Capital Budgeting

(NPV and other

Investments Rules)
 Investment Evaluation
Criterion

Non-Discounting
Discounting Criteria
Criteria

Benefit to Cost Accounting Rate of

NPV IRR Payback Period
Ratio Return (ARR)

Discounted Payback
MIRR
Period
Net Present Value (NPV):
Capital Budgeting is the decision making process for accepting or rejecting
the projects. NPV is the 1st method of the process which is considered to be
a classical economic method to evaluate investment proposal. It is based on
DCF technique that explicitly recognises the time value of money.
The net present value is the difference between the present value of future
cash inflow and the present value of cash outflow over a period of time.
 Example: 1
Net Present Suppose project X costs Rs. 2500 now and is expected to generate cash flow at
Value (NPV): the end of each year for 5 years by 900, 800, 700, 400 and 500 respectively. If the
discount rate or opportunity cost of capital is 10% p.a., then calculate NPV of the
Time line of the investment.
Project

900
800
700
500
400

0 1 2 3 4 5

-2500
 𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹4 𝐶𝐹5
𝑁𝑃𝑉 = 1
+ 2
+ 3
+ 4
+ 5
− [Initial Investment]
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖)

900 800 700 400 500

𝑁𝑃𝑉 = 1
+ 2
+ 3
+ 4
+ 5
− 2500
(1.1) (1.1) (1.1) (1.1) (1.1)

= 2589 – 2500
= Rs. 89
Case 2: Suppose Project Y has the following CFs:
3,50,000
3,00,000 3,00,000

2,00,000 2,00,000

0 1 2 3 4 5

-10,00,000
Now substituting in formula:

200000 200000 300000 300000 350000

𝑁𝑃𝑉 = 1
+ 2
+ 3
+ 4
+ 5
− 1000000
(1.1) (1.1) (1.1) (1.1) (1.1)

= 994728 – 1000000
= (-) Rs. 5272
The basic investment decision rules as follows:
1. If NPV = +ve → Accept the project
2. If NPV = -ve → Reject the project
3. If NPV = 0 → Indifference
The Net Present Value (NPV) Rule

 Net Present Value (NPV) =

Total PV of future CF’s + Initial Investment
 Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs
 Minimum Acceptance Criteria: Accept if NPV > 0
 Ranking Criteria: Choose the highest NPV
NPV rules lead to good decision making because +ve NPV of a project adds
to the value of a firm and hence considered as the contribution of any
project to the value of the firm.

Critical Aspects of NPV:

1. First important aspects of NPV approach is to identify a correct discount
rate. It is the return of a risky asset that one expects to earn equal to a
comparable risky asset.
2. Another key attribute of NPV method is use of cash flow, instead of
earnings. Although earnings is useful from accounting prospective, still
earnings has less relevance in capital budgeting as comparison to cash
flow.

3. Again NPV approach ignores the CFs beyond a particular date, and it
may be considered as a negative aspect of NPV.
 Internal Rate of Return
IRR of the project is the discount rate that makes NPV equal to zero. In
other words, IRR is the discount rate that equates PV of the future CF of
the project with its initial investment. If IRR is considered as ‘R’, then

𝑛
𝐶𝐹 𝑡
Investment = ෍ 𝑡
𝑡=1 1+IR𝑅
Consider an investment of Rs. 100 that generates Rs. 110 after 1 yr. That is:
110
 NPV = − 100 That is R = 10%
1+𝑅

Where NPV = 0 and sum of future CF is equal to initial investment.

While calculating NPV, we assume that the discount rate is known and while
calculating IRR, we assume that NPV = 0 and try to calculate ‘R’ through trail
& error approach.

 Example : 2

Calculate IRR of a project having the following cash flows:

Initial Investment is ₹ 1,00,000 followed by 4 continuous cash inflows i.e.

