Capital Budgeting Basics

Capital Budgeting
Decisions
Nature of Investment Decisions

The investment decisions of a firm are generally
known as the capital budgeting, or capital

expenditure decisions.
The firms investment decisions would generally
include expansion, acquisition, modernisation and
replacement ,Diversification 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 longterm implications for the firms expenditures and
benefits, and therefore, they should also be
evaluated as investment decisions.
Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Features of Investment Decisions

Capital Budgeting refers to long term planning for
proposed capital outlays and their financing.(It involves
firms decision to invest firms current fund for addition,
modification, disposition, and replacement of long term
assets)
It includes searching for new and more profitable investment
proposals, investigating, engineering and marketing
considerations to predict the consequences of accepting the
investment and making economic analysis to determine the
profit potential of each investment proposal.
Capital Expenditure Budget

Its a type of functional budget which provides a guidance as
to the amount of capital that may be required for
procurement of capital assets during the budgeted period.
Tactical Vs. Strategic Investment Decisions

A tactical decision involves a relati9vely small amount of
funds and does not constitute a major departure from the
past practices of the company
A strategic decision involves a large sum of money and may
also result in a major departure from the past practices of
the company.
Importance of Investment
Decisions
Involvement of heavy funds

Risk
Long term Implications
Irreversibility Decisions
Complexity

Types of Investment Decisions

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 or, Dependent Projects

Investment Evaluation Criteria

Four steps are involved in the evaluation of
an investment:
Estimation of cash flows(Amount of investment)

Estimation of the Minimum rate of return on the
investment(the opportunity cost of capital) or,
Expected return from the investment( Economic
value, Accounting ambiguities, Time value of
money.
Application of a decision rule for making the
choice
7
Investment Decision Rule

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
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)
Modified IRR
Profitability Index (PI)

PAY-BACK PERIOD
The payback period is the amount of time
required for the firm to recover its initial
investment.
The payback period is defined as the

number of years required for the proposals
cumulative cash inflows to be equal to its
cash outflows.
The payback period is the length of time
required to recover the initial cost of the
project.
Basic formulae
When annual inflows are equal

Payback period = Initial Outflow / Annual Cash
Inflow
When annual inflows are unequal

Payback period = (Last year with a negative
cash flow) + (absolute value of net benefits /
total cash flow next year)
Case 1:
EXAMPLE:
A proposal requires a cash outflow of Rs.
1,00,000 and is expected to generate cash
inflows of Rs.20,000 p.a. for 6 years. In this
case the payback period will be:
PAYBACK PERIOD = INITIAL
OUTFLOW
ANNUAL INFLOW
= 100000
20000
Case 2:
EXAMPLE:
A proposal requires a cash outflow of
Rs.20,000 and is expected to generate cash
inflows of Rs.8000, 6000, 4000, 2000 and
2000 over next five years respectively. Then
the payback period will be 4 years because
the sum of cash inflows of first four years is
20,000.
If the annual cash outflow is only 19000 then the

payback period
may be calculated as follows:
Year
Annual CF
Cumulative CF
8000
8000
6000
14000
4000
18000
2000
20000
Now the required cumulative cash inflow is

Rs.19000.At the end of third year the cumulative
cash inflow is 18000. For the fourth year the annual
cash inflow is 2,000. Therefore cash inflows of
Rs.1000 only during the fourth year will be
sufficient to make the total cumulative cash inflows
to be Rs.19000.
It would be calculated by:
payback period of 3 years
+19000-18000/2000 = 1000 /2000 = .5 years
So the total payback period will be 3.5 years.
DECISION RULE:
If the projects payback period is less than the maximum
acceptable payback period, accept the project.

