Capital Budgeting

Payback Period
A project’s payback period is the number of years its
takes for a project’s net cash flows to pay back the net
investment. Shorter paybacks are better than longer
paybacks.

It is the time required for a firm to recover its original

investment.
 FORMULA: Payback Period
Payback period tells how long it will take a
project to break even.

Payback period
= Original investment ÷ Annual cash flows
= Rs.1,000,000 / Rs.500,000
= 2 years

3
 Payback Period
• Suppose a project has a Rs.200,000 net
investment and net cash flows (NCFs) of
Rs.70,000 annually for 7 years. What is the
payback?

– In 3 years, the project will generate a total of

Rs.200,000 from net cash flows. Therefore, the
payback must be a little less than 3 years. It is
more precisely:

Rs.200,000
Payback Period   2.86 Years
Rs.70,000
Example 1:
Due to increased demand, the management of Rani Beverage Company is considering to
purchase a new equipment to increase the production and revenues. The useful life of the
equipment is 10 years and the company’s maximum desired payback period is 4 years. The
inflow and outflow of cash associated with the new equipment is given below:

The initial cost of equipment $37,500

Annual cash inflow:
Sales $75,000
Annual cash outflow:
Cost of ingredients $45,000
Salaries expenses $13,500
Maintenance expenses $1,500
Non cash expenses:
Depreciation $5,000

Required: Should Rani Beverage Company purchase the new equipment? Use payback method
for your answer.
Step 1: In order to compute the payback period of the equipment, we need to workout the net
annual cash inflow by deducting the total of cash outflow from the total of cash inflow associated
with the equipment.

Computation of net annual cash inflow:

$75,000 – ($45,000 + $13,500 + $1,500)

= $15,000

Step 2: Now, the amount of investment required to purchase the equipment would be divided by
the amount of net annual cash inflow (computed in step 1) to find the payback period of the
equipment.

= $37,500/$15,000

=2.5 years

Depreciation is a non cash expense and therefore has been ignored.

According to payback method, the equipment should be purchased because the payback period
of the equipment is 2.5 years which is shorter than the maximum desired payback period of the
Example 2:
The management of Health Supplement Inc. wants to reduce its labor cost by installing a new
machine. Two types of machines are available in the market – machine X and machine Y.
Machine X would cost $18,000 where as machine Y would cost $15,000. Both the machines can
reduce annual labor cost by $3,000.

Required: Which is the best machine to purchase according to payback method?

Solution:

Machine X Machine Y
Cost of machine (a) $18,000 $15,000
Annual cost saving (b) $3,000 $3,000
Payback period (a)/(b) 6 years 5 years

According to payback method, machine Y is more desirable than machine X because it has a
shorter payback period than machine X.
Payback method and uneven cash flow:
In the above examples we have assumed that the projects generate even cash inflow (same cash
inflow during each period) but when projects generate uneven cash inflow (different cash inflow
in different periods), the payback period formula given above cannot be used to compute
payback period.

Example 3:
An investment of $200,000 is expected to generate the following cash flows in six years:

Year Net cash flow

1 $30,000
2 $40,000
3 $60,000
4 $70,000
5 $55,000
6 $45,000

Required: Compute payback period of the investment. Should the investment be made if
management wants to recover the initial investment in 3 years or less?
Solution:

(1). Because the cash inflow is uneven, the payback period formula cannot be used to compute
the payback period. We can compute the payback period by computing the cumulative net cash
flow as follows:

Net cash Cumulative net

Year
flow cash inflow
1 $30,000 $30,000
2 $40,000 $70,000
3 $60,000 $130,000
4 $70,000 $200,000
5 $55,000 $255,000
6 $45,000 $300,000

Payback period is 4 years because the cumulative cash flow at the end of 4th year becomes equal
to initial amount of investment.

(2). As the payback period is longer than the maximum desired payback period of the
management (3 years), the investment should not be made.
The calculation of the Payback Period is best illustrated with an example. Consider Capital
Budgeting project A which yields the following cash flows over its five year life.

Cash
Year
Flow
0 -1000
1 500
2 400
3 200
4 200
5 100
To begin the calculation of the Payback Period for project A let's add an additional column to the
above table which represents the Net Cash Flow (NCF) for the project in each year.

