Capital Budgeting

1
Nature of Investment Decisions
The investment decisions of a firm are generally known as the capital budgeting, or capital
expenditure decisions.
Examples:
• Expansion
• Acquisition
• Modernisation
• Replacement
• Sale of a division or business (divestment)
• Change in the methods of sales distribution
• Advertisement campaign
• Research and development
Features of Investment Decisions
• The exchange of current funds for future benefits.

• The funds are invested in long-term assets.

• The future benefits will occur to the firm over a series of years.
Importance of Investment Decisions
• Growth  

• Risk 

• Large amount of Funding  

• Irreversibility

• Complexity  
Types of Investment Decisions
• One classification is as follows:
•  Expansion of existing business
•  Expansion of new business(Related & Non Related)
•  Replacement and Modernisation(To improve Operating Efficiency & Reduce
Cost)
• Yet another useful way to classify investments is as follows:
•  Mutually exclusive investments
•  Independent investments
•  Contingent investments
Investment Evaluation Criteria
Three steps are involved in the evaluation of an investment:
 Estimation of cash flows
 Estimation of the required rate of return (the cost of capital)
 Application of a decision rule for making the choice
Investment Criteria

• Net Present Value

Discounting • Profitability Index
Method • Internal Rate of Return

Non- • Pay Back Period

Discounting • Accounting Rate of Return
Method
Time Value of Money
Let us refresh
Future Value of SINGLE Cash Flow
• F = P x (1+i)n

• Here FVIF (Future Value Interest Factor) is (1+i)n

• F = Future Value
• P = Present Value
• i = Rate of Interest
• n = time period( No. of Years)
Present Value of SINGLE Cash Flow
• P = F/(1+i)n
• Here PVIF (Present Value Interest Factor) is 1/(1+i)n
• F = Future Value
• P = Present Value
• i = Rate of Interest
• n = time period( No. of Years)

• Example
• How much amount you should deposit today in a bank to receive Rs
50,000 at the end of 7 years? Assume 10% rate of interest per annum.
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Future Value of Annuity(FVA)

01 2 3 4 5
A A A A A

FVA
FVA = A x [ (1+i)n - 1]
i
Here [ (1+i)n - 1] is called FVIFA (Future Value Interest Factor for Annuity)
i
Present Value of Annuity(PVA)

01 2 3 4 5
A A A A A

PVA

PVA = A x [ (1+i)n - 1]
i x (1+i)n
Here [ (1+i)n - 1] is PVIFA (Present Value Interest Factor for Annuity)
i x (1+i)n
Cash Flows at BEGINNING of Year
• If Annuities (Cash flows or investments) are at beginning of each year
then
• Multiply all the formula by (1+i)

• For Example:
FVA = A x [ (1+i)n - 1] x (1+i)
i
Present Value of Perpetuity

Present value of perpetuity = A

A Present value of Growing perpetuity =

i-g

Here i is required rate of return

And g is growth rate in annuity

Present Value of a Growing Annuity
A cash flow that grows at a constant rate for a specified period of time is a growing annuity. The time line of a growing annuity is shown below:

2 n-1
A A(1 + g) A(1 + g) A(1 + g)

0 1 2 3 n

The Future value of a growing annuity can be determined using the following formula :

n n
FVAg = A x [ (1+i) - (1+g) ]

(i-g)

The present value of a growing annuity can be determined using the following formula :

n n
PVAg = A x [ (1+i) - (1+g) ]
n
(i-g) x (1+i)
Investment Criteria

• Net Present Value

Discounting • Profitability Index
Method • Internal Rate of Return

Non- • Pay Back Period

Discounting • Accounting Rate of Return
Method
Net Present Value Method
NPV is the difference between Present Values of
Cash Inflows and Cash Outflows.

