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Capital Budgeting

Decisions
2
Capital Budgeting Techniques
1. Non-discounted Cash Flow Criteria
Payback Period (PB)
Discounted Payback Period (DPB)
Accounting Rate of Return (ARR)
2. Discounted Cash Flow (DCF) Criteria
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
3
Payback
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:


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:
0
Initial Investment
Payback = =
Annual Cash Inflow
C
C
Rs 50,000
PB = = 4 years
Rs 12,000
4
Payback
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 projects
payback?
3 years + 12 (1,000/3,000) months
3 years + 4 months
5
Acceptance Rule
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.
6
Evaluation of Payback
Serious limitations:
Cash flows after payback
Cash flow patterns
Time value ignored

7
Payback Reciprocal and the Rate of Return
The reciprocal of payback will be a close
approximation of the internal rate of return if
the following two conditions are satisfied:

The life of the project is large or at least twice the
payback period.

The project generates equal annual cash inflows.
8
Discounted Payback Period
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.
3 DI SCOUNTED PAYBACK I LLUSTRATED

Cash Flows
(Rs)
C0 C1 C2 C3 C4
Simple
PB
Discounted
PB
NPV at
10%
P -4,000 3,000 1,000 1,000 1,000 2 yrs
PV of cash flows -4,000 2,727 826 751 683 2.6 yrs 987
Q -4,000 0 4,000 1,000 2,000 2 yrs
PV of cash flows -4,000 0 3,304 751 1,366 2.9 yrs 1,421

9
Accounting Rate of Return Method
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.


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.
Average income
ARR =
Average investment
10
Acceptance Rule
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.
11
Evaluation of ARR Method
Serious shortcoming
Cash flow patterns
Time value ignored
The following two projects A and B require an
investment of Rs. 2, 00,000 each. The income after taxes
for these projects is as follows:
Year Project A (in Rs.) Project B (in Rs.)
1 80,000 20,000
2 80,000 40,000
3 40,000 40,000
4 20,000 40,000
5 ------- 60,000
6 ----- 60,000
12
Using the following criteria, determine which of the
project is preferable:
(i)6 years pay back; (ii) Average Rate of Return
(iii) Present value approach if the companys cost
of capital is 10 per cent
Note 1: Depreciation = Initial cost Salvage value Life period
Project A: (Rs.2,00,000 0) 4 = Rs.50,000;
Project B: (Rs.2,00,000 0) 6 = Rs.33,333
13
Year Project A Project B
EAT Cash inflow
(Rs.)
Cumulative EAT Cash
inflow
Cumulative
(Rs.) CFAT (Rs.) (Rs.) (Rs.) CFAT (Rs.)
1 80,000 1,30,000 1,30,000 20,000 53,333 53,333
2 80,000 1,30,000 2,60,000 40,000 73,333 1,26,666
3 40,000 90,000 3,50,000 40,000 73,333 1,99,999
4 20,000 70,000 4,20,000 40,000 73,333 2,73,332
5 ------- -------- -------- 60,000 93,333 3,66,665
6 ------- -------- -------- 60,000 93,333 4,59,998
PBP: Project A: 1+ (70,0001,30,000) = 1.583 Years;
Project B = 3 years
Decision: Based on 6 years pay back both the projects should be selected Project A should be
selected since their PBP is less than the 8 years pay back period which is to considered as standard
pay back period. But Project A should be selected because its pay back period is less than the
Project B.
14
ii) Computation of Average Rate of Return
= (Annual Avg. IAT Average investment) 100
Annual Average Income (AAI)= Total EAT No. of years
Project A: 2,20,000 4 = Rs.55,000;
Average Investment = 2,00,000 2 = Rs.1,00,000
Average rate of return = (55,000 / 1,00,000)100 = 55 per cent
Project B: AAI = 2,60,000 6 = Rs. 36,667
Average investment = 2,00,000 2 = Rs. 1,00,000
Average rate of return = (36,667 / 1,00,000)100 = 36.67 per cent
Decision: Project A should be selected since its ARR is greater than
the Project B.
15
c) Computation of Net Present Value (NPV)
Year CFAT (in Rs.) DF PVs (in Rs.)
Project A Project B 10 % Project A Project B
1 1,30,000 53,333 0.909 1,18,170 48,480
2 1,30,000 73,333 0.826 1,07,380 60,573
3 90,000 73,333 0.751 67,590 55,073
4 70,000 73,333 0.683 48,181 50,086
5 -------- 93,333 0.621 -------- 57,960
6 -------- 93,333 0.564 ------ 52,640
Present Value of cash inflows 3,41,321 3,24,812
Less: Cash outflows 2,00,000 2,00,000
Net Present Values (NPV) 1,41,321 1,24,812
Decision: Based on the NPV both the Projects A and B eligible to accept.
However, Project A is preferable since its NPV is more than that of Project B.
A project will cost Rs.40000. its stream of earnings
before depreciation, interest and taxes (EBDIT)
during first year through five years is expected to be
Rs.10000, Rs.12000, Rs.14000, Rs.16000 and
Rs.20000. Assume a 50 per cent tax and depreciation
on straight line basis. Calculate ARR of the project.


