Capital Budgeting

Capital budgeting is the process of identifying, analyzing and

selecting investment projects whose returns (cash flows) are
expected to extend beyond one year.
Types of Projects
Projects analyzed in capital budgeting have a large upfront cost,
cash flows for a specific time period and a salvage value at the
end
Projects may be classified into one of the following categories:
(i) New products or expansion of existing products.
(ii) Replacement of equipment or building
(iii) Research and development
(iv) Exploration
(v) Others e.g. safety related, pollution control etc.
 Steps in Capital Budgeting
Capital budgeting involves the following steps:
(i) Generating investment project proposals consistent with

a firm’s strategic objectives.

(ii) Estimating after-tax incremental operating cash flows

for the investment projects.

(iii) Evaluating projects’ incremental cash flows.
(iv) Selecting projects based on a value maximizing
acceptance criterion.
(v) Re-evaluating implemented investment projects
continually and performing post-audits for completed
 Estimating Project Cash Flows
Concern in capital budgeting is with cash flows rather than
income flows because only cash flows can be
reinvested or paid as dividends.

Only operating cash flows are considered. Financing

cash flows such as interest
payments, principal payments, cash dividends are
excluded. The discount rate takes
care of financing costs.

Cash flows should be determined on an after-tax basis.

 Estimating Project Cash Flows
Only incremental cash flows are relevant.

Cannibalization of existing sales or loss of market share because

new investment is not made, should also be accounted for.

Sunk costs are irrelevant.

 Estimating Project Cash Flows
Opportunity costs also need to be considered. All costs need not
be incurred in cash. For example, existing unused space used for
a new project must be included at its opportunity cost.

Working capital addition and release also should be considered.

Effect of inflation should also be included.

Determining Initial Cash Flows
Cost of new assets
• (+) Capitalized expenditure ( installation cost, shipping
expenses)
• (+) (-) Increased (decreased) level of net working capital
• (-) Net proceeds from sale of old asset if investment is a
replacement decision.
• (+) (-) Taxes (tax savings) due to sale of old assets if the

investment is a replacement decision.

= Initial cash outflow
 Determining Incremental Net
Cash Flow Per Period
Net increase (decrease) in operating revenue less (plus) any
net increase (decrease) in operating expenses excluding
depreciation.
(-) (+) Net increase (decrease) in depreciation
= Net change in income before tax
(-) (+) Net increase (decrease) in taxes
= Net change in income after taxes
(+) (-) Net increase (decrease) in depreciation
= Net cash flow for the period
 Determining Terminal Year
Incremental Cash Flows
Besides normal cash flows, some cash flows are connected
with a project’s termination. These are:

(i) Salvage value on the disposal of assets

(ii) Taxes (tax savings) related to disposal

(iii) Release of working capital

 Investment Appraisal Techniques
At any point of time, a manager may have a number of
proposals in which he can invest money. Evaluation of capital
budgeting proposals has two dimensions, profitability and
risk.
The following techniques are generally employed to
evaluate the profitability of capital budgeting proposals:
• a. Payback Period
• b. Average Rate of Return
• c. Net Present Value
• d. Internal Rate of Return
• e. Profitability Index
 Payback Period
It is the period within which the total cash inflows from the project equal the cost
of project. Cash flow means profit after tax but before depreciation.

There are two ways of calculating the payback period. The first method is used
when yearly cash inflows are uniform. In such a case, the initial cost of investment
is divided by the constant annual cash flow.
Investment
Payback Period = ---------------------------------
Constant annual cash flow

For example, if an investment of Rs. 50,000 is expected to produce cash flow

after tax (CFAT) of Rs. 10,000 for 10 years, the payback period is 5 years
(50,000/10,000).
 Payback Period
• The second method is used when a project’s cash flows are not
uniform but vary from year to year.

• In such a situation, the Payback Period is calculated by the process of

cumulating cash flows till the time the cumulative cash flows becomes
positive.

• The payback year is the year prior to full recovery plus a fraction
equal to shortfall at the end of that year divided by the cash flow
during the full recovery year.

