Capital Budgeting

KSB
 LEARNING OBJECTIVES
2

• Explain the nature and importance of investment decisions.

• Explain the methods of calculating the net present value (NPV),
internal rate of return (IRR) and profitability index.
• Show the implications of net present value (NPV) and internal rate
of return (IRR).
• Describe payback and accounting rate of return and their
computation.
• Illustrate the computation of the discounted payback and
profitability index.
• Compare and contrast NPV and IRR.
• Explain the controversy regarding reinvestment assumption and the
calculation of MIRR.
 Nature of Investment Decisions
3

• The investment decisions of a firm are generally known as the

capital budgeting, or capital expenditure decisions.

• The firm’s investment decisions would generally include expansion,

acquisition, modernisation and replacement of the long-term
assets. Sale of a division or business (divestment) is also as an
investment decision.

• Decisions like the change in the methods of sales distribution, or an

advertisement campaign or a research and development
programme have long-term implications for the firm’s expenditures
and benefits, and therefore, they should also be evaluated as
investment decisions.
Capital Budgeting Defined
• A capital budgeting decision may be defined as the firm’s decision to
invest its current funds (internal & external) most efficiently in the
long-term assets in anticipation of an expected flow of benefits over a
series of years.

• The long-term assets are those that affect the firm’s operations beyond the one-
year period.
• Investment Decision and Capital Budgeting –used synonymously (in the present
context)
 Features of Investment Decisions
5

• The exchange of current funds for future benefits.

• The funds are invested in long-term assets.

• The future benefits will occur to the firm over a series

of years.
 Types of Investment Decisions
7

• One classification is as follows:

• Expansion of existing business
• Expansion of new business
• Replacement and modernisation
• Yet another useful way to classify investments is as
follows:
• Mutually exclusive investments
• Independent investments
• Contingent investments
 Investment Evaluation Criteria
8

• Three steps are involved in the evaluation of an

investment:
1. Estimation of cash flows
2. Estimation of the required rate of return (the
opportunity cost of capital)
3. Application of a decision rule for making the choice
 Investment Decision Rule should be based on
some considerations
9

• It should maximise the shareholders’ wealth.

• It should consider all cash flows to determine the true profitability of
the project.
• It should provide for an objective and unambiguous way of
separating good projects from bad projects.
• It should help ranking of projects according to their true profitability.
• It should recognise the fact that bigger cash flows are preferable to
smaller ones and early cash flows are preferable to later ones.
• It should help to choose among mutually exclusive projects that
project which maximises the shareholders’ wealth.
• It should be a criterion which is applicable to any conceivable
investment project independent of others.
Evaluation Criteria
10

• 1. Discounted Cash Flow (DCF) Criteria

• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI)
• 2. Non-discounted Cash Flow Criteria
• Payback Period (PB)
• Discounted payback period (DPB)
• Accounting Rate of Return (ARR)
Net Present Value Method
11

• Cash flows of the investment project should be forecasted based on realistic

assumptions.
• Appropriate discount rate should be identified to discount the forecasted cash
flows.
• Present value of cash flows should be calculated using the opportunity cost of
capital as the discount rate.
• Net present value should be found out by subtracting present value of cash
outflows from present value of cash inflows. The project should be accepted if
NPV is positive (i.e., NPV > 0).
Net Present Value Method
12

• The formula for the net present value can be written as follows:
 Net present value
NPV is the sum of the present value of all cash flows – positive as well as
negative.
NPV = PV of all cash inflows – initial investment
Year Cash flows
0 -10,00,000 If NPV is positive, accept the project
1 200,000
2 200,000 If NPV is negative, reject the project
3 300,000
If NPV is zero, indifferent
4 300,000
5 350,000

= Rs. – 5273
Calculating Net Present Value
14

• Assume that Project X costs Rs 2,500 now and is expected to

generate year-end cash inflows of Rs 900, Rs 800, Rs 700, Rs
600 and Rs 500 in years 1 through 5. The opportunity cost of
the capital may be assumed to be 10 per cent.
Why is NPV Important?
15

• Positive net present value of an investment represents the

maximum amount a firm would be ready to pay for purchasing
the opportunity of making investment, or the amount at
which the firm would be willing to sell the right to invest
without being financially worse-off.