If the projects payback period is greater than
the
maximum acceptable payback period, reject the project.
Management determines maximum acceptable

payback period.
Pros and Cons of Payback Method

Advantages of payback method:
Computational simplicity
Easy to understand
Focus on cash flow
Disadvantages of payback method:

Does not account properly for time value of
money
Does not account properly for risk
Cutoff period is arbitrary
Discounted Payback Period

It is the length of time required for an
investments discounted cash flows to equal
its initial cost.
Project discounted payback period

Years
CF
C(0)
PV
Accumulated
PV
To be
recovered
Dis.
Payback
100000
30000
27272.7
27272.727
72727.27273
50000
41322.3
68595.041
31404.95868
>2
60000
45078.9
113673.93
-13673.92938
<3
2+(31404/45079)
= 2.70 years
Decision Rule
An investment is accepted,
If discounted payback period < some specified
number of time period.
An investment is rejected,
If discounted payback period > some specified
number of time period.
Again, the cutoff is arbitrarily chosen.
The decision:
The discounted payback period is longer than 2
years and shorter than 3 years.
If the cutoff is 2 years, wed reject the project.
If the cutoff is 3 years, wed accept the project.
Pros and Cons of Discounting Payback Method

Advantages of discounting payback method:
Still fairly easy to understand and

communicate.
Take TVM into consideration.
Disadvantages of discounting payback

method:
Requires an arbitrary cutoff point.
Ignores cash flows beyond the cutoff.
Biased against long-term projects.
Does not lead to value-maximizing decisions.
AVERAGE RATE OF RETURN

ARR is defined as the annualized net income earned
on average funds invested in the project.
This method is considered better than pay-back period

method because it considers earnings of the project
during its full economic life. This method is also known
as Return On Investment (ROI). It is mainly expressed in
terms of percentage.
WHEN PROFITS ARE EQUAL:

In case the expected profits generated by a project
are equal for all the years then the annual profit
itself is the average profit.
WHEN PROFITS ARE UNEQUAL:

If profits are unequal the ARR will be calculated by
finding out the average annual profit and then
comparing it with average investment of the
project.
CALCULATION OF AVERAGE
INVESTMENT:
Average investment refers to average annual quantum
of funds that are invested in the project over its
economic life.
AVERAGE INVESTMENT =1/2(INITIAL
COST+INSTALLATION EXPENSES- SALVAGE VALUE)+
SALVAGE VALUE.
EXAMLPE:
ABC Ltd. Takes the project costing Rs.1,20,000 with
expected life of five years and the salvage value of
Rs.20,000. Then
AVERAGE INVESTMENT=1/2(1,20,000-20,000)+20,000
=70,000.
AVERAGE INVESTMENT CAN ALSO BE

CALCULATED AS FOLLOWS:
YEAR
OPENING B.V.
CLOSING B.V.
AVERAGE B.V.
1,20,000
1,00,000
1,10,000
1,00,000
80,000
90,000
80,000
60,000
70,000
60,000
40,000
50,000
40,000
20,000
30,000
3,50,000
TOTAL=
AVERAGE INVESTMENT=3,50,000/5
=70,000
DECISION RULE
IF ARR is more than the pre-specified rate of return

of the project should be accepted.
A project with highest ARR will have the top priority
while the project with lowest ARR will be assigned
lowest priority.
Pros and Cons of ARR

Advantages of ARR:
Simple to calculated and easy to understand.
Considers earning of the project during the

entire operative life.
Helps in comparing the projects which differ
widely.
Considers net earning after depreciation and
taxes.
Disadvantages of ARR:
It ignores time value of money.
It lays more emphasis on profit and loss on cash

flows
It does not consider re-investment of profit over

years.
It does not differentiate between the size of
investments required for different projects.
DISCOUNTING CASH FLOWS TECHNIQUE

Discounted cash flows or time-adjusted techniques
are based upon the discounted procedure by which
the future cash flows are discounted to find out
their present economic worth.
These are based on the concept of time value of
money in order to reflect the true economic tradeoff and returns.
These are of 4 types:
1. Net present value (NPV)
2. Profitability Index (P I)
3. Internal Rate of Return (IRR)
4. Modified Internal Rate of Return (MIRR)
5. Benefit-Cost Ratio (BCR)
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).
32
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:
NPV= Excess of PV of inflows over PV of outflows
= PV of inflows PV of outflows
C3
Cn
C1
C2
C0
L
2
3
n
(1 k )
(1 k )
(1 k ) (1 k )
n
Ct
NPV
C0
t
t 1 (1 k )
NPV

