Capital Budgeting

Capital budgeting (or investment appraisal) is the process of determining the viability to
long-term investments on purchase or replacement of property plant and equipment, new
product line or other projects.

Capital budgeting consists of various techniques used by managers such as:

1. Payback Period
2. Discounted Payback Period
3. Net Present Value
4. Accounting Rate of Return
5. Internal Rate of Return
6. Profitability Index

All of the above techniques are based on the comparison of cash inflows and outflow of a
project however they are substantially different in their approach.

A brief introduction to the above methods is given below:

Payback Period measures the time in which the initial cash flow is returned by the project. Cash
flows are not discounted. Lower payback period is preferred.
Net Present Value (NPV) is equal to initial cash outflow less sum of discounted cash inflows. Higher
NPV is preferred and an investment is only viable if its NPV is positive.
Accounting Rate of Return (ARR) is the profitability of the project calculated as projected total net
income divided by initial or average investment. Net income is not discounted.
Internal Rate of Return (IRR) is the discount rate at which net present value of the project
becomes zero. Higher IRR should be preferred.
Profitability Index (PI) is the ratio of present value of future cash flows of a project to initial
investment required for the project.

The above techniques are explained in detail in next pages.

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Discounted Payback Period

One of the major disadvantages of simple payback period is that it ignores the time value of
money. To counter this limitation, an alternative procedure called discounted payback period
may be followed, which accounts for time value of money by discounting the cash inflows of
the project.

Formulas and Calculation Procedure

In discounted payback period we have to calculate the present value of each cash inflow taking
the start of the first period as zero point. For this purpose the management has to set a suitable
discount rate. The discounted cash inflow for each period is to be calculated using the formula:

Actual Cash Inflow

Discounted Cash Inflow =
(1 + i)n

where,
i is the discount rate;
n is the period to which the cash inflow relates.

Usually the above formula is split into two components which are actual cash inflow and
present value factor ( i.e. 1 / ( 1 + i )^n ). Thus discounted cash flow is the product of actual cash
flow and present value factor.

The rest of the procedure is similar to the calculation of simple payback period except that we
have to use the discounted cash flows as calculated above instead of actual cash flows. The
cumulative cash flow will be replaced by cumulative discounted cash flow.

B
Discounted Payback Period = A +
C

Where,
A= Last period with a negative discounted cumulative cash flow;
B = Absolute value of discounted cumulative cash flow at the end of the period A;
C = Discounted cash flow during the period after A.

Note: In the calculation of simple payback period, we could use an alternative formula for
situations where all the cash inflows were even. That formula won't be applicable here since it
is extremely unlikely that discounted cash inflows will be even.

The calculation method is illustrated in the example below.

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 Decision Rule

If the discounted payback period is less that the target period, accept the project. Otherwise
reject.

Example

An initial investment of $2,324,000 is expected to generate $600,000 per year for 6 years.
Calculate the discounted payback period of the investment if the discount rate is 11%.

Solution

Step 1: Prepare a table to calculate discounted cash flow of each period by multiplying the
actual cash flows by present value factor. Create a cumulative discounted cash flow column.

Year Cash Flow Present Value Factor Discounted Cash Flow Cumulative Discounted
n CF PV$1=1/(1+i)n CFPV$1 Cash Flow

0 $ 2,324,000 1.0000 $ 2,324,000 $ 2,324,000

1 600,000 0.9009 540,541 1,783,459

2 600,000 0.8116 486,973 1,296,486

3 600,000 0.7312 438,715 857,771

4 600,000 0.6587 395,239 462,533

5 600,000 0.5935 356,071 106,462

6 600,000 0.5346 320,785 214,323

Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 5.32 years

Advantages and Disadvantages

Advantage: Discounted payback period is more reliable than simple payback period since it
accounts for time value of money. It is interesting to note that if a project has negative net
present value it won't pay back the initial investment.

Disadvantage: It ignores the cash inflows from project after the payback period.

Accounting Rate of Return (ARR)

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Accounting rate of return (also known as simple rate of return) is the ratio of estimated
accounting profit of a project to the average investment made in the project. ARR is used in
investment appraisal.

Formula

Accounting Rate of Return is calculated using the following formula:

Average Accounting Profit

ARR =
Average Investment

Average accounting profit is the arithmetic mean of accounting income expected to be earned
during each year of the project's life time. Average investment may be calculated as the sum of
the beginning and ending book value of the project divided by 2. Another variation of ARR
formula uses initial investment instead of average investment.