• The formula for the net present value can be written

as follows:

 C1 C2 C3 Cn 
NPV    2
 3
 n   C0
 (1  k ) (1  k ) (1  k ) (1  k ) 
n
Ct
NPV   t
 C0
t 1 (1  k )
 Acceptance Rule
• Accept the project when NPV is positive NPV > 0
• Reject the project when NPV is negative NPV < 0
•  May accept or reject the project when NPV is zero NPV = 0

The NPV method can be used to select between mutually exclusive projects; the one
with the higher NPV should be selected.
NPV Calculation, Discount rate = 10%
1/(1+i)^n

Year Cash Flow Discount Present Value of Cash Flow in

in Rs. (A) Factor (B) Rs. (A) x (B)
0 (5000) 1 (5000)
1000 0.909 909
1
2000 0.826 1652 Sum all
2 cash flows
1000 0.751 751
3 =NPV
4000 0.683 2732
4

NPV = 1044
Evaluation of the NPV Method
• NPV is most acceptable investment rule for the following
reasons:
• Time value consideration
• Measure of true profitability
• Value- additivity
• Shareholder wealth creation
• Limitations:
• It is an absolute measure and not a relative measure.
• Does not consider life of project i.e. biased towards long project in case
of mutual exclusive projects.
• Ranking of projects may differ( in case of different discount rates)
Practice Problem:
Calculate NPV, Assume discount rate 15%
0 1 2 3 4
• Project A -25,000 12000 4000 10000 18000
PROFITABILITY INDEX (Benefit Cost Ratio)
• Profitability index is the ratio of the present value of
cash inflows, at the required rate of return, to the
initial cash outflow of the investment.
• The formula for calculating benefit-cost ratio or
profitability index is as follows:

• Profitability Index = Present Value of Cash Inflows

Initial Investment
Benefit Cost Ratio(Profitability Index)
Calculate Benefit Cost Ratio for a project which is being evaluated by a firm that has
a cost of capital of 12 percent.
Initial investment : Rs 100,000
Benefits: Year 1 25,000
Year 2 40,000
Year 3 40,000
Year 4 50,000

The benefit cost ratio measures for this project are:

BCR = 25,000 40,000 40,000 50,000
(1.12)1 (1.12)
+
2
(1.12)
+
3
(1.12)
+
4

= 1.145 100,000

Net Benefit Cost Ratio, NBCR=BCR-1 = 0.145

Acceptance Rule
• The following are the BCR acceptance rules:
• Accept the project when BCR is greater than one. PI > 1
• Reject the project when BCR is less than one. PI < 1
• May accept or reject the project when BCR is equal to one. PI = 1

• The project with positive NPV will have BCR greater than one. BCR
less than one means that the project’s NPV is negative.
• The project with positive NPV will have NBCR greater than 0. NBCR
less than 0 means that the project’s NPV is negative.
Practice Problem:

• The initial cash outlay of a project is Rs 100,000 and it can

generate cash inflow of Rs 40,000, Rs 30,000, Rs 50,000 and Rs
20,000 in year 1 through 4. Assume a 10 percent rate of
discount.
• Calculate Profitability Index(Benefit-cost ratio).
Evaluation of BCR(PI) Method
• Time value
• True Profitability
• Value maximization
• Relative profitability
 NPV VERSUS PI
• If Decision same as NPV then WHY Profitability Index??
• A conflict may arise between the two methods if a choice between
mutually exclusive projects has to be made. NPV method should
be followed( PI is useful in case of Capital Rationing).
Practice Problem:
Which project be selected?
0 1 2 3 4
• Project A -50,000 20000 25000 10000 18000
• Project B -75000 25,000 20000 30000 12000
• Calculate NPV @ Discount rate=15%
• Calculate Profitability Index
• Recommend which project should be selected incase of:
• Both A and B are Mutual Exclusive Projects
• Both A and B are Independent Projects
Internal Rate of Return
(IRR)
 IRR (Internal Rate of Return)
• The internal rate of return (IRR) is the rate that equates the
investment outlay with the sum of present value of all cash inflows
received. This also implies that the Internal Rate of Return is that
discount rate which makes NPV = 0.
Net Present Value

IRR

Discount Rate
 Acceptance Rule
• Accept the project when IRR > Cost of Capital
• Reject the project when IRR < Cost of Capital
• May accept or reject the project when IRR = Cost of Capital

• In case of independent projects, IRR and NPV rules will give the same
results while in case of mutual exclusive projects there may be
conflict in few cases.
• In case of conflict (for mutual exclusive projects), select project with
higher NPV.
 Calculation of IRR

Year Cash
Flows
0 (1000)
1 200
2 300
3 400
4 500
5 600

• To find IRR we need that discount rate at which NPV is zero.

• First Step is to find two discount rates where at one discount rate NPV is positive while at another NPV
is negative.

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 Calculation of IRR: Solution

• To find IRR we need that discount rate at which NPV is zero.