₹ 30,000, ₹ 30,000, ₹ 40,000 and ₹ 45,000 subsequently.
Now the IRR is the ‘r’ that satisfies the following condition:

30,000 30,000 40,000 45,000

1,00,000 = + + +
1+𝑟 1 1+𝑟 2 1+𝑟 3 1+𝑟 4

We have to find out ‘r’ with trial and error method, that is:
If r = 15%

30,000 30,000 40,000 45,000

= + + + = 1,00,802
1.151 1.152 1.153 1.154
If r = 16%
30000 30000 40000 45000
= + + + = 98641
1.161 1.162 1.163 1.164

Hence, r is in between 15% & 16%

 At r = 15% , NPV = 802 more (+ve)

 At r = 16% , NPV = 1359 less (-ve)

802 + 1359 = 2161

802 1359
= 0.37 % or = 0.6289 %
2161 2161

→ 15% + 0.37% = 15.37 % IRR or 16% - 0.6289 % = 15.37 % IRR

Decision Rule:

1. Accept the project, if IRR is greater than discount rate.

2. Reject the project, if IRR is less than discount rate.

Problems with IRR approach:

Defining independent and mutually exclusive projects.

▪ An independent project is one whose acceptance or rejection is independent of the

acceptance or rejection of other projects.
▪ Two projects A and B are mutually exclusive when you can accept A or can
accept B or can reject both A & B. But you cannot accept both A & B at the same
time. Hence A is mutually exclusive to B and vice versa.
Lets consider the CF of 3 projects A, B and C. Discounting rate = 10%

Project A Project B Project C

130 100 230

1 0 1 0 1 2
0
-130 -100 -132
-100
 In Project A:
130
NPV = -100 + = Rs. 18.18
1.10
130
and IRR = 30 % (That is = -100 + )
1.30
Decision: Accept the project if discount rate is less than IRR (30%)

 In Project B:
130
NPV = 100 - = (-) Rs. 18.18 IRR = 30 %
1.10
130
(That is = +100 - )
1.30
Decision: Reject the project even if the discount rate is less than IRR (30%)
due to negative NPV.
Project C:

NPV = 0 @ 10% and 20%

 Discount rate NPV
5% (-) Rs. 0.65
8% (-) Rs. 0.19
10% 0
12.5% Rs. 0.13
15% Rs. 0.16
17.5% Rs. 0.12
20% 0
25% (-) Rs. 0.38
30% (-) Rs. 0.91
▪ So IRR of project C should be greater than 10% & less than 20%

▪ Hence, accept the project when discount rate is between 10% & 20%.

▪ Project C is the case of Multiple Rate of Return.

▪ Project B is a substitute for borrowing when IRR is 30%, accepting the

project is equivalent to borrowing at 30%. If any bank is ready to lend us
less than 30%, then we should reject the project and borrow from bank.
Otherwise we should accept the project.
Problems with IRR

❑ Multiple IRRs
❑ Are We Borrowing or Lending
❑ The Scale Problem
❑ The Timing Problem
The Scale Problem

Would you rather make 100% or 50% on your

investments?
What if the 100% return is on a $1
investment, while the 50% return is on a
$1,000 investment?
The Timing Problem

$10,000 $1,000 $1,000

Project A
0 1 2 3
-$10,000
$1,000 $1,000 $12,000
Project B
0 1 2 3
-$10,000
Modified Internal Rate of Return (MIRR)
MIRR technique is highly useful to handle multiple IRR problem. This process
combines cash flows until only one change in sign remains.
➢ Discounted Approach – All negative cash flows are discounted
to the current investment and added to the initial cost.

 Reinvestment Approach – All positive and negative cash flows

(except the first one) are compounded to the end of the project
tenure, and IRR is calculated on the same.

 Combination Approach – It is the hybrid method where the above

two are merged and applied. In this approach, all negative cash
flows are discounted back to the current investment, and all positive
cash flows are compounded for the IRR to be calculated.
How to Interpret MIRR vs. Cost of Capital

 For purposes of capital budgeting, the following rules are generally

followed:

• If MIRR > Cost of Capital ➝ Accept Project

• If MIRR < Cost of Capital ➝ Reject Project
Combination Approach
MIRR technique is highly useful to handle multiple IRR problem. This process
combines cash flows until only one change in sign remains.

