Capital Budgeting

•Accounting rate of return (ARR), payback period method, NPV method, and
IRR method
•Compute payback period and discounted payback period
•Compare the NPV method and IRR method
•Examine the relevant cash flows for investment projects
•Project cash flows for replacement projects
 Introduction
• Capital budgeting decisions relate to
acquisition of asset and generally have long-
term strategic implications for the firm.

• Capital budgeting decision is the investment

decision where the allocation of capital among
the different project is decided.
 Features of capital budgeting
1. Non-reversible: The strategic decisions are often irreversible.
Utmost caution must be exercised while making a decision.
2. Large initial outlays followed by small periodic inflows: The
initial outflow of capital is rather large making it mandatory
for the firm to evaluate the financing options.
3. Information gap and inexperience: Capital budgeting
decisions are either completely or somewhat new to the
managers and the management of the firm.
4. Inflexibility: Unlike working capital decision which is
repetitive in nature, capital budgeting decisions are one time,
they offer little scope for adjustment for learning with the
experience.
 Steps in capital budgeting
1. Identifying investment opportunities
2. Short-listing of identified opportunities that match certain
pre requisites
3. Collecting of relevant data of revenue, cost, cash flows, etc.
4. Selecting proper evaluation criteria
5. Make a decision of acceptance or rejection based on
evaluation criteria
 Technique of Capital Budgeting
1. Discounted Cash Flow (DCF) Technique: It evaluate the
proposal on the basis of cash flows in different periods,
timings of such cash flows, and the risk perceived with cash
flows.
2. Non-DCF techniques may not consider all above aspects.
These techniques include (1) Accounting rate of return; and
(2) pay back method
 Payback Period Method
• Payback period of the project is the time required to recover
the investment. When done on discounted cash flow basis it is
called discounted payback period.
Figure in Rs.
Initial cash outflow 10,00,000
Cash inflows
1st year 3,00,000
2nd year 5,00,000
3rd year 4,00,000
4th year 5,00,000
Of the initial investment of 10 Lacs, the project returns 17 lacs in
4 years.
Pay back period = 2 years + 200000/400000 i.e. 2 ½ yrs.
• The pay-back period can be ascertained in the following
manner:
(1) Calculate annual net earnings (profits) before depreciation
and after taxes; these are called annual cash inflows.
(2) Divide the initial outlay (cost) of the project by the annual
cash inflow, where the project generates constant annual
cash inflows

Thus, where the project generates constant cash inflows.

PBP = Cash outlay of the project or original cost of asset
Annual Cash Inflows
(3) Where the annual cash inflows (profit before dep. and after
taxes) are unequal, the pay-back period can be found by
adding up the cash inflows until the total is equal to the
initial cash outlay of project or original
 Disadvantages of pay-back period
1. It does not take into account the cash inflows earned after the pay back
period and hence the true profitability of the projects cannot be correctly
assessed.
2. This method ignores the time value of money.
3. It does not take into consideration the cost of capital.
4. It may be difficult to determine the minimum acceptable pay-back
period.
5. It treats each asset individually in isolation with other assets which is not
feasible in real practice.
6. Pay back period method is feasible for a limited short period only.
 Improvement in Pay Back Period Method
(a) Post pay-back profitability method

Post pay-back profitability index = Post pay-back profit x 100

Investment
(b) Discounted Pay-back method: Under this method the
present values of all cash outflows and inflows are computed
at an appropriate discount rate. The present value of all
inflows are cumulated in order of time.
• The time period at which the cumulated present value of
cash inflows equals the present value of cash outflows is
known as discounted pay-back period.
• The project which gives a shorter discounted pay-back period
is accepted.
Q1. For the following project calculate (a) post pay-back
profitability and (b) post pay-back profitability index
Initial outlay Rs. 50,000
Annual Cash Inflow (after tax but before depreciation)
First three year Rs. 15000
Next five years Rs. 5000
Estimated life 8 years

Q2. Calculate discounted pay-back period from the information

given below:
Cost of project Rs. 600000
Life of the project 5 years
Annual cash inflow Rs.200000
Cut off rate 10%
 Accounting Rate of Return
• Accounting Rate of Return is defined as average profit as % of
average investment over the life of the project.

ARR = Average annual net income (savings) x 100

Average investment
Average Investment = Initial investment + Scrap value
2
Evaluation of project: Rate of return is compared with the cut-off
or the pre-specified rate of return. If the return is more than
the cut-off rate, the project should be accepted, otherwise,
rejected.
In the evaluation of mutually exclusive projects, project with
highest rate is selected.
 Net Present Value Method
• NPV considers :-
– all cash flows over the life of the project
– assigns time value to each of the cash flows.

