation 50000 350000
Profit before interest and taxes 125000 Interest 25000 Profit
before tax 100000

Tax @30% 30000 Profit after tax 70000

Narain

Cash flow computations

The cost of a new plant is Rs. 5,00,000. It
has an estimated life of 5 years after
which it would be disposed off (scrap
 value is nil). Profit before depreciation,
interest and taxes (EBITDA) is estimated
to be Rs. 1,75,000 p.a.
Find out the yearly cash flow from the plant,
if tax rate is assumed to be 30% and
depreciation is provided on straight line
basis.

Narain

Cash flow computations

ABC Ltd. is evaluating a capital budgeting proposal
 for which relevant figures are as follows: Cost of
Plant Rs. 10,00,000 Installation cost Rs. 5,000 Economic life
5 years Scrap value (net of taxes) Rs. 80,000 Profit before
depreciation and tax Rs. 5,00,000 p.a.
Tax rate 30%Compute cash flows for the relevant
period assuming written down method of providing

depreciation for tax purposes is 40%.

Narain

Illustration 1
A company will create a computer facility at the
cost of Rs. 2 lac. The annual maintenance
cost shall be Rs. 20,000. After 5 years the
 system will be phased out. The expected
scrap value is Rs. 40,000. The project gross
cash inflows are expected to be:
1st yr 2nd yr 3rd yr 4th yr 5th yr 50,000 80,000 1,00,000 80,000
60,000

Compute the cash flows for the project if tax

rate is 30% and depreciation is provided at
60% WDV.

Narain

Illustration 2
A firm is using a two year old machine that was
purchased for Rs. 70,000. The remaining life is 5
years. Depreciation rate is 40%.
Firm is considering its replacement with a new
machine costing Rs. 1,40,000 which would be used for
5 years. The installation charges will be Rs. 10,000.
The increase in the working capital requirement will be
Rs. 20,000 as a result of using the new machine. The
firm is subject to income tax rate of 35%.
Determine the initial cash flow if salvage value of
existing machine is (a) 80,000 (b) 60,000
(c) 50,000 (d) 20,000.
Narain
Illustration 3
A machine has a book value of Rs. 90,000. and
remaining life of 5 years. It is depreciable @
20%. Its present salvage value is its book
value but nil after 5 years.
It can be replaced with a new machine worth
Rs. 4,00,000. It will have a salvage value of
Rs. 2,50,000 after 5 years. The new machine
will save Rs. 1,00,000 p.a. in manufacturing
costs. It will depreciate @ 33.33%. The tax
rate is 35%.
Determine the post tax incremental cash
flo
w.
Narai
n

Exercise
A machine purchased for Rs. 96,000 has a book
value of Rs. 24,000 and remaining life of 4
years. It is depreciable @ 50%. Its present
salvage value is Rs. 20,000 but nil after 4
years.
It can be replaced with a new machine worth Rs.
 1,30,000. It will have a salvage value of Rs.
8,000 after 4 years. The new machine will save
Rs. 60,000 p.a. in manufacturing costs. It will
depreciate @ 40%. The tax rate is
35%.
Determine the post tax incremental cash flow.
Narain

Illustration
Find incremental CFAT from the following information:
Purchase price of the new asset 10,00,000 Installation costs 2,00,000
Depreciation on new asset 20% Scrap value of the new asset after 4
years 3,50,000 Annual revenues from new asset 21,50,000 Annual cash
expenses on new asset 9,50,000 Current book value of old asset 4,00,000
Present scrap value of old asset 5,00,000 Annual revenue from old asset
 19,25,000 Annual cash expenses on old asset 11,25,000 Scrap value of
the old asset after 4 years 50,000 Depreciation on old asset 25%
Planning period 4 years Tax rate 30% What if new asset also result in an
increase in Working Capital of Rs. 2,50,000 ?