Decision Rule

Accept the project only if its ARR is equal to or greater than the required accounting rate of
return. In case of mutually exclusive projects, accept the one with highest ARR.

Examples

Example 1: An initial investment of $130,000 is expected to generate annual cash inflow of

$32,000 for 6 years. Depreciation is allowed on the straight line basis. It is estimated that the
project will generate scrap value of $10,500 at end of the 6th year. Calculate its accounting rate
of return assuming that there are no other expenses on the project.

Solution
Annual Depreciation = (Initial Investment Scrap Value) Useful Life in Years
Annual Depreciation = ($130,000 $10,500) 6 $19,917
Average Accounting Income = $32,000 $19,917 = $12,083
Accounting Rate of Return = $12,083 $130,000 9.3%

Example 2: Compare the following two mutually exclusive projects on the basis of ARR. Cash
flows and salvage values are in thousands of dollars. Use the straight line depreciation method.

Project A:

Year 0 1 2 3

Cash Outflow -220

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Cash Inflow 91 130 105

Salvage Value 10

Project B:

Year 0 1 2 3

Cash Outflow -198

Cash Inflow 87 110 84

Salvage Value 18

Solution

Project A:

Step 1: Annual Depreciation = ( 220 10 ) / 3 = 70

Step 2: Year 1 2 3

Cash Inflow 91 130 105

Salvage Value 10

Depreciation* -70 -70 -70

Accounting Income 21 60 45

Step 3: Average Accounting Income = ( 21 + 60 + 45 ) / 3

= 42

Step 4: Accounting Rate of Return = 42 / 220 = 19.1%

Project B:

Step 1: Annual Depreciation = ( 198 18 ) / 3 = 60

Step 2: Year 1 2 3

Cash Inflow 87 110 84

Salvage Value 18

Depreciation* -60 -60 -60

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 Accounting Income 27 50 42

Step 3: Average Accounting Income = ( 27 + 50 + 42 ) / 3

= 39.666

Step 4: Accounting Rate of Return = 39.666 / 198 20.0%

Since the ARR of the project B is higher, it is more favorable than the project A.

Advantages and Disadvantages

Advantages

Like payback period, this method of investment appraisal is easy to calculate.

It recognizes the profitability factor of investment.

Disadvantages

It ignores time value of money. Suppose, if we use ARR to compare two projects having equal
initial investments. The project which has higher annual income in the latter years of its useful
life may rank higher than the one having higher annual income in the beginning years, even if
the present value of the income generated by the latter project is higher.

It can be calculated in different ways. Thus there is problem of consistency.

It uses accounting income rather than cash flow information. Thus it is not suitable for projects
which having high maintenance costs because their viability also depends upon timely cash
inflows.

Net Present Value (NPV)

Net present value is the present value of net cash inflows generated by a project including
salvage value, if any, less the initial investment on the project. It is one of the most reliable
measures used in capital budgeting because it accounts fortime value of money by using
discounted cash inflows.

Before calculating NPV, a target rate of return is set which is used to discount the net cash
inflows from a project. Net cash inflow equals total cash inflow during a period less the
expenses directly incurred on generating the cash inflow.

Calculation Methods and Formulas

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The first step involved in the calculation of NPV is the determination of the present value of net
cash inflows from a project or asset. The net cash flows may be even (i.e. equal cash inflows in
different periods) or uneven (i.e. different cash flows in different periods). When they are even,
present value can be easily calculated by using the present value formula of annuity. However,
if they are uneven, we need to calculate the present value of each individual net cash inflow
separately.

In the second step we subtract the initial investment on the project from the total present
value of inflows to arrive at net present value.

Thus we have the following two formulas for the calculation of NPV:

When cash inflows are even:

1 (1 + i)-n
NPV = R Initial Investment
i

In the above formula,

R is the net cash inflow expected to be received each period;
i is the required rate of return per period;
n are the number of periods during which the project is expected to operate and generate cash
inflows.

When cash inflows are uneven:

R1 R2 R3
NPV = + + + ... Initial Investment
(1 + i)1 (1 + i)2 (1 + i)3

Where,
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period;
R3 is the net cash inflow during the third period, and so on ...

Decision Rule

Accept the project only if its NPV is positive or zero. Reject the project having negative NPV.
While comparing two or more exclusive projects having positive NPVs, accept the one with
highest NPV.