• For example, an initial investment of Rs. 30,000 yields cash inflows of Rs.
14,000, Rs. 12,000 and Rs. 8,000 during the first three years. The cumulative
cash flows are Rs. -4000 up to year 2 and become positive in the third year .
The Payback Period is therefore 2+4,000/8,000=2.5 years .
 Payback Period
• Decision Rule for Payback Period:

• A project having a lower Payback Period will be preferred.

• Alternatively, the Payback Period of a project is compared

with the Payback Period set by the management as the
maximum.

• The project will be accepted if its Payback Period is less

than the predetermined Payback Period.
 Payback Period-Merits
• This method is simple and easy to understand and is
particularly useful in those industries where the risk of
obsolescence is very high.
• In situations of liquidity crunch and high cost of capital, this
method takes care of the liquidity position by placing
emphasis on earlier cash flows.
• Uncertainty relating to cash flow determines the risk
associated with a project. A shorter Payback Period resolves
the uncertainty faster.
• Correctness of managerial assessment of cash flows becomes
clear in a short period of time.
 Payback Period-Limitations
• It completely ignores all cash inflows after the Payback Period.
• In the Table below, two projects X and Y have the same payback
period of 3 years and get an equal ranking. However, project Y
should be preferred as it provides an extra cash inflow of Rs.240,000
in years 4 through 6.
Project X Project Y
Total Cost of Project (Rs.) 300,000 300,000
Cash Inflows- Year
1 100,000 80,000
2 120,000 100,000
3 80,000 120,000
4 0 120,000
5 0 60,000
6 0 60,000
Payback Period (Years) 3 3
 Payback Period-Limitations
• This method does not give any consideration to time value of
money.
• The following Table shows the cash flows of two projects
having the same initial cost and the same payback period.
However, project A should be preferred as it returns cash earlier
than project B.
• Project A Project B
Total cost of project (Rs.) 1,500,000 1,500,000
Cash inflows (CFAT) (Rs.)
Year 1 1,000,000 100,000
Year 2 400,000 400,000
Year 3 100,000 1,000,000
 Payback Period-Limitations
• The cut-off is arbitrary.

• Sometimes a discounted payback period is calculated after

discounting the cash flows at a predetermined rate.

• However, even the discounted payback period suffers from the

flaws of arbitrary cut-off and ignoring cash flows occurring
after the payback period.
 Accounting Rate of Return
(ARR)
• Accounting or Average Rate of Return means the average
annual yield on the project.
• Under this method, profit after tax and depreciation as a
percentage of average investment is considered.
• Suppose a project requires an investment of Rs. 5,00,000 .
The project has a residual value of Rs.40,000 at the end of
5 years. It yields an average profit after depreciation and
tax of Rs. 27,000 per year.

• ARR= Rs.27,000/Rs.270,000 = 10%

 Accounting Rate of Return
(ARR)
• Decision Rule for ARR:
• This rate is compared with the rate expected on other projects,
had the same funds been invested alternatively in those projects.
• Sometimes, the management compares this rate with the
minimum rate (called cut off point) they may have in mind.
• For example, the management may decide that it will not
undertake any project that has an average annual yield after tax
less than 15 percent.
• Any capital expenditure proposal that has an average annual
yield after tax less than 15 percent will be rejected
 Accounting Rate of Return
(ARR)
• Merits of ARR: This method is quite simple and popular
because it is easy to understand and includes income from the
project throughout its life.

• Limitations of ARR: ARR method is based on a crude average

of the profits of future years.
• It uses accounting income instead of cash flows.
• It ignores the effect of fluctuations in profits from year to year.
• It thus ignores the time value of money that is very important in
capital budgeting decisions.
 Accounting Rate of Return (ARR)
• Management of a company is considering two projects costing
Rs.500,000 each and having profits after depreciation and tax as
follows. The two projects have the same average rate of return.
The projects cannot be considered equal because project B starts
giving profits at a much later than project A.
Year Profit after depreciation and tax (Rs.)
Project A Project B
1 25,000 0
2 37,500 0
3 62,500 0
4 65,000 115,000
5 40,000 115,000
Total 230,000 230,000
 Accounting Rate of Return
(ARR)
• Despite its limitations, ARR continues to be used in
practice because:
1. Accounting information is easily available

2. Analysts often use accounting ratios to analyze firm

performance.