Exercise
A company is considering to install a machine costing Rs.
5,00,000 with an additional investment of Rs. 1,50,000 for
its installation. The salvage value at the end of year 10 is
estimated at Rs. 2,50,000. The machine is estimated to
generate a sales revenue of Rs. 20,00,000 in the first year
and the sales are expected to grow at 5% p.a. for the
remaining life of the machine. The profit after tax is
expected at 10% of the sales while the working capital
requirement are expected to be 5% of the sales.
Compute the cash flows assuming SLM depreciation and
additional working capital is required at the beginning of
each year and is fully salvageable.
Sixth Year CFAT – Rs.
Solution 2,88,875 ❑ Seventh Year
CFAT – Rs. 3,01,319 ❑ Eighth
❑ Initial investment outlay –
Year CFAT – Rs. 3,14,385 ❑
Rs. 7,50,000 ❑ First Year
Ninth Year CFAT – Rs.
CFAT – Rs. 2,35,000 ❑
3,28,104 ❑ Tenth Year CFAT
Second Year CFAT – Rs.
– Rs. 7,55,396
2,44,750 ❑ Third Year CFAT –
Rs. 2,54,987 ❑ Fourth Year
CFAT – Rs. 2,65,737 ❑ Fifth
Year CFAT – Rs. 2,77,024 ❑
CAPITAL BUDGETING EVALUATION
TECHNIQUES

Computing the yield on projects to be compared

with the hurdle rate

Basic Terminology
❑ Independent vs. Mutually Exclusive
Projects
❑ Accept-Reject vs. Ranking
Approaches
❑ Unlimited Funds vs. Capital
Rationing
❑ Conventional vs. Non-conventional

Cash Flow Patterns

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Criteria of Evaluative Tools

1. Simplicity

2. Sufficiency

3. Objectivity

4. Consistency

5. Reasonable
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Desirable features of evaluation
techniques in Capital Budgeting

1. Simple to understand & easy to use 2. Should

consider total benefits over the economic life of
the project
3. Benefits based on Cash Flows rather than
Accounting Profit
4. Should be consistent with the objective of
shareholder’s wealth maximisation
5. Internally consistent assumption of
 reinvestment rate.
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Value
Evaluation 2. Internal Rate of Return
Techniques 3. Profitability Index

4. Project Duration

5. Net Terminal Value

Non-discounted cash
6. Adjusted Present Value
flow techniques 1.
7. Equity Present Value
Accounting Rate of Return
2.Payback Period
Discounted cash flow
techniques 1. Net Present
Evaluation Techniques
Mathematical Programming
techniques 1. Linear Programming
2. Integer Programming
or Zero-one Programming
3. Goal Programming
 Narain

Accounting Rate of Return

It compares the average annual profits to average
investment
❑ The
steps to
determine the ARR is:
1. Determine after tax expected
Profits
for the
life of
the project
2. Take the average of these profits for the
life of the
project
3.
Determine average investment over the
life of the
project
like:
Average investment = Net working capital + (Initial
 outlay + Salvage value)/2
4. Divide the two average figures to get the ARR ❑ It
ignore the time value of money
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Illustration
A company takes a project costing Rs.
1,20,000 with expected life of 5-years
and the salvage value of Rs. 20,000.
The project requires an additional
working capital of Rs. 20,000 and is
 expected to generate annual average
profit after tax of Rs. 18,000.
What is the Accounting Rate of Return of

this project?
Narain

Exercise 1

Determine the average rate of return from the following

data of two machines, A and B Machine A Machine B
Cost 56,125 56,125 EATDA
Year 1 3,375 11,375 Year 2 5,375 9,375 Year 3 7,375 7,375
 Year 4 9,375 5,375 Year 5 11,375 3,375 36,875 36,875
Estimated life (in years) 5 5 Estimated Salvage Value 3,000
3,000Narain

Payback Period
It is exact time which cash benefits take to payback the
original cost normally disregarding the salvage value. ❑
Cash flow benefits in this case is cash flow after tax
ignoring interest & other financial expenses ❑ It
minimises the risk to the investor
❑ Under capital rationing, the cash earned may be used
for other profitable projects
❑ It yields same results as NPV method for the annuity
 type cash flows
❑ It is very useful where the quality of data about costs

and benefits is poor

Narain

Illustration
A project requires a cash outflow of Rs. 20,000
and is expected to generate cash inflows over
next five years as follows:
Years 1 2 3 4 5 CFAT 8,000 6,000 4,000 2,000
2,000What is the payback period of this
 project? What is the payback period of the
project if the project requires Rs. 18,500 as
the cash outflow?