Cash Net Cash

Year
Flow Flow
0 -1000 -1000
1 500 -500
2 400 -100
3 200 100
4 200 300
5 100 400

Notice that after two years the Net Cash Flow is negative (-1000 + 500 + 400 = -100) while after
three years the Net Cash Flow is positive (-1000 + 500 + 400 + 200 = 100). Thus the Payback
Period, or breakeven point, occurs sometime during the third year. If we assume that the cash
flows occur regularly over the course of the year, the Payback Period can be computed using the
following equation:
Thus, the Payback Period for project A can be computed as follows:

Payback Period
Payback Period = 2 + (100)/(200) = 2.5 years

Thus, the project will recoup its initial investment in 2.5 years.
Advantages and disadvantages of payback method:
Advantages:

1. An investment project with a short payback period promises the quick inflow of cash. It
is therefore, a useful capital budgeting method for cash poor firms.
2. A project with short payback period can improve the liquidity position of the business
quickly. The payback period is important for the firms for which liquidity is very
important.
3. An investment with short payback period makes the funds available soon to invest in
another project.
4. A short payback period reduces the risk of loss caused by changing economic conditions
and other unavoidable reasons.
5. Payback period is very easy to compute.

Disadvantages:

1. The payback method does not take into account the time value of money.
2. It does not consider the useful life of the assets and inflow of cash after payback period.
For example, If two projects, project A and project B require an initial investment of
$5,000. Project A generates an annual cash inflow of $1,000 for 5 years whereas project
B generates a cash inflow of $1,000 for 7 years. It is clear that the project B is more
profitable than project A. But according to payback method, both the projects are equally
desirable because both have a payback period of 5 years ($5,000/$1,000).
 Discounted Payback Period - DPP
• This improves upon the payback period by taking
into account the time value of money.

• A project’s discounted payback period is the

number of years it takes for the net cash flows’
present values to pay back the net investment.

• Again, shorter paybacks are better than longer

paybacks
 Discounted Payback Period
• Compute the discounted payback period
(DPP) using the same example. We will need
a required rate of return for the computation.
Let’s use 10%.

• The following table is used to compute the

project’s DPP.
 Year Cash Flow PV of Cash Flow Cumulative

0 -Rs.200,000 -Rs.200,000 -Rs.200,000

1 Rs.70,000 Rs.63,636 -Rs.236,364
2 Rs.70,000 Rs.57,851 -Rs.78,513
3 Rs.70,000 Rs.52,592 -Rs.25,921
4 Rs.70,000 Rs.47,811
5 Rs.70,000 Rs.43,464

After 3 years there is still Rs.25,921 that has not been

paid back by the present value of the net cash flows.
 Discounted Payback Period
• The DPP will be 3 years plus whatever
proportion of year 4 is needed to pay back the
final Rs.25,921.

• The discounted payback is 3.54 years. This

project recovers its net investment in 3.54 years
when considering the time value of money.
 Discounted Payback Period Calculation
Period Cash Flow Cost of Funds Cumulative
(15%)* Cash Flow
0 -$85,000 0 -Rs.85,000

1 15,000 -Rs.85,000(0.15) = -12,750 -82,750

2 25,000 -Rs.82,750(0.15) = -12,413 -70,163

3 35,000 -Rs.70,163(0.15) = -10,524 -45,687

4 45,000 -Rs.45,687(0.15) =-6,853 -7,540

5 45,000 -Rs.7,540(0.15) = -1,131 36,329

6 35,000 Rs.36,329(0.15) = 5,449 76,778

Illustration of Discounted Payback Period
 Summary
Payback periods can be used as a screening tool for
liquidity, but we need a measure of investment worth for
profitability.
 Accounting Rate of Return (ARR)

# The ARR is a method of appraising a project by

estimating the accounting rate of return that the
project should generate.

# If the accounting rate of return is greater than the

required rate of return, the project may be
accepted.

# The higher the rate of return, the higher the project

would be ranked.
 ARR – Formula

Average Net Income/Pro fit

ARR = x 100
Average Investment /Average Book Value

Total accounting profit over the investment period

Average Profit =
Years of Investment

Initial investment + Scrap Value + Working Capital

Average Book Value =
2
 Net Present Value
NPV is the sum of the present values of the net cash flows
minus the net investment. The cash flows are discounted at
a project’s required rate of return.
 NPV Acceptance rules are:
Accept if NPV > 0
This means that the cash inflows from a project will
yield a return in excess of the cost of capital

Reject if NPV < 0

This means that the cash inflows from a project will
yield a return below the cost of capital

May Accept if NPV = 0

This means that the cash inflows from a project will yield a
return which is exactly the same as the cost of capitalNPV
is a direct measure of how well this project will meet the goal of
increasing shareholder wealth.
The Net Present Value Method:
Summary
 Rationale for the NPV Method
• NPV = PV inflows – Cost
NPV=0 → Project’s inflows are “exactly sufficient
to repay the invested capital and provide the
required rate of return”

• NPV = net gain in shareholder wealth

• Rule: Accept project if NPV > 0

NPV is a direct measure of how well this project
will meet the goal of increasing shareholder
wealth.
 Internal Rate of Return

• An internal rate of return (IRR) is a project’s true

annual percentage rate of return based upon the
estimated cash flows.