For example lets take the case of Project C: 230

If discount rate is 10% then,

-132 on 2nd year is equal to
-100 -132
−132
= −120 in 1st year
1.10
Now in time period 1, there are two cash flows, cash out flow of 120 (-ve)
and cash inflow of 230. Hence the net cash flow at time 1 is 230 -120 =
Rs. 110. Now the 3 time CF is reduced to 2 time i.e.
110

And IRR = 10 %

110
i.e. 0 = -100 +
1.10 -100

When NPV = 0, we are indifferent.

 −132
If discount rate is 20% then, -132 on2nd year is equal to = −110 in
1.20
1st year. Hence the net cash flow at time 1 is 230 -110 = Rs. 120. Now the
3 time CF is reduced to 2 time i.e.
120

And IRR = 20 %

120
i.e. 0 = -100 +
1.20
-100
When NPV = 0, we are indifferent.
 −132
If discount rate (r) is 14% then, -132 on 2nd year is equal to = −115.79 in
1.14
1st year. Hence the net cash flow at time 1 is 230 -115.79 = Rs. 114.21, and the 3
time CF is reduced to 2 time i.e. -100 and 114.21.

Here IRR = 14.21% & NPV = +ve

As per our decision, the project should be accepted if discount rate is between
10% and 20%.
Note: In spite of conceptual superiority of NPV, analyst prefer IRR as it
represents a (%) measure of capital budgeting which is much better than an
absolute measure (like NPV). But the biggest shortcoming of IRR is multiple IRR
scenario which can be handled by MIRR.
Reinvestment Approach:
1. Calculate the PV of cash flow associated with the project using cost of capital as an
appropriate discounting rate.

𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤𝑡
 PV of cost = σ𝑛𝑡=0
(1+𝑟)𝑡

2. Calculate terminal value (TV) of the cash inflow expected from the project.
 TV = σ𝑛0 𝐶𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑡 (1 + 𝑟)𝑛−1

3. Obtain MIRR as below

𝑇𝑉
 PV of cost =
(1+𝑀𝐼𝑅𝑅)𝑛
Example: Suppose a project has the following CFs:
0 80 100 120
20 60

2 3 4 5 6
1

-80
-120

If the cost of capital (r) = 15%, then calculate MIRR of the project.
80
Step 1: PV of cost (PVC) = 120 + = 189.6
1.15
Taking the project cash flows from the return phase (ie year two forward in this case),
compound each cash flow forward to the end of the project using the firm’s cost of
capital.

Step 2: Terminal Value (TV) of cash inflow:

20 (1.15)4 +60 (1.15)3 + 80 (1.15)2 + 100 (1.15)1 +120
=34.98+ 91.26+ 105.76+ 115+ 120 = 467

467
3. Step 3: 189.6 =
(1+𝑀𝐼𝑅𝑅)6

(1 + 𝑀𝐼𝑅𝑅)6 = 2.463
1
(6 )
MIRR = 2.463 - 1 = 0.162 or 16.2 %
Evaluation of MIRR:
MIRR is superior over IRR in two ways:
1. MIRR assumes that project CFs are reinvested at the cost of capital whereas
IRR assumes that project CF are reinvested at project’s own IRR.

Since reinvestment of CF at cost of capital is more appropriate than

reinvestment at IRR, MIRR reflects better result of project’s assessment than
IRR.

2. Secondly, the problem of multiple rate doesn’t arise with MIRR.

Now comparing MIRR with NPV we can conclude that:

1. In case of mutually exclusive projects of same size, NPV and MIRR generates
same decision irrespective of variation in life time.

2. But if mutually exclusive projects differ in size, then decision between NPV
& IRR may generate contradict results. However for mutually exclusive
projects of different size, NPV is considered to be better to address value of
the firm.
 The Profitability Index (PI)

Another method used to evaluate project is Profitability Index (or) Benefits to Cost
ratio.

