CAPITAL BUDGETING

Net Present Value and Other

Investment Rules
 The Finance function

(1a) Raise
Funds
Financial
Financial
Operations
Operations Markets
Markets
(Plant,
(Plant, (2) Investment (Investors)
Financial (Investors)
Equipment,
Equipment, Manager (1b) (Stocks,
Projects,
Projects,etc.)
etc.) Debt)

(3) Cash from (4) Reinvest

Operations

(5) Dividends or
Interest Payments

The finance function manages the cash flow

 The Finance function

Finance focuses on these two decisions

Financial
Financial
Operations
Operations Investment Financial
Financial Financing Markets
Markets
Decision Manager
Manager Decision

How much to Where is the

invest and in money going to
what assets? come from?
Capital Budgeting
 The Finance function

By making investing and financing decisions, the financial manager is

attempting to achieve the following objective:

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 Issues in capital Budgeting

• Investment

How should capital be allocated?

» Do I invest / launch a product / buy a building / scrap /
outsource...
» Should I acquire / sell / accept offer for company or division?
Which choices should I make?
» make or buy
» which distribution channel
 Investment and Returns

• The fundamental evaluation issue in dealing with a long-

term asset is whether its future benefits justify its initial
cost.

• Investment is the monetary value of the assets the

organization gives up to acquire a long-term asset.

• Return is the increased future cash inflows attributable to

the long-term asset
– Investment and return form the foundation of capital
budgeting analysis, which focuses on whether the
expected increased cash flows (return) will justify the
investment in the long-term asset
 Time value of money
• Time value of money (TVM) is a central concept in capital
budgeting.

• Because money can earn a return:

– Its value depends on when it is received
– Using money has a cost
• The lost opportunity to invest the money in another
investment alternative.

• In making investment decisions, the problem is that

investment cash is paid out now, but the cash return is
received in the future
– We need an equivalent basis to compare the cash flows
that occur at different points in time
 Time value of money

• Because money has a time-dated value, the critical

idea underlying capital budgeting is:

Amounts of money spent or received at different periods of

time must be converted into their value on a common date
in order to be compared
 Choosing a common date

• An investment’s cash flows must be converted to their

equivalent value at some common date in order to make
meaningful comparisons between the project’s cash
inflows and outflows.

• Although any point in time can be chosen as the common

date, the conventional choice is the point when the
investment is undertaken.
– Analysts call this time zero, or period zero

• Therefore, conventional capital budgeting analysis

converts all future cash flows to their equivalent value at
time zero
 Cost of Capital

• The cost of capital is the interest rate used for discounting

future cash flows
– Also known as the discount rate.
The organization’s cost of capital reflects:
– The amount and cost of debt and equity in its financial
structure
– The financial market’s perception of the financial risk of
the organization’s activities
• The cost of capital is the return the organization must earn
on its investment to meet its investors’ return
requirements.
 Capital Budgeting

• Capital budgeting is the collection of tools that

planners use to evaluate the desirability of acquiring
long-term assets.
• Organizations have developed many approaches to
capital budgeting.
• Six approaches are discussed here:
Payback  Internal rate of return
Net present value  Profitability index
Discounted Payback  Accounting rate of return
 Consider the following project?

• Initial outlay- Rs. 228,000

• Cash flows
• Year 1 59.00
• 2 122.60
• 3 62.20
• 4 58.50
• 5 16.92
• 6 14.38
Shall we go ahead with the project?
The cost of capital is 10% ( the discount rate)
 Pay back method..calculation
• Year cash flows Cumulative cash flows
• (Rs. 000s) (Rs. 000s)
• 1 59.0 59.0
• 2 122.6 181.6
• 3 62.2 243.8
• 4 58.5 302.3
• 5 16.92 319.22
• 6 14.38 333.60
• Period taken to generate the amount needed (Initial investment of Rs. 2, 28,000)
• Initial investment 228,000 Thus, 46.4 X 12 MONTHS
• - year 2 cumulative 181,600 62.2
• 46,4000 =8.95 ~ 9 MONTHS
• The pay back period is 2 years and 9 months.
 Payback criterion
• The payback period is the number of periods needed to
recover a project’s initial investment
– Project’s initial investment of Rs. 228,000 is recovered
midway between years 2 and 3
» The payback period for this project is 2 years and 9
months
• Many people consider the payback period to be a measure of
the project’s risk
– The organization has unrecovered investment during the
payback period
– The longer the payback period, the higher the risk
– Organizations compare a project’s payback period with a
target that reflects the organization’s acceptable level of
risk
 Problem with payback