• The net present value can also be interpreted to represent the

amount the firm could raise at the required rate of return, in
addition to the initial cash outlay, to distribute immediately to
its shareholders and by the end of the projects’ life, to have
paid off all the capital raised and return on it.
Acceptance Rule
16

• Accept the project when NPV is positive NPV > 0

• Reject the project when NPV is negative NPV < 0
• May accept the project when NPV is zero NPV = 0

The NPV method can be used to select between mutually exclusive projects; the one
with the higher NPV should be selected.
 Conventional & Non-Conventional Cash
Flows
18

• A conventional investment has cash flows the pattern of an initial

cash outlay followed by cash inflows. Conventional projects have
only one change in the sign of cash flows; for example, the initial
outflow followed by inflows, i.e., – + + +.

• A non-conventional investment, on the other hand, has cash

outflows mingled with cash inflows throughout the life of the
project. Non-conventional investments have more than one change
in the signs of cash flows; for example, – + + + – ++ – +.
 PROFITABILITY INDEX
19

• Profitability index is the ratio of the present value of

cash inflows, at the required rate of return, to the
initial cash outflow of the investment.
• The formula for calculating benefit-cost ratio or
profitability index is as follows:
 Benefit Cost Ratio
It is also known as profitability index

PVB is the present value of benefits (CF) and I is the initial investment

Year Cash flows NBCR = BCR – 1 = 1.145 – 1 = 0.145

0 - 100,000
1 25,000 BCR NBCR Rule
2 40,000 >1 >0 Accept
3 40,000 <1 <0 Reject
4 50,000 =1 =0 Indifferent

Cost of capital is 12%

• The initial cash outlay of a project is Rs 100,000 and it can generate
cash inflow of Rs 40,000, Rs 30,000, Rs 50,000 and Rs 20,000 in year 1
through 4. The company has employed debt and equity in 1:1
proportion. The post tax cost of debt is 8% and the cost of equity
capital is 12%.Calculate the PI/BCR.
PROFITABILITY INDEX
22

• The initial cash outlay of a project is Rs 100,000 and it can generate cash inflow of
Rs 40,000, Rs 30,000, Rs 50,000 and Rs 20,000 in year 1 through 4. The company
has employed debt and equity in 1:1 proportion. The post tax cost of debt is 8%
and the cost of equity capital is 12%.Calculate the PI/BCR.
• WACC=?
 Benefit Cost Ratio/PI
• Since this criteria measures the NPV per rupee of outlay, it can
easily discriminate between large and small investments, and
hence is preferable over NPV.

• Under unconstrained conditions, the BCR criterion will accept

and reject the same projects as NPV.
 Acceptance Rule
24

• The following are the PI acceptance rules:

• Accept the project when PI is greater than one. PI > 1
• Reject the project when PI is less than one. PI < 1
• May accept the project when PI is equal to one. PI = 1
• The project with positive NPV will have PI greater
than one. PI less than means that the project’s NPV is
negative.
INTERNAL RATE OF RETURN METHOD
26

• The internal rate of return (IRR) is the rate that equates

the investment outlay with the present value of cash
inflow received after one period. This also implies that
the rate of return is the discount rate which makes NPV =
0.
CALCULATION OF IRR
27

• Uneven Cash Flows: Calculating IRR by Trial and Error

• The approach is to select any discount rate to compute the
present value of cash inflows.
• If the calculated present value of the expected cash inflow
is lower than the present value of cash outflows, a lower
rate should be tried.
• On the other hand, a higher rate should be tried if the
present value of inflows is higher than the present value of
outflows.
• This process will be repeated unless the net present value
becomes zero.
CALCULATION OF IRR
28

• Uniform/Level Cash Flows

• Let us assume that an investment would cost Rs 20,000 and
provide annual cash inflow of Rs 5,430 for 6 years
• The IRR of the investment can be found out as follows

You can use the formula of PVAF by trial and error to

find the rate which gives 3.683 PVAF. It is 16%.
NPV Profile and IRR(HW to Cross check)
29

NPV Profile
IRR(HW)
• It is that discount rate at which the NPV of the project is equal to zero.
• In other words, it is the discount rate which equates the present value of future cash flows with the
initial investment.
Year Cash flows
0 - 100,000 NPV
1 30,000 45,000
2 30,000
3 40,000
4 45,000
0
At 15%, PV = 100,801 0 15.37% Discount rate
At 16%, PV = 98,636

IRR = 15.37%
 Acceptance Rule
31

• Accept the project when r > k

• Reject the project when r < k

• May accept the project when r = k

• In case of independent projects, IRR and NPV rules

will give the same results if the firm has no shortage
of funds.
NPV vs IRR
• Do the NPV and IRR lead to identical decisions?