• Cash flows are discounted to the present value and then

compared with the initial outlay giving NPV of the project.

NPV = ∑CFt - CF0

(1+r)t
CFt = Cash flow (profit after tax before depreciation) for period t
t = period 1,2,3,….
n= life of the project in number of periods
r= discount rate
• The Decision Rule
ACCEPT if NPV > 0
REJECT if NPV < 0
• By accepting the project, the additional wealth created for the shareholders is
equal to the NPV of the project. Projects with positive NPV create value for the
shareholders.

Q. From the following calculate NPV of the two projects assuming a discount rate of
10%

Project X Project Y
Initial investment Rs. 20,000 Rs. 30,000
Estimated life 5 years 5 years
Scrap value Rs. 1000 Rs. 2000
The profits before depreciation and after taxes (cash flows) are as follows:

Year 1 Year 2 Year 3 Year 4 Year 5

Rs. Rs. Rs. Rs. Rs.
Project X 5000 10000 10000 3000 2000
Project Y 20000 10000 5000 3000 2000
Q. Cash inflows of a certain project along with cash outflows are given below
(assume yield at 10%):
The salvage value at the end of the 5th year is Rs. 40,000. Calculate net present
value.

Years Outflows Inflows

Rs. Rs.
0 150000 -----
1 30000 20000
2 30000
3 60000
4 80000
5 30000
 Procedure to use NPV method
(i) Calculate the cash outflow linked with the proposal
Cost of New machine
+ installation cost
+/- increase/decrease in working capital
- Proceeds from the sale of old machine
- investment allowance
+/- payment/saving in tax liability
(ii) Calculate cash flow after tax for each year and find out their
PV using appropriate discount rate.

Year Earnings Depreci EAD Tax EAT CFAT=EA Discount PV of

ation T + Dep factor CFAT
1 2 3=1-2 4 5=3-4 6=5+2 7 8=6*7
(iii) Take the sum of all present values of cash flow after taxes
and subtract cash outflow from it.
(iv) The resultant value is the net present value
 Internal Rate of Return (IRR) Method
• IRR of the project is that rate of return at which the net
present value is zero. It is the maximum discount rate that the
cash flows of the project can support.

NPV = ∑CFt - CF0 = 0

(1+r)t
• DERTERMINATION OF IRR
(a) When the annual net cash flows are equal over the life of
the asset:
(i) Firstly, find out present value factor by dividing cost of
investment by annual cash flow, i.e.,
Present Value Factor = Initial Outlay
Annual Cash Flow
(ii) Consult present value annuity tables and find out the rates at
which the calculated present value factor is equal to the
present value given in the table with the number of years.
(b) When the annual cash flows are unequal over the life of the
asset:
The internal rate of return is calculated by hit and trial method.
The calculation process is as follows:
(i) Prepare the cash flow table using an arbitrary assumed
discount rate (or discount rate calculated with above
formula) to discount the net cash flows to the present value.
(ii) Find out NPV by deducting cash outflow from PV of cash
inflow
(iii) If NPV is +ive, apply higher rate of discount and further
increase till NPV becomes negative
(iv) The IRR is between these two rates.
r = LDR + NPV at LDR x (HDR – LDR)
(PV at LDR – PV at HDR)
LDR = Lower discount rate
HDR = Higher discount rate
 NPV and IRR – A Comparison
• Under the NPV rule, we discount the cash flows at a given rate
(normally cost of capital ‘k’) and arrive at NPV
• Under the IRR method, we find a discount rate that makes NPV
zero and compare this rate with ‘k’.
• For calculating NPV we need the cost of capital, but for
calculating IRR we don’t need cost of capital.

• Consider a project with an estimated life of five years and with

initial outlay of Rs. 100. It yields cash inflows of Rs. 50, 60, 30,
20, and Rs. 10 for 5 years.
• Calculate NPV at progressively increasing discount rate. As the
discount rate increases, the NPV falls.
 Conflict between NPV and IRR
• There could be situations where NPV and IRR may give
contradictory results.
• These situations may arise –
(1) if the project has multiple cash outflows instead of a
single outflow
(2) when there are mutually exclusive projects under
consideration
 Multiple IRRs – Non-conventional Cash Flows

• There can be some projects that may have more than one net
cash outflows in different periods. Such kinds of projects may
pose a problem in decision making while using the IRR
technique.
• For example, consider an example where the initial cash
outflow is Rs. 504, which provides a cash flow of Rs. 2862 in
Year 1. It also needs an outflow of 6070 in Year 2 followed by
an inflow of 5700 in Year 3. Again in Year 4 there is cash
outflow of Rs. 2,000 that may occur due to tax liability arising
in the subsequent year after the useful life of the project is
over in Year 3. IRR could be found out :

