Capital Budgeting

Payback Period
• The payback period is the time required to recover the initial cost of
an investment. It is the number of years it would take to get back the
initial investment made for a project. Therefore, as a technique of
capital budgeting, the payback period will be used to compare
projects and derive the number of years it takes to get back the initial
investment. The project with the least number of years usually is
selected.
Features of Payback Period
• The payback period is a simple calculation of time for the initial
investment to return.
• It ignores the time value of money. All other techniques of capital
budgeting consider the concept of the time value of money. Time
value of money means that a rupee today is more valuable than a
rupee tomorrow. So other techniques discount the future inflows and
arrive at discounted flows.
• It is used in combination with other techniques of capital budgeting.
Owing to its simplicity the payback period cannot be the only
technique used for deciding the project to be selected.
Illustration
• Apple Limited has two project options.
• The initial investment in both projects is Rs. 10,00,000.
• – Project A has an even inflow of Rs. 1,00,000 every year.
– Project B has uneven cash flows as follows:

-> Year 1 – Rs. 2,00,000

-> Year 2 – Rs. 3,00,000
-> Year 3 – Rs. 7,00,000
-> Year 4 – Rs. 1,50,000
Formula
• Payback period= Initial investment/Net annual cash inflows

• Project A - 10,00,000/ 1,00,000 = 10 years

• Project B:
Total inflows = 10,00,000 (2,00,000+ 3,00,000+ 7,00,000+ 1,50,000)
Total outflows = 10,00,000
• The formula to calculate the payback period for uneven cash flows is:
Considering the year of recovery as ‘n’.
• (Year + uncovered balance at the end of the year)/Cash inflow
during of the subsequent year
• Year 1 – Rs. 2,00,000
Year 2 – Rs. 3,00,000
Year 3 – Rs. 7,00,000
Year 4 – Rs. 1,50,000
• The payback period can be calculated as follows:
Year Total flow ( in Cumulative Year Total flow ( in Cumulative
Lakh) flow Lakh) flow
0 -10 -10 0 -10 -10
1 2 -8 1 2 2
2 3 -5 2 3 5
3 7 2 3 7 12
4 1.5 3.5 4 1.5 13.5
Problem
• An investment of Rs.200,000 is expected to generate the following cash inflows in
• six years:
• Year 1: Rs.70,000
• Year 2: Rs.60,000
• Year 3: Rs.55,000
• Year 4: Rs.40,000
• Year 5: Rs.30,000
• Year 6: Rs.25,000
• Compute payback period of the investment. Should the investment be made if
management wants to recover the initial investment in 3 years or less?
Problem
Year Amount (Rs.)

1 12,00,000

2 19,00,000

3 25,00,000

4 27,00,000

5 26,00,000

Initial Investment is 50,00,000

Calculate Payback period
• An opportunity arises for a company which requires an initial
investment of Rs.800,000 now. The management’s discount rate is
12%.
• The amount of cash inflows expected from the new opportunity are:
• Year-1 cash Inflow: Rs.250,000
• Year-2 cash Inflow: Rs.400,000
• Year-3 cash Inflow: Rs.300,000
• Year-4 cash Inflow: Rs.450,000
• Calculate the discounted payback period
• Present value factor at 12%: (1/1.12)^1 = 0.893; (1/1.12)^2 = 0.797;
(1/1.12)^3 = 0.712; (1/1.12)^4 = 0.636
ARR
• Accounting Rate of Return (ARR) is the average net income an asset is
expected to generate divided by its average capital cost, expressed as
an annual percentage. The ARR is a formula used to make capital
budgeting decisions. It is used in situations where companies are
deciding on whether or not to invest in an asset (a project, an
acquisition, etc.) based on the future net earnings expected
compared to the capital cost.
Formula

Where,
Average Annual Profit = Total profit over Investment Period / Number of Years

Average Investment = (Book Value at Year 1 + Book Value at End of Useful Life) / 2
Components of ARR
• If the ARR is equal to 5%, this means that the project is expected to
earn five cents for every rupee invested per year.