33
Example:
A firm is considering a capital budgeting proposal
having initial cost of Rs. 1,70,000. The project is
expected to generate annual cash flows of Rs.
20,000, Rs. 50,000, Rs. 60,000 and Rs. 40,000
respectively during next 4 years. And the discount
rate is 10% .
Time
Cash Flows
PVF(10%, T)
Present Values
T0
-1,70,000
1.000
-1,70,000
T1
20,000
.909
18,180
T2
50,000
.826
41,300
T3
60,000
.751
45,060
T4
40,000
.683
27,320
Total
- 38140
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.
35
Pros and Cons of NPV

Advantages of NPV:
Makes appropriate adjustment for time value of
money.
Focuses on cash flows, not accounting earnings
It recognizes the risk associated with future
cash flow - it's less certain.
Disadvantages of NPV:
Lacks the intuitive appeal of payback.

Biased towards short run projects.
Doesnt capture managerial flexibility (option
value) well.
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.
C3
Cn
C1
C2
C0
L
2
3
(1 r ) (1 r )
(1 r )
(1 r ) n
n
C0
t 1
n
t 1
Ct
(1 r )t
Ct
C0 0
t
(1 r )
37
Example: When cash flows are equal:

A firm is evaluating a proposal costing Rs. 1,OO,OOO
and having annual inflows of Rs. 25,000 occurring at
the end of each of next 6 years. There is no salvage
value. Then IRR is calculated as follows:
Step 1.
Make an approximation of the IRR on the basis of cash
flows data. This approximation can be made with reference to
the pay back period. In this case the pay back period is 4
years. Now, search for a value nearest to 4 in the 6th year
row of the PVAF table. The closest figures are given in rate
12% (4.111) and the rate 13% (3.998). This means that the
IRR of the proposal is expected to lie between 12% and 13%.
Step 2.
Find out the NPV of the project for both
these rates as follows:
At 12%, NPV=(25000* PVAF(12%, 6y)100000)
=(25000*4.111) 100000
= Rs. 2775
At 13%, NPV=(25000* PVAF(13%, 6y)100000)
=(25000*3.998) 100000
= Rs. 50
Step 3.
Find out the exact IRR by interpolating between 12% and

13%. It may be noted that IRR is the discounted rate at which
NPV is Zero, so the rate at which NPV is Zero will be higher
than 12% but less than 13%. The rate of which NPV would be
Zero can be found with the help of interpolation technique.
Formula:
IRR= Lower Rate + NPV at lower rate * (Difference in

Rates)
Difference of NPV at Lower

rate & Higher Rate
By interpolating difference of 1% i.e.(13% - 12%), over
NPV difference of Rs. 2825 i.e. [2775- (-50)]
When cash flows are unequal:

If there is no apparent pattern of annuity in the cash
inflows then the weighted or simple average of cash
inflows can be used as follows:
Example:
A firm is evaluating a proposal costing Rs. 1,60,000
and expected to generate cash inflows of Rs.
40,000, Rs60,000, Rs. 50,000, Rs. 50,000 and Rs.
40,000 at the end of each next 5 years respectively.
There is no salvage value. In this case IRR is
calculated as follows:
Step 1. Find out the weighted average of cash inflows:

Year
Cash
Inflows
Weight
CF* W
40000
2,00,000
60000
2,40,000
50000
1,50,000
50000
1,00,000
40000
40,000
Total=
15
7,30,000
Weighted average= 7,30,000/ 15= Rs. 48,