• IRR can also be defined as the interest rate causing

a project’s NPV to be equal to zero.

• IRR is the rate of return that equates the present

value of future cash flows to the investment
outlay.
 Internal Rate of Return
A project is:

– Acceptable if the IRR > required rate of

return.

– Unacceptable if the IRR < required rate of

return.
The Internal Rate of Return Method:
Summary
 IRR Calculation Formula
C
IRR = A +{ x B – A} %
C-D

Where:
A is the rate of return with a positive NPV
B is the rate of return with a negative NPV
C is the amount of the positive NPV
D is the amount of the negative NPV
 Example of Mutually Exclusive
Projects

Period Project Project The required return for

A B both projects is 10%.
0 -500 -400 Which project should you
accept and why?
1 325 325
2 325 200
IRR 19.43 22.17
% %
NPV 64.05 60.74
 Conflicts Between NPV and
IRR
• NPV directly measures the increase in value to the
firm

• Whenever there is a conflict between NPV and

another decision rule, always use NPV

• IRR is unreliable in the following situations:

– Non-conventional cash flows
– Mutually exclusive projects
NPV and IRR always lead to the 11same
- 43
accept/reject decision for independent
projects:

NPV (Rs.)
IRR > r r > IRR
and NPV > 0 and NPV < 0.
Accept. Reject.

r (%)
IRR
 Net-Present-Value Method
Mattson Co. has been offered a five year contract to
provide component parts for a large manufacturer.

Cost and revenue information

Cost of special equipment $160,000
Working capital required 100,000
Relining equipment in 3 years 30,000
Salvage value of equipment in 5 years 5,000
Annual cash revenue and costs:
Sales revenue from parts 750,000
Cost of parts sold 400,000
Salaries, shipping, etc. 270,000

16-44
 Net-Present-Value Method
• At the end of five years the working capital
will be released and may be used elsewhere
by Mattson.
• Mattson uses a discount rate of 10%.

Should the contract be accepted?

16-45
 Net-Present-Value Method
Annual net cash inflows from operations

Sales revenue $ 750,000

Cost of parts sold 400,000
Gross margin 350,000
Less out-of-pocket costs 270,000
Annual net cash inflows $ 80,000

16-46
 Net-Present-Value Method
Cash 10% Present
Years Flows Factor Value
Investment in equipment Now $(160,000) 1.000 $ (160,000)
Working capital needed Now (100,000) 1.000 (100,000)
Annual net cash inflows 1-5 80,000 3.791 303,280
Relining of equipment 3 (30,000) 0.751 (22,530)
Salvage value of equip. 5 5,000 0.621 3,105
Working capital released 5 100,000 0.621 62,100
Net present value $ 85,955

Mattson should accept the contract because the

present value of the cash inflows exceeds the present
value of the cash outflows by $85,955. The project
has a positive net present value.

16-47
 Profitability Index

Profitability Index (PI)

It is the ratio of the present value of cash inflows (at the rate of return) to the initial cash
outflows of the investment.

PV of Cash inflow
PI =
Initial Cash outlay

PI Acceptance rules are:

Accept if PI > 1
Reject if PI < 1
May Accept if PI = 1
 Profitability Index
• A project’s PI is the sum of the present values of
the net cash flows divided by the net investment.

• A PI greater than 1.0 indicates a project is

acceptable.

• A PI less than 1.0 indicates a project is not

acceptable.

• The PI is most useful when a firm is facing

capital rationing. The PI indicates which projects
generate the greatest NPV per dollar invested.
 Often used for government or other non-for-
profit investments.

 Measures the benefit per unit cost, based on the

time value of money.

 A profitability index of 1.2 suggests that for

every Rs.1 of initial investment, we create an
additional Rs.0.20 in value.
Project PI
 Capital Budgeting Methods Pros and Cons

• Payback Period

– A measure of liquidity and risk

– Does not take into account the time value of

money

– No information on project profitability

 Capital Budgeting Methods Pros and Cons

• Discounted Payback

– A better measure of liquidity and risk than the

ordinary payback period

– Does take into account the time value of money

– Provides an objective criterion for normal

projects: DPP < economic life
 Capital Budgeting Methods Pros and Cons
• Net Present Value

– Best measure of project profitability.

– Does not provide much information about

project risk.

– Is consistent with maximizing firm value.