• Find two discount rates where at one discount rate NPV is positive while at another NPV is negative.

Year Cash PVIF @ Present Year Cash PVIF @ Present

Flows 20% Value Flows 32% Value
0 (1000) 1 (1000) 0 (1000) 1 (1000)
1 200 0.833 167 1 200 0.758 152
2 300 0.694 208 2 300 0.574 172
3 400 0.579 232 3 400 0.435 174
4 500 0.482 241 4 500 0.329 165
5 600 0.402 241 5 600 0.250 150
NPV 89 NPV (188)

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 Calculation of IRR: Solution
NPV at 20% = 89, NPV at 32% = (188)

Smaller NPV at the smaller rate

Bigger Smaller
IRR = discount + x
Sum of the absolute values of the discount – discount)
rate rate rate
NPV at the smaller and the bigger
discount rates

89
IRR= 20% + x (32% - 20% ) = 23.85%
89 + 188
Practice: Find IRR
0 1 2 3
(10000) 3000 6000 5000

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IRR Limitations

 Non-Conventional Cash Flows

 Mutually Exclusive Projects

 Differences between Short-term and Long-term i.e. if Interest Rates (cost

of capital changes). How to compare?
 Reinvestment at IRR
Why Conflict Between NPV &
IRR?
• The NPV and IRR rules give conflicting ranking to the projects under the following
conditions:
• The cash flow pattern of the projects may differ. That is, the cash flows of one
project may increase over time, while those of others may decrease or vice-
versa.
• The cash outlays of the projects may differ.
• The projects may have different expected lives.

• In case of Conflict between NPV and IRR, Go ahead with

higher NPV
Timing (Pattern) of cash flows  
Outlays (Scale of investment)  
Project life span  
Payback
 Payback Period
Payback period is the length of time required to recover the initial
outlay on the project
Year Cash flow Cumulative cash flow
0 -100 -100
1 40 -80
2 40 -55 Payback period =
3 20 -10 3+ [10/(10 +10)]
4 30 +10 x 12 = 3 years 6
months
Pros Cons
• Easy • Does not consider the time value of money
• Rough and ready method • Ignores cash flows beyond the payback period
for dealing with risk
• Emphasises earlier cash inflows
 Payback Period

Year Cash flow Cumulative cash flow

0 -100 -100
Payback period =
1 20 -80
3+ [10/(10 +10)]
2 25 -55 x 12 = 3 years 6
3 50 -10 months
4 20 +10
 Payback Period
Year Cash flow Cumulative cash flow
0 -100 -100
1 20 -80
2 25 -55
3 50 -5
Payback period is
4 20 +15 between 3 & 4 years

Payback period = 3+ [5/(5 +15)] x 12 = 3 years 3 months

Payback Period: Practice Problem

Year Cash flow Cumulative cash flow

0 -1000 -100
Payback period =
1 300 -80
3+ [10/(10 +10)]
2 250 -55 x 12 = 3 years 6
3 350 -10 months
4 300 +10
Acceptance Rule
• The project would be accepted if its payback period is
less than the maximum or standard payback period
set by management.
• As a ranking method, it gives highest ranking to the
project, which has the shortest payback period and
lowest ranking to the project with highest payback
period.
Discounted Payback Period
• The discounted payback period is the number of periods
taken in recovering the investment outlay on the present
value basis.
• The discounted payback period still fails to consider the
cash flows occurring after the payback period.
Accounting Rate of Return
• The accounting rate of return is the ratio of the average
Operating Profit after-tax divided by the average investment.
The average investment would be equal to half of the original
investment if it were depreciated constantly.

or
ARR Example
• A project will cost Rs 40,000. Its stream of earnings
before depreciation, interest and taxes (EBDIT) during
first year through five years is expected to be Rs
10,000, Rs 12,000, Rs 14,000, Rs 16,000 and Rs
20,000. Assume a 50 per cent tax rate and
depreciation on straight-line basis.
Calculation of Accounting Rate of
Return
Acceptance Rule
• This method will accept all those projects whose ARR is higher than
the minimum rate established by the management and reject those
projects which have ARR less than the minimum rate.