667
Step 2.
Consider the weighted average as the annuity of cash
inflows and find out the payback period.
Pay back period is Rs. 1,60,000/ 48,667= 3.288.
Step 3.
Now, search for a value nearest to 3.2888 in 5 years row
of the PVAF table. The closest figure given in the table are
at 15% (3.352) and at 16% (3.274). This means that IRR
is expected to lie between 15% and 16%.
Step 4.
Find out NPV

Year
Cash
Inflow
PVF(16%,
n)
PVF(15%, PV
n)
(16%)
PV(15%)
40,000
.862
.870
34,480
34,800
60,000
.743
.756
44,580
45,360
50,000
.641
.658
32,050
32,900
50,000
.552
.572
27,600
28,600
40,000
.476
.497
19,040
19,880
1,57,75
0
1,61,540
Total
At 16% , NPV= 1,57,750- 1,60,000= Rs. 2,250

At 15% , NPV= 1,61,540- 1,60,000= Rs. 1,540
Step 5.
Find out exact IRR by interpolating between 15%
and 16%. At 15% the NPV is Rs. 1,540 and at 16%,
the NPV is zero will be more than 15% but less than
16%. By interpolating the difference of 1% (i.e. 16%15%) over the NPV difference of Rs. 3,790 i.e. 2250-(1540)
IRR= 15% + 1,61,540-1,60,000 * (16-15)
1,61,540- 1,57,750
= 15.40%
Decision Rules
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.
In case of Mutually Exclusive Projects,
ACCEPT the project with the largest IRR,
provided it is greater than the required rate of
return & REJECT others.
48
Pros and Cons of IRR:

Advantages of IRR:
Makes appropriate adjustment for time value of

money.
Properly adjusts for time value of money.
Uses cash flows rather than earnings.
Project IRR is a number with intuitive appeal.
Disadvantages of IRR:
Most difficult method of evaluation of investment

proposals.
Timing problem
Based upon the assumption that the earnings are

reinvested at the IRR for remaining life of the
project.
It may result in incorrect decisions in comparing

the mutually exclusive projects.
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.

51
A projects modified internal rate of return (MIRR) is

the interest rate equating a projects investment costs
with the terminal value of the projects net cash flows.
The present value of a projects investment costs is

called the beginning value.
The future value of a projects net cash flows is called

the terminal value.
52
12/17/15
A projects beginning value is the sum of the present

values of all investment cash outflows for a project.
If all investment cash outflows occur at the very

beginning (time = 0), then the beginning value equals
the net investment.
If investment outlays occur over several years, the

discount rate used to compute present values is
usually the required rate of return.
53
12/17/15
A projects terminal value is the sum of the future

values of the net cash flows at the end of the projects
economic life.
The interest rate used to compute the future values is

usually the required rate of return.
54
12/17/15
Example
Suppose a project has a Rs 2,00,000 net investment

and net cash flows (NCFs) of Rs. 70,000 annually for
5 years. The required rate of return is 10%. What is
the MIRR?
55
12/17/15
The projects beginning value is just the net

investment of Rs. 2,00,000. The projects terminal
value (TV) is:
56
12/17/15
The projects MIRR equates the PV of the beginning

value with the FV of the terminal value:
The MIRR equals 16.40%.
57
12/17/15
Question
From the following information, evaluate the proposal
using T.V.:
Initial Outlay
Rs. 20,000
Project Life
5 years
Net Cash Flow
Rs. 8000 each year
Cost of capital
10%
Expected Interest rate:
Year
1
2
3
4
5
%
6
6
8
8
8
58
Answer:
Year
Cash
Flows
Rates of
return(%)
Period of
Reinvest
ment
Compoun
ding
Factor
Compoun
ding Cash
Inflows
8000
1.262
10,096
8000
1.191
9528
8000
1.166
9328
8000
1.080
8640
8000
1.000
8000
45592
PV of Cash Inflow = 45592 X PVF(10%, 5)

