Capital Budgeting

Capital Budgeting
Net Present value

• The net present value method uses a specified
discount rate to bring all subsequent net cash
inflows after the initial investment to their present
values (the time of the initial investment is year 0).
• Net present value =
Present value of net cash inflow - Initial investment
Decision Rule:
• If NPV ≥ 0 Accept the Proposal
• If NPV ≤ 0 Reject the Proposal
Compute the net present value for a project with
a net investment of 1, 00,000 and net cash
flows year one is 55,000, for year two is
80,000 and for year three is ` 15,000.Further,
the company’s cost of capital is 10%?
• ABC Ltd is a small company that is currently analyzing
capital expenditure proposals for the purchase of
equipment; the company uses the net present value
technique to evaluate projects. The capital budget is limited
to 500,000 which ABC Ltd believes is the maximum
capital it can raise. The initial investment and projected net
cash flows for each project are shown below. The cost of
capital of ABC Ltd is 12%.
You are required to compute the NPV of the different projects.

Profitability Index
• Profitability Index (PI):
Present Value of cash Inflows
Present Value of Cash Outflows
• Decision Rule:
If PI ≥ 1 Accept the Proposal
If PI ≤ 1 Reject the Proposal
• In case of mutually exclusive projects; project
with higher PI should be selected
• Suppose we have three projects involving
discounted cash outflow of 5,50,000, 75,000
and 1,00,20,000 respectively. Suppose further
that the sum of discounted cash inflows for
these projects are 6,50,000, 95,000 and
1,00,30,000 respectively.
Calculate the profitability Index for three
projects.
• http://www.retailinvestor.org/pdf/futurevalue
tables.pdf
Internal Rate of Return
• The internal rate of return is a discount rate that

makes the net present value (NPV) of all cash flows
from a particular project equal to zero.
• The higher the IRR on a project, and the greater the
amount by which it exceeds the cost of capital,
the higher the net cash flows to the company.
• A company may also prefer a larger project with
a lower IRR to a much smaller project with a higher
IRR because of the higher cash flows generated by the
larger project
Steps in IRR Calculation
• Step 1 : Compute approximate payback period
also called fake payback period.
• Step 2 : Locate this value in PVAF table
corresponding to period of life of the project.
• The value may be falling between two
discounting rates.
• Step 3 : Discount cash flows using these two
discounting rates.
• Step 4 : Use following Interpolation Formula:
Formula for IRR
• IRR= PVLDF - COI
LDF + ----------------- * (HDF-LDF)
PVLDF- PVHDF
• LDF = Lower Discounting Factor.

• HDF = Higher Discounting Factor.
• PVLDF= Present value of Cash Flows at LDF.
• PVHDF = Present value of Cash Flows at HDF.
• COI= Cost of Investment.
• Accept/ Reject
IF IRR > Cost of Capita- Accept
IF IRR< Cost of Capital- Reject
Calculate the internal rate of return of an investment of
Rs.1,36,000 which yields the following cash inflows:
Year Cash Inflows Cash Inflows
(Rs.) (Rs.)
1 30000
2 40000
3 60000
4 30000
5 20000
• Step:1 Fake Payback Period =
Cost of investment/ Average Cash Inflows
136000
36000 = 3.77 years
The calculated is between 10% and 11%
Then LDF=10% and HDF 11%
Average Cash Inflows = 30000+40000+60000+30000+20000

5 = 36000
Calculation of PVLDF @10
Discount Factor
Years Cash Inflows @10% PVHDF
1 30000 0.909 27270
2 40000 0.826 33040
3 60000 0.751 45060
4 30000 0.683 20490
5 20000 0.623 12460
138320
Calculation of PVLDF @11%
Discount Factor
Years Cash Inflows @11% PVHDF
1 30000 0.909 27000
2 40000 0.811 32440
3 60000 0.731 43860
4 30000 0.658 19740
5 20000 0.593 11860
134900
IRR = 10% + 138320-136000
---------------------- * 11-10
138320- 134900
IRR= 10. 67%.
Problem
• Suppose there are two Projects A and Project B are under
consideration with a cost of capital of 10%. Which project will
you accept as NPV and IRR. The cash flows associated with
these projects are as follows:
Year Project A (Rs.) Project B (Rs.)

0 (100000) (300000)
1 50000 140000
2 60000 190000
3 40000 100000
Suppose ABC Ltd. is considering two Project X and Project Y for
investment whose cost of Capital is 10%. Which project will
you accept as per NPV and IRR Method. The cash flows
associated with these projects are as follows:
Year Project X (Rs.) Project Y (Rs.)

0 (250000) (300000)
1 200000 50000
2 100000 100000
3 50000 300000

Capital Budgeting

Uploaded by

Copyright:

Available Formats

Capital Budgeting

Uploaded by

Document Information

Original Description:

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

Uploaded by

Copyright:

Available Formats

Capital Budgeting

Net Present value

You are required to compute the NPV of the different projects.

• The internal rate of return is a discount rate that

• LDF = Lower Discounting Factor.

Then LDF=10% and HDF 11%

Average Cash Inflows = 30000+40000+60000+30000+20000

1 30000 0.909 27270

2 40000 0.826 33040

3 60000 0.751 45060

4 30000 0.683 20490

5 20000 0.623 12460

1 30000 0.909 27000

2 40000 0.811 32440

3 60000 0.731 43860

4 30000 0.658 19740

5 20000 0.593 11860

Year Project A (Rs.) Project B (Rs.)

Year Project X (Rs.) Project Y (Rs.)

You might also like

Pfad - The Proxy pFad of © 2024 Garber Painting. All rights reserved.