Professional Documents
Culture Documents
• Decision Making
• Implementation
• Performance Review
PROJECT CLASSIFICATION
• Mandatory Investments
• Replacement Projects
• Expansion Projects
• Diversification Projects
• Miscellaneous Projects
Techniques of
Capital Budgeting
Traditional Modern
• Disadvantages:
– Ignores the time value of money
– Ignores cash flows after the payback period
PAYBACK PERIOD
Saurabh Inc’s Capital Project
Year Cash flow Cumulative cash flow
0 -100
1 20 20
2 20 40
3 20 60
4 20 80
5 20 100
6 20
7 20
Accounting or Average Rate of Return
Average Net Income
AAR
Average Book Value of Investment
1 100 14
2 80 17.5
3 65 20.12
4 53.75 22.09
5 45.31 23.57
ARR = = 28.31%
1/5 (14+17.5 +20.12+22.09+23.57)
1/5(100+80+65+53.75+45.31)
NET PRESENT VALUE
NPV Decision
Positive Accept
Negative Reject
Zero May or may not
NET PRESENT VALUE
The net present value of a project is the sum of the present value of all the cash
flows associated with it. The cash flows are discounted at an appropriate discount
rate (cost of capital)
Saurabh Inc’s Capital Project( Cost of Capital=15%)
Year Cash flow Discount factor Present
value
0 -100.00 1.000 -100.00
1 34.00 0.870 29.58
2 32.50 0.756 24.57
3 31.37 0.658 20.64
4 30.53 0.572 17.46
5 79.90 0.497 39.71
Sum = 31.96
Pros Cons
• Reflects the time value of money • Is an absolute measure and not
a relative measure
• Considers the cash flow in its entirety
BENEFIT COST RATIO
OR
PROFITABILITY INDEX
Discount rate
The internal rate of return (IRR) of a project is the discount rate that makes its NPV equal to
zero. It is represented by the point of intersection in the above diagram
5.13
24% + 28% - 24% = 26.24%
5.13 + 4.02
DECISION REGARDING PROJECT FOR
INTERNAL RATE OF RETURN
IRR Decision
>Cost of Capital Accept
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IRR Vs. NPV Vs. PI(Contd.)
3. IRR = COST OF CAPITAL
NPV = 0
PI = 1
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