 Capital Budgeting Methods Pros and Cons

• Profitability Index

– A relative measure of profitability

– Provides some information about project risk

– May not rank mutually exclusive projects

correctly
 Capital Budgeting Methods Pros and Cons

Internal Rate of Return

– A relative measure of profitability

– Provides some information about project risk

– May not rank mutually exclusive projects

correctly
 Income Taxes in Capital Budgeting: After-Tax Cost

A cash expense net of its tax effect is known as

an after-tax cost.

EXAMPLE: Suppose a company puts on a

training program that costs $40,000. What is the
after-tax cost of the training program?
 Income Taxes in Capital Budgeting: After-Tax Cost
No With
Training Training
Program Program
Sales ........................................................... $250,000 $250,000
Less expenses:
Salaries, insurance, other ........................... 150,000 150,000
Training program ....................................... 0 40,000
Total expenses ............................................. 150,000 190,000
Taxable income ............................................ $100,000 $ 60,000
Income taxes (30%)..................................... $ 30,000 $ 18,000
Before-tax cost of the training program .............. $40,000
Less reduction in taxes ($30,000 – $18,000) ....... 12,000
After-tax cost of the training program................. $28,000

The following formula shows the after-tax cost of a tax-deductible cash expense:
After-tax cost = (1 – Tax rate) × Cash expense
= (1 – 0.30) × $40,000
= $28,000
 Income Taxes in Capital Budgeting: After-Tax Benefit

• A cash receipt net of its tax effects is known as

an after-tax benefit. The formula to compute
the after-tax benefit from any taxable cash
receipt is:
After-tax benefit = (1 – Tax rate) × Cash receipt
• EXAMPLE: A company receives Rs.80,000 per
year from subleasing part of its office space. If
the tax rate is 30%, what is the after-tax
benefit?
After-tax benefit = (1 – 0.30) × Rs.80,000 = Rs.56,000
Income Taxes in Capital Budgeting: After-Tax Benefit

Tax-deductible cash expenses can be deducted from taxable cash receipts

and the difference multiplied by (1 – Tax rate) to find the net after-tax
cash flow.

EXAMPLE: A Company can invest in a project that would provide cash

receipts of $400,000 per year. Cash operating expenses would be
$280,000 per year. If the tax rate is 30%, what is the after-tax net cash
inflow each year from the project?

Annual cash receipts ............................ $400,000

Annual cash operating expenses ........... 280,000
Annual net cash inflow before taxes...... $120,000
Multiply by (1 – 0.30)........................... × 0.70
Annual after-tax net cash inflow ........... $ 84,000
 Depreciation Tax Shield
• Although depreciation is not a cash flow, it does have an
impact on income taxes. Depreciation deductions shield
revenues from taxation (called a depreciation tax shield)
and thereby reduce tax payments.
• EXAMPLE: Consider the impact of a $60,000 depreciation
expense on a company’s income taxes:

Without With
Depreciation Depreciation
Deduction Deduction
Sales.................................... $500,000 $500,000
Less expenses:
Cash operating expenses .... 340,000 340,000
Depreciation expense ......... 60,000
Total expenses ..................... 340,000 400,000
Taxable income .................... $160,000 $100,000
Income taxes (30%) ............. $ 48,000 $ 30,000
 Depreciation Tax Shield
The depreciation deduction reduces the company’s
income taxes by $18,000.

The tax savings provided by the depreciation tax

shield can be computed using the following formula:

Tax savings = Tax rate × Depreciation deduction

= 0.30 × $60,000
= $18,000
Considering “Soft” Benefits In
Investment Decisions
1. “Soft” Benefits not directly related to
NPV or IRR.
2. Hard to quantify.
3. Includes indirect benefits to:
a. Future sales.
b. Firm reputation.
c. Derivative products.
Calculating the Value of Soft
Benefits Required To Make an
Investment Acceptable
Needed present value = Discount factor x
Value of benefits

Value of Benefits: Needed Present Value

Discount Factor
• Negombo Foods Corporation (NFC) currently processes
seafood with a unit purchased several years ago.
Current book value of the unit, which originally cost
Rs.500, 000/-, is Rs.250, 000/-. NFC is considering
replacing the existing unit with a newer, more efficient
one. The new unit will cost Rs.700, 000/- and will
require an additional Rs.50, 000/- for delivery and
installation.

• The new unit will also require NFC to increase its

investment in initial net working capital by Rs.40, 000/-.
The new unit will be depreciated on a straight-line basis
over five years to a zero balance. NFC expects to sell
the existing unit for Rs.275, 000/-. NFC’s tax rate is 40%.
You are required to calculate the project’s net
investment.