= 45592 X 0.621 = 28312
T.V. = 28312
59
Decision Rule
A project is:
Acceptable if the MIRR > required rate of return.
Unacceptable if the MIRR < required rate of

return.
In our example, the project is acceptable since the

16.40% MIRR is greater than the 10% required rate
of return.
60
12/17/15
Benefit Cost Ratio (BCR)
A benefit-cost ratio (BCR) is an indicator, used in the formal

discipline of Cost-Benefit Analysis, that attempts to
summarize the overall value of money of a project or
proposal.
A BCR is the ratio of the benefits of a project or proposal,
expressed in monetary terms, relative to its costs, also
expressed in monetary terms.
All benefits and costs should be expressed in discounted
present values.
Benefit Cost Ratio (BCR)

The procedure of deriving the benefit cost ratio criterion is the
same,as that of NPV. The ratio between the two would give us
the benefit cost ratio which indicates benefit per dollar of cost.
The formula of BCR is shown as follows.
Benefit Cost Ratio (BCR) = Discounted total benefits
Discounted total cost
or
= Present value of benefits
Present value of costs
If benefit-cost ratio (R) >1, then the project should be

undertaken.
Example:
A project which is being evaluated by a firm that has a
cost of capital of 12%
Initial investment:
100000
Benefits:
Year1
Year 2
Year3
Year4
Calculate the Benefit-Cost ratio.
25000
40000
40000
50000
BCR = PVB
I
PVB = Present Value of Benefits
I
= Initial Investment
25000 + 40000 + 40000 + 50000
BCR = (1.12) (1.12)2 (1.12)3 (1.12)4

100000
= 1.145
NBCR = BCR-1
= 1.145-1
= 0.145
Decision Rule
When BCR
NBCR
RULE
>1
>0
ACCEPT
=1
=0
INDEFFERENT
<1
<0
REJECT
Benefit-Cost Ratio (Contd)
Problems?
Sometimes it is not possible to rank projects with the Benefit-Cost
Ratio
Mutually exclusive projects of different sizes
Mutually exclusive projects and recurrent costs subtracted out of
benefits or benefits reported gross of operating costs
Not necessarily true that R >R
that project A is better
A
B
Case 1: (Independent Projects)

The management of the Egyptian investors Plc is evaluating
a capital budget decision. The available alternatives are as
follows:
Required :
Rank these investment alternatives using the payback period,
and the NPV. The required rate of return is 18%
The payback period:

To calculate the payback period, the net cash flows for each alternative
should be accumulated till it gives a positive value (i.e. till it pays back its
initial investment). The one that pays back faster is the best alternative.
Year
NCF (P1)
Cum. CF
NCF (P2)
Cum. CF
-500
150
150
200
200
300
300
150
300
200
400
100
400
650
950
100
500
000
400
950
1200
1700
000
400
-600
NCF (P3)
Cum. CF
-400
According to the payback method, project C which pays back after 2 years is
No. 1, followed by project A which pays back after 3 years, while project B
is No. 3 because it pays back during the fourth year.
Do you agree with this ranking?

Why?
The NPV:
According to the net present value method, the net
cash flows should be discounted and accumulated
to get the NPV, by the end of the useful life. The
project that generates the highest NPV is the most
feasible one.
Project B generates the highest positive NPV, thus it is

ranked as No. 1, followed by project A. While project C
should be rejected as it gives a negative NPV.
Case 2: (Mutually Exclusive Projects)

The management of Goldi is evaluating an investment proposal
to acquire one of two mutually exclusive production lines to
produce motherboards. The following data is available:
The companys cost of capital is 12%.

Required: Select the best alternative.
The best method to use in selecting between

mutually exclusive projects is the NPV, thus the net
cash flows for each project is discounted @ the
cost of capital rate (12%) and the project that yield
the highest NPV is selected.
Project A gives net present value that is higher than project

B, thus it is more feasible (i.e. project A maximizes the
shareholders wealth).
Note: The IRR in this case may give a conflicting result,
both projects will give an IRR of 22%.
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.