• In terms of decision making, if the ARR is equal to or greater than a

company’s required rate of return, the project is acceptable because
the company will earn at least the required rate of return.

• If the ARR is less than the required rate of return, the project should
be rejected. Therefore, the higher the ARR, the more profitable the
company will become.
Illustration 1
• ABC Company is looking to invest in some new machinery to replace
its current malfunctioning one. The new machine, which costs
Rs.420,000, would increase annual revenue by Rs.200,000 and annual
expenses by Rs.50,000. The machine is estimated to have a useful life
of 12 years and zero salvage value.
Solution
Step 1: Calculate Average Annual Profit
Inflows, Years 1-12
(200,000*12) Rs.2,400,000
Less: Annual Expenses
(50,000*12) Rs.600,000
Less: Depreciation 420,000
Total Profit Rs.1,380,000

Average annual profit = 1380000/12 = 115000

• Step 2: Calculate Average Investment
• Average Investment
• (Rs.420,000 + Rs.0)/2 = Rs.210,000

• Step 3: Use ARR Formula

• ARR = Rs.115,000/Rs.210,000 = 54.76%

• Therefore, this means that for every Rupee invested, the investment
will return a profit of about Rs. 54.76.
Problem
• XYZ Company is considering investing in a project that requires an
initial investment of Rs.100,000 for some machinery. There will be net
inflows of Rs.20,000 for the first two years, Rs.10,000 in 3rd and 4th
year, and Rs.30,000 in year five. Finally, the machine has a salvage
value of Rs.25,000.
Solution
• Step 1: Calculate Average Annual Profit
Inflows, Years 1 & 2
(20,000*2) Rs.40,000
Inflows, Years 3 & 4
(10,000*2) Rs.20,000
Inflow, Year 5 Rs.30,000
Less: Depreciation
(100,000-25,000) - Rs.75,000
Total Profit Rs.15,000
Average Annual Profit
(15,000/5) Rs.3,000

Step 2: Calculate Average Investment

Average Investment
(Rs.100,000 + Rs.25,000) / 2 = Rs.62,500

Step 3: Use ARR Formula

• ARR = Rs.3,000/Rs.62,500 = 4.8%

Problem - ARR
• Initial Investment – Rs. 20,00,000
• Effective life: 5 yrs
• Projected net profits after depreciation and income tax
• Year-1 cash Inflow: Rs.450,000
• Year-2 cash Inflow: Rs.600,000
• Year-3 cash Inflow: Rs.700,000
• Year-4 cash Inflow: Rs.750,000
• Year-5 cash Inflow: Rs.700,000
• Total Rs.32,00,000
 Problem on ARR
A company needs to decide to buy machines. Two machines details are given, which one would you
choose on the basis of ARR.
• Capital Outlay Machine A Machine B
• 1,56,125 1,56,125
• Annual estimated Income After depreciation & Income-tax
• Machine A Machine B
• Year PAT PAT
• 1 13,375 21,375
• 2 15,375 19,375
• 3 17,375 17,375
• 4 19,375 15,375
• 5 21,375 13,375
• Total 86,875 86,875
Estimated life for both the machines is five years. Estimated salvage value for both the machines are 13000 each.
Depreciation has been charged on straight line basis solution.
• Company is willing to purchase a new machine for Rs. 1,50,000. The
usable life of the machine is 10 years, at the end of its usable life the
machine can be sold for Rs. 50000/-. The machine will provide an
additional profit of Rs. 80000 every year. Annual expenses on
operating the machine is Rs. 30,000. calculate ARR of the
investment in machine.
• Answer is 40%
Acceptance Rule (ARR)
• 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.
NPV
There are certain signs that are used in the net present value formula that
determine whether the investment is good or bad. They are as follows:

NPV > 0 - The present value of money coming in is more than the money
going out. The investment is good since the money earned from the
investment is more than the money invested
NPV = 0 - When the money earned from the investment is equal to the
money invested
NPV < 0 = The money earned from the investment is less than the money
invested
illustration
An investor made an investment of Rs.500 in property and gets back Rs.570 the next year.
If the rate of return is 10%. Calculate the net present value.