• Only when 2 conditions are met

• The cash flows must be conventional
• Projects must be independent

• What are the limitations of IRR?

• When the cash flows are not conventional
 Year Cash flows
Consider the following project
0 - 160,000
The IRR equation for this project is 1 10,00,000
2 -10,00,000

The simple computation tells us that this equation has two roots, viz., 1.25 and 5.00

It means, the IRR corresponding to these roots will be 25% and 400%, i.e., the
NPV is zero at two discount rates

NPV

Discount rate
25% 400%
 PAYBACK
36

• Payback is the number of years required to recover the

original cash outlay invested in a project.
• If the project generates constant annual cash inflows,
the payback period can be computed by dividing cash
outlay by the annual cash inflow. That is:
 Payback: Example
37

• Assume that a project requires an outlay of Rs

50,000 and yields annual cash inflow of Rs 12,500
for 7 years. The payback period for the project is:
• 4 years
Payback period
• It is the length of time required to recover the initial on the project.

• The shorter the time, the better.

• For instance, if a project costs Rs. 600,000, and it generates Rs.

100,000, Rs. 150,000, Rs. 150,000, and Rs. 200,000 in the first,
second, third and fourth years, respectively, then the payback time is
4 years.

• This is simple both in concept and application.

 Acceptance Rule
39

• The project would be accepted if its payback period is

less than the maximum or standard payback period
set by management.
• As a ranking method, it gives highest ranking to the
project, which has the shortest payback period and
lowest ranking to the project with highest payback
period.
Limitations of payback period
• It does not consider time value of money
• It ignores the cash flows beyond the payback period.

Year Project A Project B

0 -100,000 -100,000
1 50,000 20,000
2 30,000 20,000
3 20,000 20,000
4 10,000 40,000
5 10,000 50,000
6 5,000 60,000

• It is a measure of capital recovery, not profitability

 PAYBACK: Unequal Cash Flows
41

• Unequal cash flows In case of unequal cash inflows, the

payback period can be found out by adding up the cash inflows
until the total is equal to the initial cash outlay.
• Suppose that a project requires a cash outlay of Rs 20,000 and
generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs
3,000 during the next 4 years. What is the project’s payback?
• Accumulated cash flow for three years is ₹19,000. Remaining
amount is ₹1000. Thus, payback period is:
3 years + 12 × (1,000/3,000) months
3 years + 4 months
 Accounting rate of return
• It is also known as average accounting return or average rate of
return.
• It is defined as the average profit after tax or net income divided by
the average book value of investments.
• If a project involves an initial investment of Rs. 500,000 and PAT
generated in 5 years is given below, what will be ARR?

Year PAT
1 100,000
2 150,000
3 50,000
4 0
5 -50,000
Limitations of ARR
• It does not consider time value of money

• It is based upon accounting profit, not cash flows

• It is internally inconsistent

• The numerator measures the profit after tax which belongs

to only equity shareholders, however, its denominator
represents fixed investment which may include debt as well.
 Payback Reciprocal and the Rate of Return
46

• The reciprocal of payback will be a close

approximation of the internal rate of return if the
following two conditions are satisfied:
1. The life of the project is large or at least twice the
payback period.
2. The project generates equal annual cash inflows.
DISCOUNTED PAYBACK PERIOD
47

• The discounted payback period is the number of periods

taken in recovering the investment outlay on the present
value basis.
• The discounted payback period still fails to consider the
cash flows occurring after the payback period.
Discounted Payback Illustrated
ACCOUNTING RATE OF RETURN
METHOD
48

• The accounting rate of return is the ratio of the average after-

tax profit divided by the average investment. The average
investment would be equal to half of the original investment if
it were depreciated constantly.

or

• A variation of the ARR method is to divide average earnings

after taxes by the original cost of the project instead of the
average cost.
 ACCOUNTING RATE OF RETURN:
Example
49

• A project will cost Rs 40,000. Its stream of earnings before

depreciation, interest and taxes (EBDIT) during first year through
five years is expected to be Rs 10,000, Rs 12,000, Rs 14,000, Rs
16,000 and Rs 20,000. Assume a 50 per cent tax rate and
depreciation on straight-line basis.
Depreciation=40,000/5=₹8,000.
Average EBDIT =72,000/5=₹14,400
EBIT (1-0.50) = (14,400-8,000)=₹ 3,200
Average Investment =(40,000+0)/2=₹20,000
ARR=3,200/20,000=16%
 Calculation of Accounting
Rate of Return
50
 Acceptance Rule
51

• This method will accept all those projects whose ARR

is higher than the minimum rate established by the
management and reject those projects which have
ARR less than the minimum rate.