Narain

Exercise 2
❑ A proposal requires a cash outflow
of Rs. 1,00,000 and is expected to
generate cash inflows of Rs. 20,000
p.a. for 6 years. What is its
 payback period?

Narain

Exercise 3
Determine the payback period of the following
projects: Annual CFAT Cumulative CFAT

Project A Project B Project A Project B

Outlay 9,000 9,000

CFAT: 1 3,000 8,000 3,000 8,000 2 4,000 4,000

7,000 12,000

3 8,000 3,000 15,000 15,000 4 2,000 2,000

17,000 17,000
Narain

Exercise 4
Determine the payback period of the following
projects: Project A Discounted cash flows @
 10%
Cumulative Cash flows
Outlay 9,000

CFAT: 1 3,000 2,727 2,727 2 4,000 3,306 6,033 3

8,000 6,011 12,044 4 2,000 1,366 13,410

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Payback Period
❑ It
 cannot be considered as a measure of
profitability
– There
is no
need to
estimate the costs
and benefits data for period beyond the
maximum payback period
❑ It does not differentiate the timings of benefits
within the recovery period
❑ It is biased against projects with longer

gestation period.
 Narain

Net Present Value

NPV is the summation of the present values of cash
inflows (CFAT) over the years minus the initial outflow.
❑ Steps
to
compute the NPV are:
1. Determine the series of cash outflow and
inflow
2.
Choose a
suitable
discount
 rate: financing decision
3. Apply this rate to discount the future cash
flows
4.
Decision
rule: Accept project if NPV>0, reject otherwise

Narain

Illustration 1.7
Determine the acceptance of the project whose cash
flows are given as follows if the project has to have a
minimum return of 10%:
 Year Cash Flows
0 -22,000
1 10,000
2 8,000
3 6,000
4 4,000
5 2,000

Narain

Exercise
A proposed investment having an after-tax cost
of Rs. 25,000 is expected to produce after-tax
cash inflows as follows:
Period Cash Flow
12345 5,000 5,000 7,500 7,500 10,000

If the firm’s hurdle rate (cost of capital) is

12%, should the investment be made using
NPV method of project evaluation?
PVF 1 2 3 4 5 12% 0.8929 0.7972 0.7118 0.6355
0.5674
Narain

Exercise
ABC is considering two investments, each of which
requires an initial investment of Rs. 1,80,000. The
total operating cash inflows after taxes and
inflation adjustments for each project are:
Year Project X
1234567 30,000 50,000 60,000 65,000 40,000 30,000
Project Y
16,000 60,000 1,00,000 65,000 45,000 - - -

ABC’s cost of capital is 8%. Rank these

investments by their excess present values. Which

is the most profitable?

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 Evaluating NPV method
❑ It is theoretically most superior method of evaluating
projects under the given assumptions.
❑ It is based on total benefits over the economic life of
the project
❑ It is consistent with the objective of maximisation of
shareholder’s wealth –
If inputs are chosen correctly, the total market value of
the firm’s stock should change by an amount equal to
the NPV of the project
❑ This method does contain the abilities to customise it
for relaxing assumptions & advanced sensitivities
 Narain

PV of project's cash inflows PI

Initial Ouflow

Profitability Index
Profitability Index measure the present value of the
returns per unit of investment
❑ It is a variant of NPV method

❑ Accept the project if PI>1, reject otherwise ❑ Unlike

NPV method, it is a relative measure. Therefore, it
can give conflicting ranking of projects ❑ This method
is more suitable in the case of capital rationing

