Capital Budgeting

Aditya Mohan Jadhav

Project
• Project is a specific activity which involves cash-inflows and cash outflows over a
definite period of time.

• Investment Project: Any project wherein the investor first pays the money (cash-
outflow) at the start and recovers his investment over a period of time (cash-
inflows) in the future is called as an investment project.

• Financing Project: Any project wherein the investor first receives money (cash
inflow) at the start and pays it back (cash-outflows) over the period of time is
called financing project.

• Our focus is on investment projects only.

Project Evaluation Criteria
• Payback Period

• Net Present Value

• Profitability Ratio

• Internal Rate of Return

Payback Period
• Payback period is the period required to recover the initial
investment.

Selection Criteria Decision

Payback Period Decision: Shorter the Payback Period
better the project
Example
Project 0 1 2 3 4
Project A -20 10 10 20 30
Project B -20 -10 20 20 50
Project C -20 0 0 20 40
Project D -20 10 -10 20 40
Payback period
Benefits Drawbacks
• Simple to calculate and • Ignores life of the project and
understand. total returns.

• Recovery of principle in focus • Ignores time value of money

Net Present Value (NPV)
•  Net present value of a project is the sum of present values of all cash-
flows (positive as well as negative) that are expected to occur over the
life of the project.
Net Present Value
• Net Present Value Project Selection Criteria:

Selection Criteria Decision

NPV >=0 Accept otherwise reject

Example
Project 0 1 2 3 4
Project A -20 10 10 20 30
Project B -20 -10 20 20 50
Project C -20 0 0 20 40
Project D -20 10 -10 20 40
Net Present Value
Benefits
• Net Present Values are Additive
• NPV allows calculation using
time varying discount rates
Drawbacks
• NPV is presented in absolute
terms irrespective of amount of
initial investment.
• NPV ignores the life of project.
Profitability Index
•  The Profitability Index defines the relationship between benefits
(NPV) and costs.
PI Criteria
• PI Decision Criteria
Selection Criteria Decision
PI > 0 Accept
PI = 0 Accept
PI < 0 Reject
Example
Project 0 1 2 3 4
Project A -20 10 10 20 30
Project B -20 -10 20 20 50
Project C -20 0 0 20 40
Project D -20 10 -10 20 40
PI
Benefits Drawbacks
• Take into consideration initial • Ignores life of the project
investment
• Not additive
• Allows calculation using time
varying discount rates
Internal Rate of Return (IRR)
•  Internal rate of return is the annualized return that you obtain by
investing in the project.

• Internal rate of return is estimated as a rate at which the present

value of cash outflows from the project is equal to the present value
of cash inflows from the project i.e. rate at which NPV becomes zero.
IRR Selection Criteria

• IRR Project Selection Criteria:

Selection Criteria Decision

IRR >= k Accept otherwise reject

IRR Estimation Process
• IRR is calculated only if NPV is positive

• Always remember that NPV and WACC (discount rate to estimate NPV
have negative relationship)

• IF NPV is positive please calculate PI

• Based on the size of PI identify an approximate rate where NPV will

become zero or negative
IRR Estimation Process
• Calculate NPV for a WACC where NPV is expected to be negative

• Calculate NPV for a WACC where NPV is expected to be nearby zero

but positive.

• Calculate the difference between the two NPV estimated above

• Calculate the difference between the WACC

IRR Estimation Process
• Using inverse proportion approach estimate the change in WACC to
make NPV zero.

• Add the change to lower WACC of the two to arrive at IRR.

Example
Project 0 1 2 3 4
Project A -20 10 10 20 30
Project B -20 -10 20 20 50
Project C -20 0 0 20 40
Project D -20 10 -10 20 40
IRR
Benefits Drawbacks
• Standardized and hence easy to • Multiple IRR
compare;
• Non-additive in nature and
• Considers all cash-flows over the hence combination of project
life of project cannot be evaluated directly.
NPV vs. IRR…Which project to choose?
• NPV • IRR

• Project A = 300 • Project A = 20%

• Project B = 350 • Project B = 17%

• Questions