504 = 2862 - 6070 + 5700 - 2000

1 + r (1+r)2 (1+r)3 (1+r)4
• Solving the above equation will give more than one value of r
that will satisfy the equation.
• An alternate way is to find out rates at which NPVs become
zero. Note that NPV becomes zero at values about 25%, 33%,
42% and 66%.
 Mutually Exclusive Projects
• Mutually exclusive projects imply acceptance of one single
project over many.
• In situation of mutually exclusive projects the manager is
faced with a decision to choose one.
• Which of the decision making rule out of IRR and NPV should
be used?
• Will both the decision rules of IRR and NPV lead to identical
choice?
 Cash Flow and NPVs for Project A
CASH YEAR  
FLOW 0 1 2 3 4 5
NPV
  -100 50 60 30 20 10
PRESENT VALUE AT
0% -100 50 60       70.00
5% -100 47.62 54.42       52.25
10% -100 45.45 49.59       37.45
15% -100 43.48 45.37       24.98
20% -100 41.67 41.67       14.36
25% -100 40 38.4       5.23
28.23% -100 38.99 36.49       -0.01
30% -100 38.46 35.5       -2.68
35% -100 37.04 32.92       -9.6
40% -100 35.71 30.61       -15.68

Cash Flow and NPVs for Project B

CASH YEAR  
FLOW 0 1 2 3 4 5
NPV
  -100 50 20 20 40 60
PRESENT VALUE AT
0% -100 50 20.00       90.00
5% -100 47.62 18.14       62.69
10% -100 45.45 16.53       41.59
15% -100 43.48 15.12       24.45
20% -100 41.67 13.89       10.53
24.57% -100 40.14 12.89 -0.01
25% -100 40 12.8       -0.92
30% -100 38.46 11.83       -10.44
35% -100 37.04 10.97       -18.44
40% -100 35.71 10.2       -25.22
• For example we have two mutually exclusive projects, Project
A and Project B. The cash flows are given for 5 years.
• IRR for Project A – 28.23% Project B - 24.57%
• Project A should be preferred according to IRR.
• According to NPV rule:
(A) At 10% discount rate : Project A NPV Rs. 37.45
Project B NPV Rs. 41.59
 Hence, at 10% Project B should be chosen which is not
consistent with IRR rule.
(B) At 20% discount rate: Project A NPV Rs. 14.36
Project B NPV Rs. 10.53
 Hence Project A should be chosen

While the NPV is dependent upon the discount rate chosen, the
IRR isn’t. The IRR rule will always provide
 Questions
1. RPS Ltd. is contemplating to purchase a machine for Rs.
50000 which is likely to give following cash flows in the next
five years.

Year 1 2 3 4 5
CFAT 15000 12000 14000 16000 8000
Should the machine be purchased if the cost of capital is (a) 12%
(b) 8%
(Discount factor at 12% = 0.893,.797,.712,.636,.567)
(Discount factor at 8% = .926,.857,.794,.735,.681)
(Discount factor at 11% = .901,.812,.731,.659,.593)
(Discount factor at 10% = 0.909, 0.826, 0.751,0.683,0.621)
NPV with salvage value and increase in working capital
2. A machine is available for Rs. 80000 while is likely to yield
following earnings in the next five years.

Year 1 2 3 4 5
Earnings 35000 32000 30000 24000 26000
The purchases of machine would result in increase of working
capital by Rs. 15,000
The machine will be depreciated on Straight Line Method basis
and has salvage value of Rs. 10000. the company is subject to
tax at the rate of 50%. Should the machine be purchased if
the cost of capital is 12%.
3. A company is considering purchase of machine which will cost
Rs. 35000. the machine will have life of 5 years and it is
expected to generate following cash flows after tax during its
life time.

Year 1 2 3 4 5
CFAT 6000 8000 9000 12000 13000
Find:
(a) Payback period of the machine
(b) Net present value (if cost of capital is 10%)
(c) Internal rate of return
4. A company is planning to buy a machine. Machine A and
Machine B are available in the market. The cash flows associated
with the purchase are given below:

Year Machine A Machine B

0 -16000 -28000
1 6400 3000
2 5000 5000
3 4000 9000
4 3000 10000
5 2000 13000
Rank these machine on the basis of:
(a) Payback period
(b) Internal rate of return
5. A machine is available for Rs. 1,20,000 which is likely to yield
following earnings in the next five years:

Year 1 2 3 4 5
Earnings 50000 45000 42000 39000 46000
The purchase of machine would result in increase of working
capital by Rs. 15,000. The machine will be depreciated on SLM
(Straight Line Method) basis and has salvage value of Rs.
10,000. The company is subject to tax at the rate of 50%.
Should the machine be purchased if the cost of capital is 12%?