05

Investment Appraisal/
Capital Budgeting
Ms. Asini Nimaya Ms. G L Aloka
asinin@sltc.ac.lk lakmaleea@sltc.ac.lk
071-9588515 070-6230109
At the end of the session students should be able to:
1. Payback period

2. Net present value

3. Internal rate of return

4. Decision making related to the theory of capital budgeting/ investment appraisal

techniques
What is Investment Appraisal?

Process that businesses use to evaluate the potential profitability of new projects or

investments.

• Analysis of potential additions to fixed assets.

• Long-term decisions; involve large expenditures.
• Very important to firm’s future.

As part of capital budgeting, a company might assess a prospective project's lifetime

cash inflows and outflows to determine whether the potential returns it would generate
meet a sufficient target benchmark.
What is a Hurdle Rate?
A hurdle rate is the minimum rate of return a project or investment must achieve before
the manager or investor approves a predetermined condition. It allows companies to
make important decisions on whether or not to pursue a specific project. The hurdle rate
describes the appropriate compensation for the level of risk present—riskier projects
generally have higher hurdle rates than those with less risk.
What is the Cost of Capital?
Cost of capital is a calculation of the minimum return that would be necessary in order
to justify undertaking a capital budgeting project, such as building a new factory. It is an
evaluation of whether a projected decision can be justified by its cost.

Many companies use a combination of debt and equity to finance business expansion.
For such companies, the overall cost of capital is derived from the weighted average cost
of all capital sources. This is known as the weighted average cost of capital (WACC).
 Methods of evaluation
Payback Period Method
The number of years required to recover a project’s cost, or

“How long does it take to get our money back?”

Calculated by adding project’s cash inflows to its cost until the cumulative
cash flow for the project turns positive.

Strengths Weaknesses

Provides an indication of a project’s Ignores the time value of money.

risk and liquidity.
Easy to calculate and understand. Ignores CFs occurring after the
payback period.
 Methods of evaluation
Net Present Value (NPV)
Sum of the PVs of all cash inflows and outflows of a project:

n
CFt
NPV   t
t 0 ( 1  k )

If projects are independent, accept if the project NPV > 0.

If projects are mutually exclusive, accept projects with the highest positive NPV,
those that add the most value.
 Methods of evaluation
Internal Rate of Return (IRR)
IRR is the discount rate that forces PV of inflows equal to cost, and the
NPV = 0

𝑁𝑃𝑉 𝑎
𝐼𝑅𝑅=𝑟 𝑎 + ( 𝑟 −𝑟 𝑎 )
𝑁𝑃𝑉 𝑎 − 𝑁𝑃𝑉 𝑏 𝑏

= lower discount rate chosen

= higher discount rate chosen
= NPV at
= NPV at If IRR > Cost of Capital - accept project.
If IRR < Cost of Capital - reject project.
Thank you!