3. Managerial compensation is often tied to attainment of

goals expressed in accounting ratios
 Net Present Value (NPV) Method
This method takes to account the time value of money. Net Present Value (NPV)
is equal to the sum of present values of all cash flows associated with a project.
CF0 CF1 CFn
NPV = -------- + ------- + -------- ---------
(1+k)0 (1+k)1 (1+k)n

Where NPV = Net Present Value

CFo, CF1, CFn = Cash flows at the end of year 0,1,--- n. A
cash inflow has a positive sign and a cash
outflow has a negative sign.
n = Life of project
k = Cost of capital used as discount rate.
Net Present Value (NPV) Method
Decision Rule for NPV:
For independent projects, the decision rule for a project
under NPV is to accept the project if the NPV is positive
and reject if it is negative. In case of a zero NPV, the firm
is indifferent to accepting or rejecting the project.
However, since in the case of zero NPV, only the original
investment is recovered, a project with zero NPV is
generally not accepted.
• Accept if NPV is > 0
• Reject if NPV is < 0
• Indifferent if NPV is = 0
• For mutually exclusive projects, accept the project with the
highest NPV. If no project has a positive NPV, reject them
all.
 Finding the NPV
• We can find the NPV as follows.
1. Calculate the present value of each cash flow discounted
at the project’s risk adjusted cost of capital
• 2. The sum of the discounted cash flows is defined as the
project’s NPV.
• Suppose, a project’s initial cost is Rs.1,000,000 and it generates
cash inflows of Rs.500,000, Rs.400,000, Rs.300,000 and Rs.
100,000, respectively over its 4-year life. The WACC is 10%.
The NPV is:
• 500, 000 400, 000 300, 000 100, 000
NPV  1, 000, 000  1
 2
 3

(1.10) (1.10) (1.10) (1.10) 4
 78,819

• We can also find out the NPV of a project using a financial

calculator or Excel’s NPV function.
 NPV-Example
A plastic manufacturer has under consideration a proposal for
producing high quality plastic glasses. The necessary equipment
to manufacture the glasses will cost Rs. 1 lakh and last for 5 years.
The tax relevant rate of depreciation is 25 percent. There is no
other asset in this block. The expected salvage value is Rs. 10,000.
The glasses can be sold for Rs. 4 each. Regardless of the level of
production, the manufacturer will incur a cash cost of Rs. 25,000
each year if the project is undertaken. The overhead cost allocated
to this new line will be Rs. 5,000. The variable costs are
estimated at Rs. 2 per glass. The manufacturer estimates that it
will sell about 75,000 glasses per year. The tax rate is 35%.

• Should the proposed equipment be purchased? Assume 20 percent

cost of capital and additional working capital requirement of Rs.
50,000..
 NPV-Example
• Present Value of Cash Outflows:

• Cost of equipment Rs. 1,00,000

• Additional working capital 50,000

-----------
1,50,000

-----------
Present Value of Cash Inflows:

Year (Amount in Rs.)

1 2 3 4 5

Sales 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000

Less Costs:

Varible cost 1,50,000 1,50,000 1,50,000 1,50,000 1,50,000

Additional fixed cost 25,000 25,000 25,000 25,000 25,000
Depreciation 25,000 18,750 14,063 10,547 --
Profit before tax 1,00,000 1,06,250 1,10,937 1,14,453 1,25,000
Tax 35,000 37,187 38,828 40,059 43,750
Operating Cash flow
after tax 65,000 69,063 72,109 74,394 81,250