𝑃𝑉 𝑜𝑓 𝐶𝐹𝑠 𝑠𝑢𝑏𝑠𝑒𝑞𝑢𝑒𝑛𝑡 𝑡𝑜 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

PI =
𝐼𝑛𝑖𝑡𝑎𝑖𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Example:
Suppose a project has following CFs. If discount rate (r) is 12% then calculate the PI
& NPV
Project CF1 CF2 CF3 PV of CFs PI NPV @ 12%
1 -20 70 10 70.5 3.53 50.5
2 -10 15 40 45.3 4.53 35.3
PV of CFs after subsequent initial investment =
70 10
70.5 = +
1.12 1.122

70.5
PI = = 3.53
20

Decision Rule:

1. Accept the independent project if PI > 1

2. Reject the independent project if PI < 1

PI is equally suffered with time and scale factor.

 Benefits-Cost Ratio (BCR)
BCR is otherwise called as Profitability Index (PI). It is defined as two ways

𝑃𝑉𝐵
BCR =
𝐼

NBCR = BCR – 1

PVB = PV of Benefits
I = Initial Investment
NBCR = Net Benefits to Cost Ratio
Example
Consider a project with opportunity cost of 12%. It requires initial
investment of Rs. 1,00,000 and generates CFs for 4 years i.e. Rs. 25,000,
Rs. 40,000, Rs. 40,000 and Rs. 50,000 respectively. Evaluate the project
using BCR technique.
Ans:
𝑃𝑉𝐵
BCR =
𝐼

25000 40000 40000 50000

PVB = + + + = Rs. 114500
1.12 1.122 1.123 1.124

Initial Investment (I) = Rs. 100000

114500
 BCR = = 1.145 or NBCR = BCR – 1 = 0.145
100000

 Decision Rule:
1. BCR > 1 or NBCR > 0 → Accept the project
2. BCR < 1 or NBCR < 0 → Reject the project
3. BCR = 1 or NBCR = 0 → Indifference
The Payback Period Method

 How long does it take the project to “pay back” its initial
investment?
 Payback Period = number of years to recover initial costs
 Minimum Acceptance Criteria:
 Set by management
 Ranking Criteria:
 Set by management
 Payback Period

1. Non-discounting criteria 2. Discounting criteria

Payback Period (Non-discounting)

 The payback period is the number of years required to recover the
original cash invested in the project. If the project generates constant
annual cash inflows, then the payback period can be calculated easily.

Example (Even Cashflow)

Suppose a project requires Rs. 50,000 initial investment and yields annual
cash inflow of Rs. 12,500 for 7 years. Then calculate the payback period of
the project?
Payback Period: Even Cash Flow

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 (𝐶0 )

Payback period (PB) =
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤 (𝑒)

50,000
PB = = 4 𝑦𝑒𝑎𝑟𝑠
12,500
Payback Period: Uneven Cash Flow

 Suppose a project requires an initial investment of Rs. 20,000 and generates cash
flows of Rs. 8000, 7000, 4000 and 3000 respectively for 4 consecutive years. What
is the project’s payback period?
Ans:
By adding CFs of first 3 years, we get (8000 + 7000 + 4000) Rs. 1900 and now it
requires Rs. 1000 from 4th year’s cash flow to cover its initial investment. If the 4th year
cash flow of Rs. 3000 is evenly distributed over the year then,

1000
× 12 = 4 𝑚𝑜𝑛𝑡ℎ𝑠
3000
Hence Payback period is 3 years and 4 months of the above project.
Or
1000
 × 365 = 121.666 𝑑𝑎𝑦𝑠
3000

121.666
 = 4.05 𝑚𝑜𝑛𝑡ℎ𝑠
30
The Payback Period Method
 Disadvantages:
 Ignores the time value of money
 Ignores cash flows after the payback period
 Biased against long-term projects
 Requires an arbitrary acceptance criteria
 A project accepted based on the payback criteria may
not have a positive NPV
 Advantages:
 Easy to understand
 Biased toward liquidity
Limitation of Payback period

1. In some projects, there will be high CFs at early time of the project or there
may be more CFs at latter timeline. The non-discounting approach considers all
the CFs equally. Hence it doesn’t consider the timing of the CFs within the
payback period.