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Illustration 1.8

Evaluate the following two projects based on the

Profitability Index criterion if the minimum required
rate of return is 10%

Project A Project B
Cash outflow
 Cash inflows 50,000 35,000

1 40,000 30,000 2 40,000 30,000

Narain

Exercise

A proposed investment having an after-tax cost

of Rs. 25,000 is expected to produce after-tax
cash inflows as follows:
 Period Cash Flow
12345 5,000 5,000 7,500 7,500 10,000 If
the firm’s hurdle rate (cost of capital) is 12%,
should the investment be made using
Profitability Index method of project evaluation?
PVF 1 2 3 4 5 12% 0.8929 0.7972 0.7118 0.6355 0.5674Narain

Exercise
ABC is considering two investments,
each of which requires an initial investment of Rs.
1,80,000. The total cash inflows, that is, profits
after taxes and depreciation charges for each
project are:
Year Project X
1234567 30,000 50,000 60,000 65,000 40,000 30,000
Project Y
16,000 60,000 1,00,000 65,000 45,000 - - -

ABC’s cost of capital is 8%. Rank these

investments by their profitability indices. Which is
the most profitable?
8%
PVF 1 2 3 4 5 6 7 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 0.5835

Internal Rate of Return

Internal rate of return of a project is that discount rate which
equates the aggregate present value of the cash inflows
(CFAT) of the project with the initial outflow of the project
 i.e. NPV=0
❑ The
decision
rule is :
– Accept project only if IRR > required return ❑
Steps
to
computing IRR –
1.

Determine the
project cash
outflow and inflows 2. Take initial guestimate of
the probable IRR rate 3. Compute NPV for such
 initial rates
4. Improve the discount rate until NPV=0
5. Use intrapolation
whenever needed
Narain

Illustration

A firm is considering following two projects for

the purpose of adoption in the next budget
year. Their cash flow estimates are given
below:
Year 0 1 2 3 4 Project A (45,555) 15,000 15,000 15,000 15,000
Project B (64,320) 20,000 25,000 28,000 24,000
Calculate the internal rate of return of both the
projects if required rate of return on the
projects are 10%.

Narain

Illustration 1.9

Determine the acceptability of the project using

IRR method with following cash flows if the
minimum required rate of return is 20%.
Cash outflow: 35,330
 Year 1 2 3 4 5 6 CFAT 10,000 12,000 14,000 16,000 18,000
20,000

Narain

Illustration

A firm is considering two projects, with a capital

outlay of Rs. 1,00,000 each and the following
cash inflows. Compute their internal rates of
returns.
 Year Project A Project
1234 33,620 33,620 33,620 33,620
B
- - - 1,36,050

Narain

Exercise
You are required to analyse following two projects, each
with a cost of Rs. 10,000 and cost of capital is 5%. The
projects’ expected net cash flows are as follows:
 Year Project X Project Y
1234 6,500 3,000 3,000 1,000
3,500 3,500 3,500 3,500

What is their Internal rate of return?

Which project should be accepted if they are
independent?
Which project should be accepted if they are mutually
exclusive?
Evaluating IRR method

❑ Ithas intuitive appeal to those who want to

analyse the project in terms of rate of return ❑
 Determination of IRR does not depend on the
required rate of return
❑ It is consistent with NPV method for
independent projects
❑ IRR method is based on the reinvestment
assumption by which cash flows of the
project are reinvested at the IRR itself: use
MIRR

Narain

Pitfalls of IRR
1. It is a relative measure of evaluation, not the absolute one.
Projects Cash flow0 Cash Flow1IRR NPV @ 10% A -1,000
+1,500 50% +364 B +1,000 -1,500 50% -364 ❑ We need to
modify the acceptance criterion of IRR method for
borrowing and lending Projects ❑ What to do in case
project is both borrowing & lending?
Period 0 1 2 3 Cash Flows +1,000 -3,600 +4,320 -1,728
Hurdle rate = 10% IRR=20% NPV=-0.75
Pitfall 2: Computational Hazards