Examples
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Example 1: Even Cash Inflows: Calculate the net present value of a project which requires an
initial investment of $243,000 and it is expected to generate a cash inflow of $50,000 each
month for 12 months. Assume that the salvage value of the project is zero. The target rate of
return is 12% per annum.

Solution

We have,
Initial Investment = $243,000
Net Cash Inflow per Period = $50,000
Number of Periods = 12
Discount Rate per Period = 12% 12 = 1%

Net Present Value

= $50,000 (1 (1 + 1%)^-12) 1% $243,000
= $50,000 (1 1.01^-12) 0.01 $243,000
$50,000 (1 0.887449) 0.01 $243,000
$50,000 0.112551 0.01 $243,000
$50,000 11.2551 $243,000
$562,754 $243,000
$319,754

Example 2: Uneven Cash Inflows: An initial investment on plant and machinery of $8,320
thousand is expected to generate cash inflows of $3,411 thousand, $4,070 thousand, $5,824
thousand and $2,065 thousand at the end of first, second, third and fourth year respectively. At
the end of the fourth year, the machinery will be sold for $900 thousand. Calculate the present
value of the investment if the discount rate is 18%. Round your answer to nearest thousand
dollars.

Solution

PV Factors:
Year 1 = 1 (1 + 18%)^1 0.8475
Year 2 = 1 (1 + 18%)^2 0.7182
Year 3 = 1 (1 + 18%)^3 0.6086
Year 4 = 1 (1 + 18%)^4 0.5158

The rest of the problem can be solved more efficiently in table format as show below:

Year 1 2 3 4

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Net Cash Inflow $3,411 $4,070 $5,824 $2,065

Salvage Value 900

Total Cash Inflow $3,411 $4,070 $5,824 $2,965

Present Value Factor 0.8475 0.7182 0.6086 0.5158

Present Value of Cash Flows $2,890.68 $2,923.01 $3,544.67 $1,529.31

Total PV of Cash Inflows $10,888

Initial Investment 8,320

Net Present Value $2,568 thousand

Advantage and Disadvantage of NPV

Advantage: Net present value accounts for time value of money. Thus it is more reliable than
other investment appraisal techniques which do not discount future cash flows such payback
period and accounting rate of return.

Disadvantage: It is based on estimated future cash flows of the project and estimates may be
far from actual results.

Internal Rate of Return (IRR)

Internal rate of return (IRR) is the discount rate at which the net present value of an investment
becomes zero. In other words, IRR is the discount rate which equates the present value of the
future cash flows of an investment with the initial investment. It is one of the several measures
used for investment appraisal.

Decision Rule

A project should only be accepted if its IRR is NOT less than the target internal rate of return.
When comparing two or more mutually exclusive projects, the project having highest value of
IRR should be accepted.

IRR Calculation

The calculation of IRR is a bit complex than other capital budgeting techniques. We know that
at IRR, Net Present Value (NPV) is zero, thus:

NPV = 0; or

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PV of future cash flows Initial Investment = 0; or

CF1 CF2 CF3

+ + + ... Initial Investment = 0
( 1 + r )1 ( 1 + r ) 2 ( 1 + r ) 3

Where,
r is the internal rate of return;
CF1 is the period one net cash inflow;
CF2 is the period two net cash inflow,
CF3 is the period three net cash inflow, and so on ...

But the problem is, we cannot isolate the variable r (=internal rate of return) on one side of the
above equation. However, there are alternative procedures which can be followed to find IRR.
The simplest of them is described below:

Guess the value of r and calculate the NPV of the project at that value.

If NPV is close to zero then IRR is equal to r.

If NPV is greater than 0 then increase r and jump to step 5.

If NPV is smaller than 0 then decrease r and jump to step 5.

Recalculate NPV using the new value of r and go back to step 2.

Example

Find the IRR of an investment having initial cash outflow of $213,000. The cash inflows during
the first, second, third and fourth years are expected to be $65,200, $96,000, $73,100 and
$55,400 respectively.

Solution
Assume that r is 10%.
NPV at 10% discount rate = $18,372
Since NPV is greater than zero we have to increase discount rate, thus
NPV at 13% discount rate = $4,521
But it is still greater than zero we have to further increase the discount rate, thus
NPV at 14% discount rate = $204
NPV at 15% discount rate = ($3,975)
Since NPV is fairly close to zero at 14% value of r, therefore
IRR 14%

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