Salvage value 10,000

Working capital 50,000
Tax benefit on short
term capital loss 7,574

Total cash flow after tax 90,000 87,813 87,172 84,941 1,48,824

Present value factor at

20% 0.833 0.694 0.579 0.482 0.402

Present value of cash 74,940 60,942 49,894 40,942 59,827

Flow after tax

Calculation of NPV

Present value of cash inflows Rs. 2,86,575

Present value of cash outflows 1,50,000

-----------
Net present value 1,36,575
-----------
 NPV Method-Merits
• This method recognizes the time value of money.
• It considers the total benefits arising out of the project over
its lifetime.
• This method conforms to the basic objective of financial
management that is the maximization of shareholders’
wealth as NPVs are additive.
• A changing discount rate can be built into the NPV
calculation by changing the denominator.
• The method unambiguously ranks mutually exclusive
projects as it can differentiate between projects of different
scale and time horizon.
 NPV Method-Limitations
• It is difficult to calculate as well as to understand and use as
compared to Payback Period and ARR methods.

• Calculation of the required rate of return that is used in

discounting the cash flows presents problems.
 Internal Rate of Return (IRR)
Internal rate of return (IRR) is the discount rate which equates the aggregate
present value of cash inflows with the aggregate present value of cash
outflows of a project. In other words, it is that discount rate which results
into a zero NPV of the project. IRR is the discount rate in the following
equation:

CF0 CF1 CFn

0 = ------ + ------ + ---------------+ -------
(1+r)0 (1+r)1 (1+r) n
Where CF0 , CF1 , ---, CFn = cash flows at the end of year 0,1,---n.
A cash inflow has a positive sign and a
cash outflow has a negative sign.
n = life of the project
r = discount rate
 Internal Rate of Return (IRR)
While in the NPV method the rate of discount is assumed to be
known, in the IRR method, this rate is derived by setting the
NPV equal to zero.

Decision Rule for IRR: A project is accepted when the IRR (r )

exceeds the cut-off rate (k) . The cut-off rate represents the
required rate of return.

• Accept if IRR is > required rate of return

• Reject if IRR is < required rate of return
• Indifferent if IRR is = required rate of return
 Finding IRR of a Project
• Three procedures can be used to find the IRR:
1. We can use a trial-and-error procedure: try a discount
rate, see if the equation solves to zero, and if it doesn’t,
try a different rate. We could then continue until we find
the rate that forces the NPV to zero, and that rate would
be the IRR.

2. We can use the IRR function of a financial calculator after

entering the project’s cash flows in the calculator.

3. We can also find a project’s IRR using Excel.

 IRR-Example
• End-of-Year Cash Flows for a project are
• Year 0 1 2 3
• Cash Flow (Rs.’000) -700 100 300 600
• NPV at 10% p.a. -700 90.91 247.93 450.79 89.63
• NPV at 14% p.a. -700 87.72 230.84 404.98 23.54
• NPV at 16% p.a. -700 86.21 222.95 384.39 -6.45

• The IRR lies between 14% and 16%

• IRR using interpolation =
14%+(23.54/(23.54+6.45))*2%=15.56%
• IRR using Excel =15.56%
 IRR-Example
• A project costs Rs. 36,000 and generates annual cash flows of Rs.
11,200 for 5 years. Find the Internal Rate of Return.
•
• Solution
• Payback Period = 36,000/11,200 = 3.214 years
• Annuity tables can be looked for values close to 3.214 for a 5 year
period.
• The present value of an annuity of Re 1 per year for 5 years is Rs.
3.274 at 16% rate of interest and 3.199 at 17% rate of interest.

• The IRR is calculated through interpolation

•
• 3.274- 3.199
• IRR = 16 + --- -------------
• 17-16
• = 16.075%
 IRR-Merits
• It considers the time value of money.

• It takes into account total cash inflows and outflows.

• It is easier to understand and use as the desirability of a

project can be determined by comparing the IRR with the cost
of capital.

• It is consistent with the objective of maximizing shareholders’

wealth as only those projects are taken up which give an IRR
higher than the required rate.
 IRR-Limitations
• It involves tedious calculations.

• It produces multiple rates when more than one cash

outflow are interspersed between cash inflows.