ARR = 3200/ 20000*100 = 16 %
16
17
Net Present Value Method
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. The appropriate
discount rate is the projects opportunity cost of
capital.
Present value of cash flows should be calculated
using the opportunity cost of capital as the discount
rate.
The project should be accepted if NPV is positive
(i.e., NPV > 0).

18
Net Present Value Method
Net present value should be found out by
subtracting present value of cash outflows from
present value of cash inflows. The formula for the
net present value can be written as follows:
3 1 2
0
2 3
0
1
NPV
(1 ) (1 ) (1 ) (1 )
NPV
(1 )
n
n
n
t
t
t
C C C C
C
k k k k
C
C
k
=
(
= + + + +
(
+ + + +

=
+

19
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.
2 3 4 5
1, 0.10 2, 0.10 3, 0.10
4, 0.10 5, 0.
Rs 900 Rs 800 Rs 700 Rs 600 Rs 500
NPV Rs 2,500
(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)
NPV [Rs 900(PVF ) + Rs 800(PVF ) + Rs 700(PVF )
+ Rs 600(PVF ) + Rs 500(PVF
(
= + + + +
(

=
10
)] Rs 2,500
NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683
+ Rs 500 0.620] Rs 2,500
NPV Rs 2,725 Rs 2,500 = + Rs 225

=

=
20
Acceptance Rule
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.
21
Evaluation of the NPV Method
NPV is most acceptable investment rule for the
following reasons:
Time value
Measure of true profitability
Value-additivity
Shareholder value
Limitations:
Involved cash flow estimation
Discount rate difficult to determine
Mutually exclusive projects
Ranking of projects
Suppose we are considering a capital investment
that costs Rs. 276,400 and provides annual net
cash flows of Rs. 83,000 for four years and
$116,000 at the end of the fifth year. The firms
required rate of return is 15%. Calculate (i)
Payback Period (ii) ARR (iii) NPV and (iv) IRR
22
PBP 3.33 Years
ARR 64.83%
NPV 18235.71
IRR 17.63%
23
Internal Rate of Return Method
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.
3 1 2
0
2 3
0
1
0
1
(1 ) (1 ) (1 ) (1 )
(1 )
0
(1 )
n
n
n
t
t
t
n
t
t
t
C C C C
C
r r r r
C
C
r
C
C
r
=
=
= + + + +
+ + + +
=
+
=
+

24
Calculation of IRR
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 value 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.
25
Calculation of IRR
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:
6,
6,
6,
NPV Rs 20,000 + Rs 5,430(PVAF ) = 0
Rs 20,000 Rs 5,430(PVAF )
Rs 20,000
PVAF 3.683
Rs 5,430
r
r
r
=
=
= =
26
NPV Profile and IRR
A B C D E F G H
1 N P V P r o f i l e