Amount invested = Rs.500

Money received after a year = Rs.570
Rate of return = 10% = 0.1
Using net present value formula,
Present value, PV = 1/(1+r%)n

PV = Rs. 518.18
Net Present Value = Rs.518.18 − Rs.500.00 = Rs.18.18
Illustration - NPV
Calculate PV of following cash flows; Assume discounting rate is 10%.
Year Cash Inflow
1 1000
2 1000
3 1000
Problem 1
• Calculate NPV of following Proposal; Assume discounting rate is
10%. Initial Cash outlay Rs.1,00,000

Year Cash flow

1 20000
2 25000
3 30000
4 35000
5 20000
Problem 2 - NPV
• Use NPV method to compare and analyse which Proposal is better
to accept; Assume discounting rate is 10%.
• Project Cash Outflow Cash Inflows
Year 0 Year 1 Year 2 Year 3
• X 20000 30000 20000 10000
• Y 20000 10000 20000 30000

Project X - NPV = 50589 – 20000 = 30589

Project Y - NPV = 47672 – 20000 = 27672
Project “X” is having higher NPV; hence it should be preferred.
Problem 2 - NPV – Net Present Value
• X ltd. Is considering a proposal of investing rs.2500000 with expected life
of 5 years and no salvage value. The projected cash inflows are as
follows:
• Year 1 – Rs. 500000
• Year 2 – Rs. 700000
• Year 3 – Rs. 950000
• Year 4 – Rs. 1000000
• Year 5 – Rs. 1100000
• The company uses 10% rate of discount. Calculate Discounted payback,
ARR and NPV
IRR
• Internal rate of return (IRR) is the discount rate at which a project’s returns
become equal to its initial investment. In other words, it attains a break-even
point where the total cash inflows completely meet the total cash outflow.
• Internal rate of return (IRR) is the percentage of returns that a project
will generate within a period to cover its initial investment. It is attained
when the Net Present Value (NPV) of the project amounts to zero.
• An IRR higher than the discount rate signifies a profitable investment
opportunity.
• It facilitates the comparison of different investment options and projects.
Based on the IRR, the most feasible and profitable options are chosen.
• The internal Rate of Return is much more helpful when it is used to carry out a
comparative analysis. When IRR is used in isolation as one single value, it is less
effective. It is often used to rank multiple prospective investment options that a firm is
planning to undertake. The higher a project’s IRR, the more desirable it is. That project
becomes potentially the best available investment option. The actual internal rate of
return obtained may vary from the theoretical value calculated. Nonetheless, the highest
value will surely provide the best growth rate among all.

• The IRR of any project is calculated by keeping the following three assumptions in mind:

• The investments made will be held until maturity.

• The intermediate cash flows will be reinvested.
• All the cash flows are periodic, or the time gaps between different cash flows are equal.
Illustration
• The DEF Group wants to diversify its business and plan to take up a
new project that requires an initial investment of Rs.400000. They will
pay it off in 4 years. It will generate Rs.40000 in the first year,
Rs.80000 in the second year, Rs.1600000 in the third year, and
Rs.259600 in the fourth year. Find out the feasibility of this
investment project if the discount rate is 8%.
Solution
• Given
•n=4
• t = 0,1,2,3,4
• CF0= – Rs.400000
• CF1= Rs.40000
• CF2= Rs.80000
• CF3= Rs.160000
• CF4= Rs.259600
• Discount Rate = 8%
• If the project’s internal rate of return is 8%, then the NPV is:
• Thus, if the IRR is 10%,
the project will be at a
break-even point. This
project generates a
positive NPV, and the
discount rate is lower than
the IRR.
NPV = Rs.23,451.06 • In other words, the IRR is
Let us assume that the internal rate of return is 10% and that the NPV = 0. more than the project’s
required rate of return;
therefore, it is a profitable
investment.
• It is important to note that
the value of CF0 is always
negative as it is the cash
outflow.