76
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:
PV Rs 40,000(PVF1, 0.10 ) + Rs 30,000(PVF2, 0.10 ) + Rs 50,000(PVF3, 0.10 ) + Rs 20,000(PVF4, 0.10 )

= Rs 40,000 0.909 + Rs 30,000 0.826 + Rs 50,000 0.751 + Rs 20,000 0.68
NPV Rs 112,350 Rs 100,000 = Rs 12,350
Rs 1,12,350
PI
1.1235.
Rs 1,00,000

77
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.

78
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.

79
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. Nonconventional investments have more than one
change in the signs of cash flows; for example,
+ + + ++ +.
80
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.

81
NPV Versus IRR

Cash Flows (Rs)
Project
X
Y
C0
-100
100
C1
120
-120

IRR
20%
20%
NPV at 10%
9
-9
82
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)
250
NPV Rs 63
0
-250
-500
-750
0

50
100
150
200
250
Discount Rate (%)
83
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.

84
Timing of Cash Flows

Cash Flows (Rs)
Project
M
N
C0
1,680
1,680
C1
1,400
140
C2
700
840

NPV
C3
140
1,510
at 9%
301
321
IRR
23%
17%
85
Scale of Investment
Cash Flow (Rs)
Project
A
B
C0
-1,000
-100,000
C1
1,500
120,000
NPV
at 10%
364
9,080

IRR
50%
20%
86
Project Life Span

Cash Flows (Rs)
Project
X
Y
C0
10,000
10,000
C1
C2
C3
C4
C5
NPV at 10%
IRR
12,000
0
20,120
908
2,495
20%
15%

87
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.

88
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.

89
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:

90

Capital Budgeting Basics

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Capital Budgeting Basics

Uploaded by

Copyright:

Available Formats

Capital Budgeting

Nature of Investment Decisions

known as the capital budgeting, or capital

Features of Investment Decisions

Capital Expenditure Budget

Tactical Vs. Strategic Investment Decisions

Involvement of heavy funds

Financial Management, Ninth Edition I M Pandey

Types of Investment Decisions

Mutually exclusive investments

Financial Management, Ninth Edition I M Pandey

Investment Evaluation Criteria

Estimation of cash flows(Amount of investment)

Investment Decision Rule

Financial Management, Ninth Edition I M Pandey

Net Present Value (NPV)

Financial Management, Ninth Edition I M Pandey

The payback period is defined as the

When annual inflows are equal

When annual inflows are unequal

If the annual cash outflow is only 19000 then the

Now the required cumulative cash inflow is

acceptable payback period, accept the project.

Management determines maximum acceptable

Pros and Cons of Payback Method

Disadvantages of payback method:

Does not account properly for risk

Cutoff period is arbitrary

Discounted Payback Period

Project discounted payback period

Again, the cutoff is arbitrarily chosen.

Pros and Cons of Discounting Payback Method

Still fairly easy to understand and

Disadvantages of discounting payback

Ignores cash flows beyond the cutoff.

Biased against long-term projects.

Does not lead to value-maximizing decisions.

AVERAGE RATE OF RETURN

This method is considered better than pay-back period

WHEN PROFITS ARE EQUAL:

WHEN PROFITS ARE UNEQUAL:

AVERAGE INVESTMENT CAN ALSO BE

IF ARR is more than the pre-specified rate of return

Pros and Cons of ARR

Simple to calculated and easy to understand.

Considers earning of the project during the

It lays more emphasis on profit and loss on cash

It does not consider re-investment of profit over

DISCOUNTING CASH FLOWS TECHNIQUE

Net Present Value Method

forecasted based on realistic assumptions.

Net Present Value Method

subtracting present value of cash outflows

Financial Management, Ninth Edition I M Pandey

Pros and Cons of NPV

Lacks the intuitive appeal of payback.

Internal Rate of Return Method

equates the investment outlay with the present

Example: When cash flows are equal:

Find out the exact IRR by interpolating between 12% and

IRR= Lower Rate + NPV at lower rate * (Difference in

Difference of NPV at Lower

When cash flows are unequal: