Capital Budgeting

Investment Decision Rules

• The investment decision rules may be referred to as capital budgeting
techniques, or investment criteria. A sound appraisal technique
should be used to measure the economic worth of an investment
project. The essential property of a sound technique is that it should
maximize the shreholders’ wealth. The following other technique is
that it should maximize the shareholders’ wealth maximization. The
following other characteristics should also be possessed by a sound
investment evaluation criterion:
Continued
• It should maximize 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 recognize 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
maximizes the shareholders’ wealth.
• It should be a criterion which is applicable to any conceivable investment project
independent of others.
Evaluation Criteria
• Discounted Cash Flow (DCF) Criteria
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI)

• Non-discounted Cash Flow Criteria

• Payback Period (PB)
• Discounted payback period (DPB)
• Accounting Rate of Return (ARR)
Net Present Value
• The net present value method is the classic economic method of
evaluating the investment proposals. It is a DCF technique that
explicitly recognizes the time value of money. It correctly postulates
that cash flows arising at different time periods differ in value and are
comparable only when their equivalents – present values are found
out. The following steps are involved in calculation of NPV:
Continued
• 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.
• Present value of cash-flows should be calculated using the
opportunity cost of capital as the discount rate.
• Net present value should be found out by subtracting present value of
cash out-flows from present value of cash in-flows. The project should
be accepted if NPV is positive (i.e.,NPV>0).
Formula
• C0 , C1 , C2 , C3 ,            , Cn are cash-flows of 0,1,2,3,--------,n years

C1 C2 C3 Cn
NPV      C0
1  K  1
1  K  2
1  K 
3
1  K 
n

• K is the cost of capital

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 higher NPV should be selected. Using the NPV
method, projects would be ranked in order of net present values; that
is first rank will be given to the project with highest positive net
present value and so on.
Problems
• Assume that project X costs ₹2500 now and is expected to generate
year-end cash in-flows of ₹900, ₹800, ₹700, ₹600 and ₹500 in years 1
through 5. The opportunity cost of the capital may be assumed to be 10
percent. Calculate Net Present Value.
• G. K. Company is evaluating a project with following cash inflows
Year 1 2 3 4 5
Cash-flow 1000 800 600 400 200
If initial cash-outlay is ₹400 and cost of capital is 12 percent, what is the
Net Present Value of the Project? Whether it should be accepted or
rejected?
How to calculate discount factor in accounting
calculator and scientific calculator
• Accounting calculator: suppose you would like to find out the
discount factor for 10% rate: Then press 1÷(1.1) then press two times
multiplication sign. Hence the total work will be 1÷(1.1) ×× you will
get first year discount factor and then press = sing you will get second
year discount factor, again press = sign you will get third year discount
factor and so on.
• Scientific Calculator: 1÷(1.1) then press you will get first year discount
factor. Then press = and multiplied by 1÷(1.1) press = you will get
second year discount factor, again press = you will get third year
discount factor and so on.
Problems
• A firm considering the following project:
Year 0 1 2 3 4 5
Cash-flow -50000 11300 12769 14429 16305 18421

Calculate the NPV of the project if the cost of capital is 10 percent.

Calculate the Internal Rate of Return also.
Problem
• From the following information calculate the net present value of the
two projects and suggest which of the two projects should be
accepted assuming a discount rate of 10%. Project life is for 5 years.
Year
Innitial
Investment 1 2 3 4 5Scrap Value
Project X 20000 5000 10000 10000 3000 2000 1000
Project Y 30000 20000 10000 5000 3000 2000 2000

• Use NPV rule.

