Capital budgeting

• It is the process of evaluating and selecting

long-term investments that are consistent
with the goal of shareholders wealth
maximisation.
• Capital expenditure is an outlay of funds
that is expected to produce benefits over a
period of time exceeding one year.
 Why capital budgeting is very
important ?
• Huge funds involved

• Irreversible

• Lengthy time period

 Techniques
• Traditional techniques

• Discounted cash flow techniques

 Traditional techniques
• Accounting rate of return [ ARR ]

• Payback period [ PBP ]

 DCF techniques
• Net present value [ NPV ]

• Internal rate of return [ IRR ]

• Profitability index [ PI ]
 Two points to remember:
• Traditional techniques ignore time value of
money whereas DCF techniques consider
time value of money.

• ARR uses accounting profits whereas all

other techniques use cash flow after tax.
Accounting profits vs Cash flows after tax

CFBT
- Depreciation
PBT
- Tax
PAT
+ Depreciation
CFAT
 Accounting rate of return
• Accounting rate of return is the rate of
return on an investment defined as
accounting profit divided by book value of
investment. It is also referred as average
rate of return.
• ARR = Average annual profit after tax / AI
Where AI = Average investment
 Average investment can be
• Investment / 2
• ½ ( cost of machine – salvage value) +
salvage value
• ½ ( cost of machine – salvage value) +
salvage value + Net working capital
 Decisions
• In case of single project – Invest if
ARR is greater than benchmark.

• In case of multiple projects – Choose

that project that has maximum ARR,
subject to condition that it is greater
than benchmark.
 Pay back period
• It is the exact amount of time required for a
firm to recover its initial investment in a
project as calculated from cash inflows.
• In case of annuity cash inflows, PBP is
calculated as follows:
• PBP = Investment / annual cash flow
• In case of mixed stream of cash flows,
cumulative cash flows are calculated to
know the period between which entire
investment outlay are collected.
 Decisions
• In case of single project – Invest if PBP
is less than benchmark.

• In case of multiple projects – Choose

that project that has minimum PBP,
subject to condition that it is less than
benchmark.
 Net present value
• Net present value is the difference
between the present value of cash
inflows and present value of cash
outflows

• NPV = PVCIF - PVCOF

 Decisions
• In case of single project – Invest if
NPV is greater than zero.( i.e. NPV is
+ve)

• In case of multiple projects – Choose

that project that has maximum NPV,
subject to condition that it is +ve.
 Profitability index
• Profitability index is the ratio of
present value of cash inflows to
present values of cash outflows.

• PI = PVCIF / PVCOF
 Decisions
• In case of single project – Invest, if
PI is greater than one.

• In case of multiple projects –

Choose that project that has
maximum PI, subject to condition
that it is greater than one.
 Internal rate of return
• Internal rate of return is the discount rate
that equates the present values of cash
inflows with the initial investment
associated with the project.

• In other words, the discount rate at which

NPV = 0.
 Internal rate of return
• Step 1: Calculate fake annuity
• Step 2: Calculate fake pay back period
• Step 3: Refer PVIFA table to identify any
rate having a factor very close to fake
payback period
• Step 4: Try with that rate to know whether
NPV is zero. If not, try with another rate.
• Step 5: Use IRR formula to know the
answer.
 IRR
=
LR
+{(PVLR- PVCO) / (PVLR – PVHR)}
x (HR – LR)
 Decisions
• In case of single project – Invest, if
IRR is greater than cost of capital.
• i.e. IRR > (COST OF CAPITAL)

• In case of multiple projects, choose

that project which gives maximum
IRR, subject to condition that it is
greater than cost of capital.
Calculate (i) ARR (ii) PBP (iii) NPV
(10%) (iv) IRR and (v) PI (10%)from
the following data. Tax rate = 35%
Year CFBT (Rs )
0 - 50,000
1 10,000
2 10,692
3 12,769
4 13,462
5 20,385
year CFBT DEP PBT TAX PAT CFAT
(0.35)
1 10,000 10,000 0 0 0 10,000

2 10,692 10,000 692 242 450 10,450

3 12,769 10,000 2,769 969 1,800 11,800

4 13,462 10,000 3,462 1,212 2,250 12,250

5 20,385 10,000 10,385 3,635 6,750 16,750

 Accounting rate of return
• ARR = Average annual profit after tax / AI

Where AI = Average Investment

AI = Investment / 2

ARR = [ 11,250 / 5 ] / [ 50,000 / 2 ] x 100 = 9%

 PAY BACK PERIOD

Year CFAT Cum CFAT

1 10,000 10,000
2 10,450 20,450
3 11,800 32,250
4 12,250 44,500
5 16,750 61,250

PBP = 4 years + [ 5,500 / 16,750 ] = 4.328

years
4 yrs + [ 0.328 x 12 ] = 4 yrs and 4 months.
 Net present value

year CFAT PV@10% PV (Rs)

1 10,000 0.909 9,090
2 10,450 0.826 8,632
3 11,800 0.751 8,862
4 12,250 0.683 8,367
5 16,750 0.621 10,401
Total PV 45,352
- Inv - 50,000
NPV - 4,648
 Profitability Index
• PI = PVCIF / PVCOF

