Module 3:

The Basics of Capital Budgeting

Should we
build this
plant?
 The Basics of Capital Budgeting

“AN INVESTMENT WILL ADD TO

SHAREHOLDERS’ WEALTH IF IT YIELDS
BENEFITS AS PER THE HURDLE
RATE/DISCOUNT RATE”
(PRINCIPLE RELATED TO INVESTMENT
DECISION)

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 Capital Budgeting
 The process of identifying, analyzing, and selecting
investment projects whose returns (cash flows) are expected
to extend beyond one year
 Importance:
 Influence the firm’s growth
 Affect the risk of the firm
 Involve commitment of large funds
 Irreversibility
 Complexity of decision making

 Investment decisions influence firm’s value

 Firm’s value will increase if investment is profitable & adds
to shareholders’ wealth
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 Capital budgeting process
 Generating investment project proposals
consistent with the firm’s strategic objectives
 Estimating after-tax incremental operating cash
flows for investment projects
 Evaluating project incremental cash flows
 Selecting projects based on value maximizing
acceptance criterion
 Re-evaluating implemented investment projects
continually & performing post audits for
completed projects
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Steps in Project Appraisal
Forecast Cost & Benefits

Select Appraisal Criteria

Assess Risk

Estimate Cost of Capital

Value the Options

Consider the overall

corporate perspective
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 Types of Investment Decisions
 May be classified as:
 New Products or expansion of existing products
 Replacement of equipment or buildings
 Research & Development
 Exploration
 Other (for e.g. safety related or pollution control
devices)

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 Types of Investment Decisions
 Mutually Exclusive investments
A project whose acceptance exclude the
acceptance of one or more alternative projects
 Independent investments
A project whose acceptance or rejection does
not prevent the acceptance of other projects
under consideration
 Contingent investments
A project whose acceptance depends on the
acceptance of one or more other projects

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Basic Principles
 Focus on Cash Flows
 Measure Cash flows on Incremental Basis
 Exclude Financing Costs
 Treat inflation Consistently

Types of Cash Flows

 Initial flows
 Operational Cash Flows
 Terminal Flows

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 Evaluation Criteria
 Discounted Cash Flow Criteria
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Profitability Index (PI)
 Terminal Value Method (TV)
 Discounted Payback period
 Non-Discounted Cash Flow Criteria
 Payback Period (PB)
 Accounting rate of return (ARR)

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Discounted Cash Flow Criteria

Considering that
rupee has time
value, How do
we decide if a
capital
investment
project should
be accepted or
rejected?

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 Net Present Value Method
 The PV of an investment project’s net cash
flows minus the project’s initial cash outflow

 Following steps are involved:

 Cash flows to be forecasted
 Appropriate discount rate to be identified
 PV of cash flows to be calculated
 NPV should be found out; Project should be
accepted if NPV>0

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 Net Present Value Method
 Net Present Value can be calculated by using
the following formula:
n
Ct
NPV    C0
t 1 1  k 
n

 Where C1, C2..represent net cash inflows in the

year 1,2,…n;
 k is the cost of capital,
 C0 is the initial cost of investment
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 Example : NPV
 Assume that for an initial cash outflow of Rs.
1,00,000. It is expected to generate net
cash flows of Rs 34,432, Rs. 39,530 Rs
39,359 and Rs 32,219 over the next 4
years. What would be the NPV

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 Merits of NPV method
 Time Value
 Measure of true profitability
 Value Additive
 Shareholder Wealth Maximization

Demerits of NPV method

 Cash Flow estimation
 Discount rate
 Mutually exclusive projects ( details to be studied later )
 Ranking of Projects

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 Profitability Index (PI)
 Also called as Benefit – cost ratio
 PI is the ratio of the PV of cash inflows, at the required rate of
return, to the initial cash outflow of the investment
 Evaluates the projects in terms of relative rather than
absolute
 Can be calculated as:

PV (Ct ) n Ct
PI    Co
t 1 (1  k )
t
Co

 Accept the project when PI > 1; Reject the project if PI < 1

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 Profitability Index (PI)
 Example:
 A company is considering an investment proposal to install
new milling controls at a cost of Rs. 50,000. The facility has
expected life of 5 years. Following are the expected after
tax cash flows:
Year Ct
1 10000
2 10450
3 11800
4 12250
5 16750
 Calculate the PI for the project. Should the company accept
the project? Will NPV give similar results?

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 Merits of PI method
 Like the NPV, PI is a conceptually sound method; it
requires same computations as NPV. Following are the
Merits:
 Time Value
 Relative Profitability
 Value Maximization

Demerits of PI method
 PI criterion also involves calculation of Cash Flows &
Discount rates that pose problems

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 Payback Period (PB)
 The payback period tells us the number of years required to recover
our initial cash investment based on the project’s expected cash
flows
 Payback period can be calculated as per the two situations:
1. When the project generates constant annual cash flow
(annuity):

Initial Investment
Payback 
Annual Cash Inflow
2. When the project’s cash flows are not uniform
 Acceptance criterion: If the payback calculated is less than some
maximum acceptable payback period, the project will be accepted,
if not, its rejected

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 Payback Period (PB)
Example 1: When the project generates constant annual cash
flow (annuity)
 An investment in a machine of Rs. 40,000is expected
to produce cash flow of Rs. 10,000 for 10 years. What
is the Payback Period?

Example 2: When the project’s cash flows are not uniform

 Assume that for an initial cash outflow of Rs. 1,00,000.
It is expected to generate net cash flows of Rs 34,432,
Rs. 39,530 Rs 39,359 and Rs 32,219 over the next 4
years. Calculate the PB

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 Merits of PB method
 Simplicity
 Cost Effective
 Short – term effects
 Risk Shield
 Liquidity

Demerits of PB method
 Cash Flows after payback
 Does not consider cash received after the payback period
 Cash Flows Patterns
 Does not consider the magnitude & timing of cash flows
 Administrative Difficulties
 Difficult to set up a standard/maximum payback
 Inconsistent with shareholder value
 Does not consider time value of money
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 Discounted Payback Period

 Number of periods taken in recovering the investment

outlay on the present value basis

 Except using discounted cash flows in calculating payback,

this method has all the demerits of payback method.

 Using the previous sum calculate the discounted payback

period

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