2. This approach is silent about payments after the payback period.

Discounting Payback Period:
Take the example of the following CFs: (-100, 50, 50, 20)
If discount rate is 10%, then the discounted CFs are:

50 50 20
-100, , ,
(1.1) (1.1)2 (1.1)3

= -100, 45.45, 41.32, 15.03

In this case (45.45+41.32+15.03 = 101.8) i.e. payback period is slightly less than 3 years.

The difference appeared because CFs are discounted at their respective discounting rate.
 Accounting Rate of Return (ARR)
The accounting rate of return (ARR), is also known as percentage rate of return
or annual percentage rate of return of a project. It is calculated as

𝐴𝑣𝑒𝑟𝑒𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡

Accounting Rate of Return (ARR) =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Average Annual Profit: It is the annual net profit from the investment/project,
which is calculated as net revenue minus annual expenses, tax and interest of the
project investment.
If the project is capital intensive, (like plant, and equipment) then accumulated
depreciation also has to be adjusted from the annual revenue before calculating
annual net profit.
 Income Statement (Rs. In Cr) of AKP Pvt. Ltd.
Income 2020 2021 2022
Sales Turnover 12,186.23 10,224.72 9,479.41
Less: Excise/Sevice Tax/Other Levies 152.17 92.94 99.12
Net Sales 12,034.06 10,131.78 9,380.29
Other Income 259.14 147.91 280.28
Stock Adjustments -228.35 349.05 158.12
Total Income 12,064.85 10,628.74 9,818.69
Raw Materials 4,783.18 4,414.37 4,002.79
Power & Fuel Cost 207.56 198.19 191.84
Employee Cost 1,789.65 1,505.58 1,284.75
Miscellaneous Expenses 2,971.60 2,401.38 2,069.50
Total Expenses 9,751.99 8,519.52 7,548.88
PBDIT 2,312.86 2,109.22 2,269.81
Interest 132.52 136.05 127.86
PBDT 2,180.34 1,973.17 2,141.95
Depreciation 440.81 433.20 323.61
Profit Before Tax 1,739.53 1,539.97 1,818.34
Tax 341.5 358.88 430
Reported Net Profit 1,398.03 1,181.09 1,388.34
Average Annual Profit = (1398.03+1181.09+1388.34)/3 1322.49
If initial investment of the project = Rs. 4618 cr.
Project time frame = 3 years
Average annual profit of 3 years = Rs. 1322.49 Cr.
1322.49
Accounting Rate of Return (ARR) = = 0.286 or 28.6%
4618

Since ARR can be calculated from expected cash flow, it provides the expected
rate of return of the project and hence are quite useful for comparing multiple
projects of similar kind. As a quick measure of profitability ARR can be used
mainly as a general comparison between multiple projects on the basis of
expected rate of return
Accounting rate of return (ARR) Vs. Required Rate of
Return (RRR)
 ARR is the annual percentage return of a project based on its initial
investments or cash outflows
 Whereas Required Rate of Return is the minimum return that the
project must generate in comparison to similar risk bearing
projects/investments. In other words, it is the minimum return that the
project must generate an investor to hold it.
 Hence, ARR is more sensitive to cash flow, whereas RRR is sensitive
to level of risk of the project and the degree of risk tolerances among
the investors.
Limitations of ARR:
 It does not consider Time Value of Money
 It assigns equal weight to all the cash flows. That is If one project returns
more revenue/CF in the early years of the project and the other project
returns revenue in the later years, ARR does not assign a higher value to
the project that returns profits sooner, which could be reinvested.
 ARR does not take into account the impact of cash flow timing
 The accounting rate of return does not consider the increased risk of
long-term projects and the increased uncertainty associated with long
periods.
Thank You