• It assumes that the project cash inflows can be reinvested

at the IRR.

• In case of mutually exclusive projects, decisions based on

IRR criterion alone may not achieve the objective of
maximizing shareholders’ wealth. This is because a
project with a larger investment but a lower IRR will
contribute more in terms of absolute NPV and increase the
shareholders’ wealth.
 Multiple IRRs
• Suppose a firm is considering a potential mining project that has a
cost of Rs.64 million. The mine will produce a cash flow of Rs.400
million at the end of Year 1; then, at the end of Year 2, the firm must
spend Rs.400 million to restore the land to its original condition.
• Therefore, the project’s expected net cash flows are as follows (in
Rs. millions):
Year 0 1 2
-64 400 -400
Here the NPV equals 0 when IRR = 25%, but it also equals 0 when IRR
= 400%.Therefore, the project has one IRR of 25% and another of
400%, and we don’t know which one to use.

We won’t face this problem if the NPV method were used; we would
simply find the NPV at the appropriate cost of capital and use it to
evaluate the project
 Modified IRR (MIRR)
• The IRR is supposed to indicate the expected rate of return on
investments.

• However, IRR overstates the project’s true return because it assumes

that the project’s cash flows are reinvested at the IRR.

• An alternative is to calculate Modified IRR (MIRR) that modifies the

IRR so that it becomes a better measure of profitability.

• MIRR is similar to the regular IRR except that it is based on the

assumption that cash flows are reinvested at the WACC (or some other
rate that represents a more reasonable assumption.
 Modified IRR (MIRR)
• The MIRR can be defined as the discount rate at which the
present value of a project’s cost is equal to the present value of
its terminal value which is the sum of the future values of cash
inflows, compounded at the firm’s cost of capital.

• The following steps are involved in the calculation of MIRR:

• 1. Calculate the PV of all cash outflows at t=0
• 2. Calculate the FV of all cash inflows compounded at the
WACC as at the ‘terminal year’, the year when the last
inflow is received.
• 3. Calculate the discount rate at which the PV of the
terminal value is equal to the cost. This discount rate is the
MIRR. The discount rate can also be calculated using the

Excel function MIRR

 MIRR-Example
• End-of-Year Cash Flows for a project are
• Year 0 1 2 3 4
• Cash Flow (Rs.’000) 1,000 500 400 300 100
• The WACC is 10%
• Terminal value of year 1 cash flow 500*(1.10)3
=665.50
• Terminal value of year 2 cash flow 400*(1.10)2
=484.00
• Terminal value of year 3 cash flow 300*(1.10)1
=330.00
• Terminal value of year 4 cash flow =100.00
-----------
• Total 1,579.50
• ------------
• MIRR =(1579.50/1000)(1/4)-1= 0.1211 or 12.11%. The
Excel function MIRR also produces MIRR=12.11%
 NPV & IRR Method- Conflict
• NPV and IRR methods give concurrent accept-reject decisions in
case of conventional and independent projects.
• A conventional investment means an investment in which the
cash flow pattern is such that an initial investment is followed by
a series of cash inflows. The cash outflows are confined to the
initial period.
• The independent proposals refer to investments, the acceptance
of which does not preclude the acceptance of others so that all
profitable projects can be accepted and there are no constraints in
accepting all profitable projects.
 NPV & IRR Method- Conflict
T h e tw o m e th o d s re s u lt in th e s a m e a c c e p t -re je c t d e c is io n b e c a u s e p ro je c ts
w ith p o s itiv e N P V w o u ld a ls o h a v e in te rn a l ra te s o f re tu rn h ig h e r th a n th e
re q u ire d ra te o f re tu rn . T h e m a rg in a l p ro je c t w ill h a v e a z e ro N P V o n ly
w h e n th e IR R is e q u a l to th e re q u i re d ra te o f re tu rn .

n
Ct
NPV = 
t 1 (1  k ) t
 C0 (1 )