Problem
• Whether project will be acceptable unless the yield is 10%. Cash inflows of
a certain project alongwith cash outflows are given below:
Outflows Inflows
Years Rs Rs
0 150000
1 30000 20000
2 30000
3 60000
4 80000
5 30000
The salvage value at the end of the 5th year is ₹40000. Calculate NPV
Problem
• A company is considering investment in a project that costs ₹200000.
The project has an expected life of 5 years and zero salvage value. The
company uses straight line method of depreciation. The companies tax
rate is 40%. The estimated earnings before depreciation and before tax
from the project are as follows:

Year 1 2 3 4 5
Earnings before
• Company’s cost of
depreciation andcapital is 10%.
tax 70000 80000 120000 90000 60000
Advantage of NPV
• Time Value: It recognizes the time value of money – a rupee received
today is worth more than a rupee received tomorrow.
• Measure of true profitability: It uses all cash flows occurring over the
entire life of the project in calculating its worth. Hence, it is a measure
of true profitability. The NPV method relies on estimated cash flows
and the discount rate rather than any arbitrary assumptions or
subjective considerations.
• Value - additivity: NPV(A+B) = NPV(A) + NPV(B)
• Share-holder value maximization: It consider the share-holder value
maximization.
Limitations of NPV method
• Cash flow estimation: The NPV method is easy to use if we know the
cash-flow properly. In practice it is very difficult to predict the cash-flow.
• Discount rate: It is also difficult in practice to precisely measure the
discount rate.
• Mutually exclusive projects: Further caution needs to be applied in using
the NPV method when alternative (mutually exclusive) projects with
unequal lives, or under fund constrain are evaluated.
• Ranking of the project: It should be noted that ranking of the project
based on NPV are not independent of the discount rate.
Internal Rate of Return (IRR)
• 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.

C1 C2 C3 Cn
NPV  1              C0  0
1  K1 1
1  K1  1  K1 
2 3
1  K1 n

• K1 is called the IRR of a project.

Problem: Uneven cash-flow: Trial and Error
method
• Calculate IRR

Initial investment 60000

Life of the Asset 4
Estimated net Annyal Cash Flows
1 15000
2 20000
3 30000
4 20000
Problem: Same cash-flow: Trial and Error
method
• An investment would cost ₹20000 and provide annual cash inflow of
₹5430 for 6 years. If the opportunity cost of capital is 10 percent,
what is the investment’s NPV? What is the IRR?
• Aasmann Ltd has currently under examination a project which will yield
the following returns over the life of the project:

Year 1 2 3 4 5
PBDIT (Gross Yield) 80000 80000 90000 90000 83000
• Cost of Machinery to be installed amount to ₹200000 and the machine
is to be depreciated at 20% p.a. at W.D.V. basis. Income tax rate is 50%.
The salvage value of the machine is zero. If the average cost of raising
capital is 11%, would you recommend accepting the project under NPV
and IRR method?
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.
Evaluation of IRR method
• Advantages of IRR method
• Time value of money: Like NPV method it also takes into account the time value of
money and can be applied for even and uneven cash-flow methods.
• Profitability index: It contains the profitability for entire life of the project and hence
enables evaluation of true profitability.
• Acceptance rule: Acceptance rule are very easy to understand.
• Shareholder value
• Disadvantages
• Multiple rate can exist
• It is assumed that cash-flows are reinvested in the same IRR, which is not possible.
• Value additivity
Comparison between NPV vs IRR
• Both methods consider the time value of money and both are
discounted cash flow method. Still there are some differences
between these two:
• In NPV cash-flows are discounted by a determined or specified rate called the
cost of capital. But under internal rate of return the cash flows are discounted
by a suitable interest rate selected by hit and trial method. Hence in IRR the
discount rate is not predetermined.
• The NPV considered the market interest rate as a discount rate where as IRR
does not considered market interest rate for discounting.
• Under NPV method the cash-flows are reinvested in cost of capital but in IRR
it is reinvested at different rate.
Profitability Index
• Another time-adjusted method of evaluating the investment
proposals is the benefit – cost (b/C) ratio or profitability index (PI).
PV C j  n
Ci
PI    C0
i 1 1  K 
i
C0

• C1, C2 , C3          , Cn are the cash-inflows

• K in the interest rate
• C0 is the initial investment
Problem
• The initial cash outlay of a project is ₹50000 and its generate cash
inflow of profitability ₹20000, ₹15000, ₹25000 and ₹10000 in four
years. Using Profitability index method comment whether the project
is acceptable or not. Assume rate of discount is 10%.
• The initial cash outlay of a project is ₹100,000 and it can generate
cash inflow of ₹40,000, ₹30,000, ₹50,000 and ₹20,000 in 1 year
through 4. Assume a 10 percent rate of discount. Calculate PI
Problems
• Considered the following projects
Projects 0 1 2 3 4
A -1000 600 200 200 1000
B -1000 200 200 600 1000

• If cost of capital is 11 percent calculate the PI.