2 C a s h F l o w
D i s c o u n t
r a t e N P V
3 - 2 0 0 0 0 0 % 1 2 , 5 8 0
4 5 4 3 0 5 % 7 , 5 6 1
5 5 4 3 0 1 0 % 3 , 6 4 9
6 5 4 3 0 1 5 % 5 5 0
7 5 4 3 0 1 6 % 0
8 5 4 3 0 2 0 % ( 1 , 9 4 2 )
9 5 4 3 0 2 5 % ( 3 , 9 7 4 )
F i g u r e 8 . 1 N P V P r o f i l e

I R
R
27
Acceptance Rule
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.
28
Evaluation of IRR Method
IRR method has following merits:
Time value
Profitability measure
Acceptance rule
Shareholder value
IRR method may suffer from:
Multiple rates
Mutually exclusive projects
Value additivity
29
Profitability Index
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.

Profitability index (PI):
PV of Annual Cash Flows
PI =
Initial investment

30
Profitability Index
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. Assume a 10 per cent rate of
discount. The PV of cash inflows at 10 per cent
discount rate is:
. 1235 . 1
1,00,000 Rs
1,12,350 Rs
PI
12,350 Rs = 100,000 Rs 112,350 Rs NPV
Rs.112,350
0.68 20,000 Rs + 0.751 50,000 Rs + 0.826 30,000 Rs + 0.909 40,000 Rs =
) 20,000(PVF Rs + ) 50,000(PVF Rs + ) 30,000(PVF Rs + ) 40,000(PVF Rs PV
0.10 4, 0.10 3, 0.10 2, 0.10 1,
= =
=
=

=
31
Acceptance Rule
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 projects NPV is negative.
32
Evaluation of PI Method
It recognises the time value of money.
It is consistent with the shareholder value maximisation
principle. A project with PI greater than one will have
positive NPV and if accepted, it will increase
shareholders wealth.
In the PI method, since the present value of cash
inflows is divided by the initial cash outflow, it is a
relative measure of a projects profitability.
Like NPV method, PI criterion also requires calculation
of cash flows and estimate of the discount rate. In
practice, estimation of cash flows and discount rate
pose problems.
33
Conventional and Non-conventional Cash Flows
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,
+ + + ++ +.
34
NPV Versus IRR
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.
35
NPV Versus IRR
Cash Flows (Rs)
Project C0 C1 IRR NPV at 10%
X -100 120 20% 9
Y 100 -120 20% -9

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.
36
Problem of Multiple IRRs
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.
NPV Rs 63
-750
-500
-250
0
250
0 50 100 150 200 250
Discount Rate (%)
NPV (Rs)
37
Case of Ranking Mutually Exclusive Projects
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.
38
Timing of Cash Flows
Cash Flows (Rs) NPV
Project C0 C1 C2 C3 at 9% IRR
M 1,680 1,400 700 140 301 23%
N 1,680 140 840 1,510 321 17%

39
Scale of Investment

Cash Flow (Rs) NPV

Project C0 C1 at 10% IRR
A -1,000 1,500 364 50%
B -100,000 120,000 9,080 20%

40
Project Life Span
Cash Flows (Rs)
Project C
0
C
1
C
2
C
3
C
4
C
5
NPV at 10% IRR
X 10,000 12,000 908 20%
Y 10,000 0 0 0 0 20,120 2,495 15%
41
Reinvestment Assumption
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.
42
Modified Internal Rate of Return (MIRR)
The modified internal rate of return (MIRR) is
the compound average annual rate that is
calculated with a reinvestment rate different than
the projects IRR.
43
Varying Opportunity Cost of Capital
There is no problem in using NPV method when
the opportunity cost of capital varies over time.
If the 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.
44
NPV Versus PI
A conflict may arise between the two methods if a
choice between mutually exclusive projects has to
be made. Follow NPV method:
Project C Project D
PV of cash inflows 100,000 50,000
Initial cash outflow 50,000 20,000
NPV
50,000 30,000
PI 2.00 2.50