• PI = 45,352 / 50,000 = 0.907

 Internal rate of return
• Step 1: Calculate fake annuity
• Step 2: Calculate fake pay back period
• Step 3: Refer Table 4 to identify any rate
having a factor very close to fake payback
period
• Step 4: Try with that rate to know whether
NPV is zero. If not, try with another rate.
• Step 5: Use IRR formula to know the
answer.
 IRR
=
LR
+{(PVLR- PVCO) / (PVLR – PVHR)}
x (HR – LR)
 Calculation of IRR
Step 1: Fake annuity = 61,250 / 5 = Rs 12,250
Step 2: Fake Pay back period = 50,000 / 12,250
= 4.0816
Step 3: Referring Table 4, we can find the factor
very close to 7% - 4.100
Step 4: Let us try with 7%. Then NPV comes to
–609.
Now let us try with 6%, wherein NPV comes to
856.
Using IRR formula, IRR = 6.6%
 Problems of IRR
• For non conventional cash flows, multiple
IRRs are possible. Eg: cash flows at
year 0 is –1,60,000, year 1 is 10,00,000 and
year 2 is –10,00,000. We have two IRRs for
this case i.e. 25% and 400%.
• No IRR exists for some cases. Cash flows at
Eg: year 0 is 15,000, year 1 is –45,000 and
year 2 is 37,500.
• In some cases, IRR and NPV give opposite
results.
 Problems in IRR
• IRR can be misleading when a choice has to
be made between mutually exclusive
projects which have different patterns of
cash flow over time.
• IRR cannot differentiate lending and
borrowing.
Proj. CF 0 CF 1 IRR NPV@10
%
A -4,000 6,000 50% 145
B 4,000 -7,000 75% -236
 A project costing Rs 2,500 now,
is expected to generate year end
cash inflows of Rs 900, Rs 800,
Rs 700, Rs 600 and Rs 500 in
years 1 to 5. The cost of capital is
10%. Calculate NPV.
• Rs 225
 A project costs Rs 16,000 and is
expected to generate cash inflows of
Rs 8,000, Rs 7,000 and Rs 6,000 for
next 3 years.(i) Calculate IRR.
(ii) If cost of capital is 20%, will you
undertake the project?
• IRR = 15.8%
• No
 A project will cost Rs 40,000. Its
expected EBDIT during first five
years are expected to be Rs 10,000,
Rs 12,000, Rs 14,000, Rs 16,000 and
Rs 20,000. Assume 50% tax and
depreciation is on straight line
method. Calculate ARR.
• ARR = 16%
 Other techniques
• Modified NPV

• Modified IRR

• Discounted Pay back period

 Modified NPV
• Step 1 : calculate the terminal value of the
project’s cash inflows using the explicitly
defined reinvestment rates.

• Step 2 :Calculate modified NPV using the

formula

NPV* = [TV / ( 1 + r )n] - I

 Modified IRR
• Step 1 : Calculate the present value of costs
associated with the project [ PVC ].
• Step 2 : Calculate the terminal value of the
cash inflows [ TV ].
• Step 3 : Calculate MIRR by solving the
following equation.

PVC = [ TV / ( 1 + MIRR )n ]
 Discounted pay back period
• Step 1 : calculate the present value of cash
inflows and outflows using the discount rate.

• Step 2 : calculate the cumulative value of

discounted cash flows.

• Step 3 : Identify the payback period in the

routine way.
 Calculate Modified NPV from the
following data
Project X Project Y
Investments Rs 1,10,000 Rs 1,10,000
CF – Year 1 31,000 71,000
CF – Year 2 40,000 40,000
CF – Year 3 50,000 40,000
CF – Year 4 70,000 20,000

Assume reinvestment rate and cost of capital

to be 14% and 10% respectively
 Solution
• Step 1 : calculate the terminal value of the
project’s cash inflows using the explicitly
defined reinvestment rates.
= 31,000 (1.14)3 + 40,000 (1.14)2 +
50,000(1.14)1 + 70,000
= Rs 2,24,911
• Step 2 :Calculate modified NPV using the
formula
NPV* = [TV / ( 1 + r )n] - I
 Solution
NPV* = [TV / ( 1 + r )n] - I

NPV* = [2,24,911 / (1.1)4] – 1,10,000

NPV* = Rs 43,614.
 Calculate Modified IRR from the
following data
year 0 1 2 3 4 5 6

CF -120 -80 20 60 80 100 120

The cost of capital is 15%.

Step 1 : Calculate the present value of costs
associated with the project [ PVC ].

= 120 + 80 x PVIF (15%,1) = 189.6

• Step 2 : Calculate the terminal value of the

cash inflows [ TV ]

= 20 (1.15)4 + 60 (1.15)3 + 80 (1.15)2 + 100

(1.15) + 120 = 467
Step 3 : Calculate MIRR by solving the
following equation.

PVC = [ TV / ( 1 + MIRR )n ]

189.6 = [ 467 / ( 1 + MIRR )6 ]

= ( 1 + MIRR )6 = 467 / 189.6 = 2.463
= 1 + MIRR = 2.4631/6
= MIRR = 1.162 – 1
= MIRR = 0.162 or 16.2%