Acceptance rule
• The following are the PI acceptance rule:
• 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 project’s NPV is negative.
Evaluation of PI method
• Time value: It recognizes the time value of money.

• Value maximization: It is consistent with the shareholder value maximization principle. A

project with PI greater than one will have positive NPV and if accepted, it will increase
shareholders’ wealth.

• Relative profitability: In the PI method, since the present value of cash in-flows is
divided by the initial cashout-flow, it is a relative measure of a project’s 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.
Pay back period
• The pay back sometimes called as pay out or pay off period method
represents the period in which the total investment is permanent
assets pays back itself. The method is based on the principle that
every capital expenditure pays itself back within a certain period out
of the additional earnings generated from the capital assets. Thus, it
measures the period of time for the original cost of a project to be
recovered from the additional earnings of the project itself.
Pay back period
• The pay back period can be ascertained in the following manner:
• 1. Calculate annual net earnings (profit) before depreciation and after
taxes, these are called annual cash inflows.
• 2. Divide the initial outlay (cost) of the project by the annual cash
inflow, where the project generates constant annual cash inflows.
• 3. Where the annual cash inflows (Profit before depreciation and after
taxes) are unequal, the payback period can be found by adding up the
cash inflows until the total is equal to the initial cash outlay of the
project or original cost of the asset.
Problems
• Determine the pay-back period for a project which requires a cash
outlay of ₹ 10,000 and generates cash inflows of ₹ 2,000, ₹ 4000,
₹3,000 and ₹ 2,000 in the first, second, third and fourth year
respectively.
• Suppose that a project requires a cash outlay of ₹ 20,000, and
generates cash inflows of ₹ 8,000, ₹ 7,000, ₹ 4,000 and ₹ 3,000 during
the next 4 years. What is the projects pay back period?
Problems
• There are two projects X and Y. Each projects requires an investment
of ₹20,000. You are required to rank these projects according to the
pay back method and discounted payback period method when
discount rate is 10% from the following information:
Project 1 2 3 4 5
X 1000 2000 4000 5000 8000
Y 2000 4000 6000 8000
Problems
• X Ltd is producing articles mostly by manual labour and is considering
to replace it by a new machine. There are two alternative models M
and N of the new machine. Prepare the statement of profitability
showing the pay-back period and discounted pay back period (when
discount rate is 12%)from the following information
M N
Estimated life of machine 4 years 5 years
Cost of Machine 90000 180000
Estimaed savings in Scrap 5000 8000
Estimated savings in direct wages 60000 80000
Additional cost of Maintenance 8000 10000
Additional cost of supervision 12000 18000
Acceptance rule
• Many firms use the payback period as an investment evaluation
criterion and a method of ranking projects. They compare the
project’s payback with a predetermined, standard payback. 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
payback period.
Evaluation of payback process
• Advantages:
• Simplicity
• Cost effective
• Short-term effects: A company can have more favourable short-run effects on
earnings per share by setting up a shorter standard payback period.
• Risk shield: The risk of the project can be tackled by having a shorter standard
payback period as it may ensure guarantee against loss. A company has to
invest in many projects where the cash inflows and life expectancies are
highly uncertain. In this case payback period is more suitable.
• Liquidity
Evaluation of payback process
• Disadvantages of Payback period
• Cash flows after payback period are not considered
• This methods ignores time value of money
• It does not take into account the cost of the project which is very important
factor in making investment decision.
• It may be difficult to determine the minimum payback period because it is a
subjective matter.
• It does not take into account the discounted cash flow method.
Improvement of the pay-back period method
• For each of the following projects compute (i) pay-back period, (ii)
post-pay back profitability and (iii) post pay-back profitability index
a Initial outlay 50,000
Annual Cash inflow (After tax but before
depriciation) 10,000
Estimated life 8
b Initial outlay
Annual Cash inflow (After tax but before
depriciation)
First three years 15000
Next five years 5000
Estimated life 8
Salvage Value 8000
Problems
• Calculate discounted pay-back period from the information given
below