• This method would rank a project as number one if it

has highest ARR and lowest rank would be assigned
to the project with lowest ARR.
 Evaluation of ARR Method
52

• The ARR method may claim some merits

Simplicity
Accounting data
Accounting profitability
• Serious shortcomings
Cash flows ignored
Time value ignored
Arbitrary cut-off
 Conventional & Non-Conventional Cash
Flows
53

• A conventional investment has cash flows the pattern of an initial

cash outlay followed by cash inflows. Conventional projects have
only one change in the sign of cash flows; for example, the initial
outflow followed by inflows, i.e., – + + +.

• A non-conventional investment, on the other hand, has cash

outflows mingled with cash inflows throughout the life of the
project. Non-conventional investments have more than one change
in the signs of cash flows; for example, – + + + – ++ – +.
Conventional Projects
54

• Conventional Independent Projects:

In case of conventional investments, which are
economically independent of each other, NPV and IRR
methods result in same accept-or-reject decision if the
firm is not constrained for funds in accepting all profitable
projects.
 Lending and Borrowing-typed Projects
55

• Lending and borrowing-type projects:

Project with initial outflow followed by inflows is a
lending type project, and project with initial inflow
followed by outflows is a lending type project, both are
conventional projects.
Problem of Multiple IRRs
56

• A project may have both lending and borrowing features together. IRR method,
when used to evaluate such non-conventional investment can yield multiple
internal rates of return because of more than one change of signs in cash flows.
 Case of Ranking Mutually Exclusive
Projects
57

• Investment projects are said to be mutually exclusive when

only one investment could be accepted and others would
have to be excluded.
• Two independent projects may also be mutually exclusive if a
financial constraint is imposed.
• The NPV and IRR rules give conflicting ranking to the projects
under the following conditions:
• The cash flow pattern of the projects may differ. That is, the cash
flows of one project may increase over time, while those of others
may decrease or vice-versa.
• The cash outlays of the projects may differ.
• The projects may have different expected lives.
 Timing of cash flows
58

The most commonly found condition for the conflict between

the NPV and IRR methods is the difference in the timing of cash
flows. Let us consider the following two Projects, M and N.
 Cont…
59

NPV Profiles of Projects M and N NPV versus IRR

The NPV profiles of two projects intersect at 10 per cent

discount rate. This is called Fisher’s intersection.
 Incremental approach
60

• It is argued that the IRR method can still be used to choose

between mutually exclusive projects if we adapt it to calculate
rate of return on the incremental cash flows.

• The incremental approach is a satisfactory way of salvaging

the IRR rule. But the series of incremental cash flows may
result in negative and positive cash flows. This would result in
multiple rates of return and ultimately the NPV method will
have to be used.
 Scale of investment
61

Yet another reason for the difference between NPV

and IRR is the scale of investment. Consider the
following example.

Based on incremental cash flows, you will get IRR of

20% of Project B over Project A and NPV of
₹118,500.
 Project life span
62

Life span differences also create conflict in NPV and

IRR of two projects.
 REINVESTMENT ASSUMPTION
63

• The IRR method is assumed to imply that the cash

flows generated by the project can be reinvested at its
internal rate of return, whereas the NPV method is
thought to assume that the cash flows are reinvested
at the opportunity cost of capital.
MODIFIED INTERNAL
RATE OF RETURN (MIRR)
64

• The modified internal rate of return (MIRR) is

considering both the cost of capital and the
compound average annual rate that is calculated with
a reinvestment rate different than the project’s IRR.
 VARYING OPPORTUNITY
COST OF CAPITAL
65

• There is no problem in using NPV method when the

opportunity cost of capital varies over time. Cash
flows are discounted at varying discount rates.

• If theNPV = +….+
opportunity cost of capital varies over time, the
use of the IRR rule creates problems, as there is not a
unique benchmark opportunity cost of capital to
compare with IRR.
NPV VERSUS PI
66

• A conflict may arise between the two methods if a choice between

mutually exclusive projects has to be made. NPV method should be
followed.