IR R is th e ra te r a t w h ic h N P V = 0

n
Ct
or 
t 1 (1  r ) t
 C0  0

n
Ct
or C 0  
t 1 (1  r ) t
 NPV & IRR Method- Conflict
S u b s titu tin g th e v a lu e o f C 0 in (1 ) a b o v e

n n
Ct Ct
NPV  
t 1 (1  k ) t
 
t 1 (1  r ) t

n
 Ct Ct 
=  
 (1  k ) t (1  r ) t 
t 1  

Ct Ct
N P V w ill b e p o s itiv e o n ly w h e n 
(1  k ) t
(1  r ) t

O r w hen r > k
 NPV & IRR Method- Conflict
• NPV would be zero when r=k and negative when r<k.
• In case of independent projects, ranking is not important since
all profitable projects will be accepted.
• In real business situations, there are alternative ways of
achieving an objective (e.g. alternative distribution channels).
• Accepting one alternative means excluding the other. The
exclusiveness can be technical or financial.
• Ranking thus becomes important incase of mutually exclusive
projects. In such a case, NPV and IRR methods can give
conflicting ranking.
 NPV & IRR Method- Conflict
The NPV and IRR rules will give conflicting ranking to the
projects under the following conditions:
(i) The cash flow pattern of projects may differ. The cash
flows of one project may increase over time while those
of the other may decrease or vice versa.
(ii) The cash outlays (initial investments) of the projects
may differ.
(iii) The projects may have different expected lives.
 Different Patterns of Cash Flow

Year Project A Project B B-A

0 1,05,000 1,05,000 0
1 60,000 15,000 -45,000
2 45,000 30,000 -15,000
3 30,000 45,000 15,000
4 15,000 75,000 60,000

Cost of Capital is 8%
 Different Patterns of Cash Flow
Year Project A Project B B-A
0 1,05,000 1,05,000 0
1 60,000 15,000 -45,000
2 45,000 30,000 -15,000
3 30,000 45,000 15,000
4 15,000 75,000 60,000
IRR 20% 16% 9%
NPV (8%) 23,970 25,455 1,485

Project A has higher IRR but lower NPV. As the required rate of return
increases, the NPV of the project that has larger cash flows later in its life,
comes down sharply. At a particular rate of discount, the NPVs are the
same. This is called Fisher’s intersection. At a discount rate above the
Fisher’s intersection, NPV and IRR give consistent results.

Whenever such a conflict occurs, it is advisable to choose a project with a

higher NPV.
 Different Patterns of Cash Flow

Year Project A Project B B-A

0 - 1,680 -1,680 0
1 1,400 140 -1,260
2 700 840 140
3 140 1,510 1,370
 Different Patterns of Cash Flow
Year Project A Project B B-A
0 - 1,680 -1,680 0
1 1,400 140 -1,260
2 700 840 140
3 140 1,510 1,370
IRR 23% 17% 10%
NPV (0%) 560 810 250
(5%) 409 520 111
(10%) 276 276 0
(15%) 159 70 -89
(20%) 54 -106 -160

Fisher’s intersection occurs at 10 percent. At a discount rate higher than

10%, both NPV and IRR are higher for project A.
 Different Initial Outlays
Year Project A Project B B-A
0 -1,000 -1,00,000 -99,000
1 1,500 1,20,000 1,18,500

Cost of Capital is 10%

 Different Initial Outlays
Difference in Scale of Investment

Example:

Year Project A Project B B-A

0 -1,000 -1,00,000 -99,000
1 1,500 1,20,000 1,18,500
IRR 50% 20% 19.7%
NPV (10%) 364 9,080 8,716

The two projects are ranked differently by NPV and IRR methods
 Different Initial Outlays

Example2

Year Project A Project B B-A

0 -5,000 -7,500 -2,500
1 6,250 9,150 2,900

Cost of Capital is 10%

 Different Initial Outlays

Example2

Year Project A Project B B-A

0 -5,000 -7,500 -2,500
1 6,250 9,150 2,900
IRR 25% 22% 16%
NPV (10%) 681.25 817.35 136.10
 Different Life Spans
Different Life Spans