Cost of the project 600000

Life of the project 6

Annual cash inflow 200000
Discount rate 12%
Account Rate of Return
• Accounting Rate of Return also known as the return on investment,
uses accounting information as revealed by financial statements, to
measure the profitability of the investment.
• ARR= Average income / Average investment

 n 
 PATt  / n
ARR   t 1 
I 0  I n  / 2
Problem
• A project will cost ₹40,000. The projects Profit before Depreciation
and tax for first through five years is expected to be ₹10,000, ₹12,000,
₹14,000, ₹16,000 and ₹20,000. Assume a 50 percent tax rate and
depreciation on straight line basis. Calculate project’s ARR.
Problem
• Calculate the accounting rate of return for project A and B from the
following data. Calculate ARR for A and B. Which project should be
accepted if rate of return is 13%?
Project A Project B
Investment 20000 30000
Expected life (no salvage value) 4 5
Projected net income (after interest, depriciation and taxes)
Years Project A Project B
1 2000 3000
2 1500 3000
3 1500 2000
4 1000 1000
5 1000
Total 6000 10000
• X Ltd. considering the purchase of a machine. Two machines are
available E and F. The cost of each machine is ₹60,000. Each machine
has an expected life of 5 years. Net Profit before tax and after
depreciation during the expected life of the machines are given
below:
Year E F
1 15000 5000
2 20000 15000
3 25000 20000
4 15000 30000
5 10000 20000
Total 85000 90000
• Using Accounting Rate of Return ascertain which of the alternatives
will be more profitable. Average tax rate is 50%.
Evaluation of ARR
• Advantages:
• It is simple to calculate.
• It is accounting information which is readily available and familiar to
businessman.
• Disadvantages:
• It is based upon accounting rate of return not cash flow.
• It doesn’t consider the time value of money.
• The accounting rate of return can be manipulated.
• Accounting rate of return can not provide any guidance on what the target
return.
Problem
• A company is considering an investment proposal to purchase a
machine costing ₹250000. The machine has a life expectancy of 5
years and so salvage value. The company’s tax rate is 40%. The
company uses straight line method for providing depreciation. The
estimated cash flows before tax after depreciation (CFBT) from the
machine are provided.
Year CFBT
1 60000
2 70000
3 90000
4 100000
5 150000
Continued
• Calculate (a) Pay-back period, (b) Accounting rate of return (c) net
present value 10% discount rate and (d) profitability index at 10%
discount rate.
Problem
• A company has an investment opportunity costing ₹40000 with the
following expected net cash-flow after taxes and before depreciation.
Year Net Cash Flow
1 7000
2 7000
3 7000
4 7000
5 7000
6 8000
7 10000
8 15000
9 10000
10 4000
Continued
• Using 10% as the cost of capital, determine the following
• A. Payback period
• B. Net Present value.
• C. Profitability index.
• D. Internal rate of return with the help of 10% and 15% discount
factor.
Problem
• X Ltd. is considering the purchase of a machine. Two machines are
available, E and F. The cost of each machine is ₹60,000. Each machine
has an expected life of 5 years. Net profit before tax (after
depreciation) during the expected life of the machine are given below,
(depreciation on straight line basis) :
Year E F
1 15000 5000
2 20000 15000
3 25000 20000
4 15000 30000
• Tax rate is 50% 5 10000 20000
Continued
• Calculate
• Net present value if the expectation of the investors are 12%
• Internal Rate of Return of the project between 15% and 22%.
• Profitability index if the expectation of the investors are 12%.
• Pay-back period.
• Accounting Rate of Return.
• Discounted pay-back period if the expectation of the investors are 12%.
Problem
• An enterprise can make either of two investments at the beginning of 2008. Assuming
required rate of return of 10% per annum evaluate the investment proposals as under:
• Pay-back period
• Net Present value
• Discounted pay-back period
• Profitability index
• Internal rate of return assume discount rate between 10% and 14%
• The forecast particulars are given below. It is estimated that each of the alternative
projects will require an additional net working capital of Rs. 2000 at the starting of the
project, which will be received back in full after the expiry of each project life.
Depreciation is provided under the straight line method. For NPV calculation consider the
discount factor at 10% and IRR calculation consider the discount factor at 10% and 14%.
• It is estimated that each of the alternative projects will require an
additional net working capital of ₹2000, which will be received back
in full after the expiry of each project life. Depreciation is provided
under the straight line method.
A B
Cost of investment 20000 28000
Life 4 5
Scrap Value from working capital 2000 2000