❑ Multiple rate of IRR

Period 0 1 2 Cash flow -160 1,000

 -1,000

IRR= 25% and 400% NPV at 10% = -77 ❑

No IRR

Period Cash flows

012 1,000 -3,000 2,500

❑ IRR= Not defined NPV at 10% = 339

Narain

Pitfall 3: Mutually Exclusive Projects

❑ Mutually exclusive
projects are those
 projects from which only one of them is to be
chosen – Technically or Financially
❑ Inconsistentranking of projects based on the
IRR criterion and other evaluation
criterion – Size-disparity
– Time-disparity
– Life-disparity

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Size Disparity Problem
❑ Try this:
Printer Outlay CFAT1IRR NPV @ 10% Inkjet 10,000
20,000 100% 8,182 LaserJet 20,000 35,000 75% 11,818❑ Which
project will you prefer?
❑ The difference lies in the implicit compounding rate of

interest
– IRR
–
 funds are compounded at the project IRR – NPV –
funds are compounded at the discount rate ❑ Use
incremental project analysis if IRR has to be computed

Narain

Time Disparity Problem

❑ Try this:
Machine CF0 CF1 CF2 CF3 CF4IRR NPV @ 10%
A -10,500 6,000 5,000 4,000 1,500 26% 3,117 B -10,500 3,000 4,000

5,000 6,000 22% 3,388 C -6,000 2,700 2,700 2,700 17% 715❑ Which

of the projects will you prefer?

❑ Project A has lower payback period, which can be
preferred in the case of capital rationing
❑ Use incremental project analysis if IRR has to be
computed

Narain

Life Disparity Problem

❑ Try this:
Machine Outlay CF1 CF2IRR NPV @ 10% P 2,000 2,400 -
20% 182 Q 2,000 - 2,650 15% 190❑ The key question here
is:
 What happens at the end of the shorter-lived

project?
– If we replace the
project
with
identical
project – may use Equivalent Annual NPV
– If we reinvest in some other project – use NPV
❑ Use incremental project analysis if IRR
has to be computed
Narain

Pitfall 4: Term structure of required return

❑ Itis assumed so far that the hurdle rate is
same for all cash flows.
❑ What to do when we have required returns
for every year of cash flows?
❑ Can use weighted average required rate of
return which is complex
❑ However, we can use the generalised NPV:

CF
Generalised NPV
n
 ∑
=
+i

i
(1
0
)
r ii
=
Narain

INDIAN PRACTICES
Which is the most important
project choice criteria?

Narain

RELATIVE IMOPTANCE OF THE FOLLOWING PROJECT CHOICE

 CRITERIA

58.20%
BREAK-EVEN-ANALYSIS

85.00% 35.10%
PROFITABILITY INDEX (PI)

INTERNAL RATE OF RETURN (IRR) NET PRESENT

66.30%

VALUE METHOD (NPV) ACCOUNTING RATE OF

34.60%

RETURN PAYBACK PERIOD

67.50%
 CAPITAL BUDGETING TECHNIQUES…
International usage
RESPONSE TO THE QUESTION: HOW FREQUENTLY YOU USE THE FOLLOWING TECHNIQUES?
% ALWAYS OR ALMOST ALWAYS
US UK
INTERNAL RATE OF RETURN 75.61 53.13 NET PRESENT VALUE 74.93 46.97 PAYBACK PERIOD
56.74 69.23 HURDLE RATE 56.94 26.98 SENSITIVITY ANALYSIS 51.54 42.86 EARNINGS
MULTIPLE APPROACH 38.92 39.06 DISCOUNTED PAYBACK PERIOD 29.45 25.40 WE
INCORPORATE THE REAL OPTIONS OF A PROJECT

WHEN EVALUATING IT 26.56 29.03 ACCOUNTING RATE OF RETURN 20.29 38.10 VALUE AT RISK
13.66 14.52 ADJUSTED PRESENT VALUE 10.78 14.06 PROFITABILITY INDEX 11.87 15.87Narain

THANKS FOR YOUR

TIME!