Example

Year Project A Project B

0 -10,000 -10,000
1 12,000 0
2 0 0
3 0 0
4 0 0
5 0 20,120

Cost of capital is 10%

 Different Life Spans
Different Life Spans

Example

Year Project A Project B

0 -10,000 -10,000
1 12,000 0
2 0 0
3 0 0
4 0 0
5 0 20,120
IRR 20% 15%
NPV (10%) 908 2,495
 Methods of Resolving Conflict in Ranking
1. Incremental Approach:
• IRR method can still be used to choose between mutually
exclusive projects, if we adapt it to calculate rate of return on
incremental cash flows.
• If the IRR on incremental cash flows is more than the cost of
capital, the project with a higher NPV and lower IRR can be
selected.
• This project will offer the incremental IRR on the extra
investment.
• In the time disparity example, IRR on incremental flows is 9%
against the discount rate of 8%. In the second example, the IRR
on incremental cash flows is 10% against a discount rate of 9%.
 Annual Equivalent Value Method for
Unequal Lives

Year Project A Project B

0 -20,000 -15,000
1 8,000 10,000
2 8,000 10,000
3 8,000 0
4 8,000 0
NPV (12%) 4,299 10,350
IRR 22.4% 21.6%
 Annual Equivalent Value Method for
Unequal Lives

Year Project A Project B

0 -20,000 -15,000
1 8,000 10,000
2 8,000 10,000
3 8,000 0
4 8,000 0
NPV (12%) 4,299 10,350
IRR 22.4% 21.6%
Annuity Factor 3.037 1.690
Annual 1,416 6,124
equivalent value
 Profitability Index/ Desirability
Factor
• This method is used to rank projects when the capital
budget is limited.

• PI is the ratio obtained dividing the present value of cash

inflows by the present value of cash outflows.

Present value of cash inflows

PI = -------------------------------------
Present value of cash outflows
 Profitability Index
Decision Rule for PI:
• A project will qualify for acceptance if its PI exceeds one.
• When PI is equal to one, the firm is indifferent to the project.
• The selection of projects with the PI method can also be done
on the basis of ranking. The highest rank will be given to the
project with the highest PI followed by others in the same
order.
Accept if PI >1
Reject if PI <1
Indifferent if PI = 1
 Profitability Index
• The PI method has all the merits of the NPV method but it
suffers from the following limitations:
• Under capital rationing, PI method may not result in optimum
decision when the projects are indivisible. Several small
projects may together have higher NPV than a single project,
but the single project may be accepted to the exclusion of
others on the basis of PI.
• There may be situations that the project with the highest PI
may have a longer life. A project with a smaller PI may
generate cash flows in such a manner that another project can
be taken up one or two years later. These two projects together
may have a higher NPV than the project with the highest PI.
• PI does not work if the funds are also limited beyond the initial
time period.
Comparison of Capital Budgeting Methods
• Each of the capital budgeting decision criteria has its strengths and
weaknesses.

• NPV is the best single measure as it tells us how much value each
project contributes to shareholder wealth and this measure should be
given the greatest weight in capital budgeting decisions.

• However, the other approaches provide useful information.

• The payback and discounted payback provide an indication of a

project’s risk and liquidity, because it shows how long the invested
capital will be tied up.

• The accounting rate of return ignores time value of money but is still
used as accounting information is easily available.
Comparison of Capital Budgeting Methods
• IRR and MIRR measure profitability expressed as a percentage rate of
return which is easily understood by decision makers. IRR and MIRR
also contain information about a project’s ‘safety margin’.

• MIRR has all the merits of IRR but it incorporates a better reinvestment
rate assumption and avoids the problem of multiple rates of return. It is,
therefore, a better indicator than the regular IRR.

• The profitability index (PI) is calculated by dividing the present value of

cash inflows by the initial cost, so it measures relative profitability—that
is, the amount of the present value per dollar of investment

• Each approach provides a different piece of information, so in this age of

computers, managers often look at all of them when evaluating projects.
However, NPV is the best single measure, and almost all firms now use
NPV