Net income after depreciation and tax Rs. Rs.

End of 2008 500 0
End of 2009 2000 3400
End of 2010 3500 3400
End of 2011 2500 3400
End of 2012 0 3400
Modified internal rate of return
• Most difficult is to calculate IRR. Hence a modified internal rate of
return has been found out.
• Steps:
• Calculate the present value of all negative cash-flows.
• Calculate the future value of all positive cash-flows.
• Find out a equivalent interest rate
Problem
• Pentagon limited is evaluating a project that has following cash flow
stream associated with it:

Year 0 1 2 3 4 5 6
Cash-flow -120 -80 20 60 80 100 120
• Find out MIRR
Problem
• Phonix company is considering two mutually exclusive investments,
Project X and Project Y. The expected cash flows of these projects are
as follows interest rate is 10%:
Year 0 1 2 3 4 5
Project X -1000 -1200 -600 -250 2000 4000
Project Y -1600 200 400 600 800 100

• Findout the MIRR for each project.

Factors Influencing Capital Expenditure
Decision
• Urgency: Sometimes an investment is to be made due to an urgency for
the survival of the firm or to avoid heavy losses. In such circumstances,
the proper evaluation of the proposal cannot be made through
profitability tests. The examples of such an urgency are breakdown of
some plant and machinery, fire, accident etc.
• Degree of certainty: Probability is directly related to risk, higher the
profits, greater the risks or uncertainty. Sometimes a project with some
lower profitability may be selected due to constant flow of income as
compared to another project with an irregular and uncertain flow of
income.
Continued
• Intangible factors: Sometimes a capital expenditure has to be made due to
certain emotional and intangible factors such as safety and welfare of workers,
prestigious project, social welfare, goodwill of the firm, etc.
• Legal factors: An investment which is required by the provision of law is solely
influenced by this factor and although the project may not be profitable yet
the investment has to be made.
• Availability of the funds: As the capital expenditure, generally, requires large
funds, the availability of funds is an important factor that influences the
capital budgeting decisions. A project howsoever profitable may not be taken
for want of funds and a project with a lesser profitability may be sometimes
preferred due to lesser pay-back period for want of liquidity.
Continued
• Future earnings: A project may not be profitable as compared to another day, but it
may promise better future earnings. In such cases it may be preferred to increase
earnings.
• Obsolescence: There are certain projects which have greater risk of obsolescence
than others. In case of projects with high rate of obsolescence, the project with a
lesser pay –back period may be preferred than one which may have higher
profitability but still longer pay-back period.
• Research and development projects: It is necessary for the long-term survival of the
business to invest in R&D project though it may not look to be profitable investment.
• Cost consideration: Cost of capital project, cost of production, opportunity cost of
capital etc. are other consideration involved in the capital budgeting decision.
Risk and uncertainty in capital budgeting
• Expected economic life of the project
• Salvage value of the asset at the end of the economic life
• Capacity of the project
• Selling price of the project
• Production cost
• Depreciation rate
• Rate of taxation
• Future demand of the product