• This method would rank a project as number one if it has highest ARR
and lowest rank would be assigned to the project with lowest ARR.
Evaluation of ARR Method
• The ARR method may claim some merits
 Simplicity
 Accounting data
 Accounting profitability
• Serious shortcomings
 Cash flows ignored
 Time value ignored
 Arbitrary cut-off
Survey: Evaluation Techniques in India
A survey of corporate finance practices in India by Manoj Anand,
reported in the October-December 2002 issue of Vikalpa, revealed
that the following methods (in order of decreasing importance) are
followed by companies to evaluate investment proposals
% of companies considering as
Method very important or important
• Internal rate of return 85.00
• Payback period 67.50
• Net present value 66.30
• Break-even analysis 58.00
• Profitability Index 35.10
Mutually Exclusive Projects of Unequal Life
NPV is biased towards projects with higher project life.
For a proper comparison of the two alternatives, that have different lives, we have to
convert the net present value of Costs (or Benefits) into a uniform annual equivalent
(UAE) figure – this is also called an equivalent annual cost or equivalent annual
benefit.
The UAE is a function of the present value of Cost (or Benefit), the life of the asset,
and the discount rate. The UAE is simply:
 
NPV Cost or NPV Benefits
UAE =
PVIFAr,n

In case of Benefit , Select Project with HIGHER UAE value

In case of Cost, Select Project with LOWER UAE value
UAE (Benefit)-Example
Equipment A Equipment B
Initial Cost (Rs.) 2,00,000 2,00,000
Life of Equipment (in years) 1 3
Present Value of Cash Inflows 2,67,857 3,34,512
(Rs.)
NPV (Rs.) 67,857 1,34,512
If the cost of capital is 10%,
should the company invest in
equipment A or B?
UAE (Benefit) select higher one = 67,857/PVIFA (1yr,10%) = 1,34,512/PVIFA (3yr, 10%)
=67857/0.909 = 74650 =134512/2.487 = 54086
 Uniform Annual Equivalent (UAE): Practice
Problem
• XYZ Ltd. is considering two machines, A and B. Though designed
differently, they serve same function.
• Machine A, a standard model, costs Rs 75,000 and lasts for 5 years. Its
annual operating costs will be Rs 12,000.
• Machine B, an economy model, costs Rs 50,000 and lasts for only 3
years. Its annual operating costs will be Rs 15,000.
• How should XYZ Ltd. choose between two machines?
• Assume discount rate of 12%
Uniform Annual Equivalent
PV of costs of machine A :
12,000 12,000 12,000 12,000 12,000
75,000 + + + + + = Rs. 118,260
(1.12) (1.12)2 (1.12)3 (1.12)4 (1.12)5
PV costs of machine B :
15,000 15,000 15,000
50,000 + + + = Rs. 86,030
(1.12) (1.12)2 (1.12)3
Machine A: UAE = 118,260 118,260
PVIFA12%,5 = 3.605 = Rs. 32,804 Minimum
Machine B: UAE = 86,030 86,030
PVIFA12%,3 = 2.402 = Rs. 35,816
 UAE (Costs)-Example
Equipment A Equipment B
Initial Cost (Rs.) 10,00,000 8,00,000
Life of Equipment (in years) 10 6
Present Value of Operating 15,01,264 13,31,708
Costs (Rs.)

Salvage value (Rs.) 1,50,000 1,00,000

If the cost of capital is 10%, should the company invest in equipment A or B?
Total Present Value of Cost = 10,00,000 + 15,01,264 – 1,50,000/(1.10) ^10 = 8,00,000 + 13,31,708 –
1,00,000/(1.10) ^6

= 20,75,260
= 24,43,432
UAE (cost): choose = 24,43,432/PVIFA(10%,10 yr) = 20,75,260/ PVIFA(10%, 6yr)
minimum
Note: Deduct Present value of Salvage Value from total present value of cost then Divide it by PVIFA( n yrs, d%)
 Which project be selected?
Practice Problem
0 1 2 3 4
• Project A -35,000 6000 8000 15000 25000
• Project B -30,000 15,000 12,000 9000 6000

• Calculate NPV, Profitability Index, IRR, Payback Period, Discounted Payback

period if Discount rate=12%
• What will be your recommendation If both projects are Mutual Exclusive or
Independent projects?
• Asnwer:
• Project A: NPV = 3299, PI = 1.09, IRR = 15.47%
• Project B: NPV = 3178, PI = 1.10, IRR = 17.80%

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Thank you
Any query??

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