• The payback criterion has two problems:

– It ignores the time value of money
– It ignores the cash outflows that occur after the initial
investment and the cash inflows that occur after the payback
period
• Despite these limitations, some surveys show that the payback
calculation is the most used approach by organizations for
capital budgeting.
This popularity may reflect other considerations, such as
bonuses that reward managers based on current profits,
that create a preoccupation with short-run performance
 Net Present value
• The net present value (NPV) is the sum of the present values of a project’s
cash flows
– This is the first method considered that incorporates the time value of
money
– Also called the discounted cash flow method
• Year cash flows cash flows Present value
• (Rs. 000s) 10% discount rate PV(Rs.000s)
• 1 59.0 .909 53.63
• 2 122.6 .826 101.27
• 3 62.2 .751 46.71
• 4 58.5 .683 39.96
• 5 16.92 .621 10.51
• 6 14.38 .564 8.11
260.19
NPV >0 ,accept less initial cost 228.00
NPV< 0 , reject NPV 32.19
 Discounted Pay back

Some organizations use the discounted payback method,

which computes the payback period but uses discounted
cash flows

• Initial investment 2,28,000

• Less present value of cash 2,01,610
flows to end of year 3
generated in year 4 26,390

26,390 X 12 months = 7.92 ~ 8 months

39.96
The discounted pay back is 3 years and 8 months
 Internal rate of return

As the discount rate increases, the PV of future cash flows is lower

and the NPV is reduced
Example: NPV
NPVand
anddicount
dicountrate
rate
50
50
40
40
30
30 IRR: Discount rate at
(Rs.)

20 which the project has a

NPV(Rs.)

20
10
10 NPV of zero
NPV

0
0
-10
-10
-20
-20
-30
-30
Discount Rate (%)
Discount Rate (%)

Internal rate of return (IRR) is the discount rate that sets the NPV to
zero
 Internal rate of return

YEAR CAH FLOW DISC. RATE PV

Rs. 000s 20% Rs. 000s
1 59 0.833 49.15
2 122.6 0.694 85.08
3 62.2 0.579 36.01
4 58 0.482 28.2
5 16.92 0.402 6.8
6 14.38 0.335 4.82
– 210.06
less initial
investment 228
NPV -17.94
 IRR…contd.

• IRR= 10% + 32, 190 X 10

• 50, 130
• = 10% + 6.42%
• = 16.42%
• This is the actual return the project is earning!

• Decision Rule: Accept the project if

IRR > Opportunity Cost of Capital

 NPV vs. IRR

– Situation I: Mutually exclusive projects

A B C
NPV (Rs.) 4,252 6,378 -467
IRR (%) 19.3 19.3 13.5
PI 1.1 1.1 0.99
Payback period 2.5 2.5 2.9
ARR (%) 25 25 18

– Few Observations
– IRR is same for a and B
– NPV is higher in case of B
– NPV is recommended when assessing mutually exclusive projects of
different scale
– IRR ignores the scale of the project (weakness)
 NPV vs. IRR

– Situation II: Variable Discount Rates

– It is not appropriate to discount cash flows at a constant

rate of return throughout a project’s life

– NPV – Discount rates can be set for each period

– IRR– can not handle variable rates as it is compared
against a single required rate of return
 NPV vs. IRR

– Situation III: Unconventional cash flows

Cash flow
Type pattern Example
conventional (outflow) capital project
inflow
inflow
inflow

Reverse Inflow Loan (borrowings)

(outflow)
(outflow)
(outflow)

Two stage developmental

Unconventional (outflow) project
inflow
(outflow)
inflow
 NPV vs. IRR

– Situation III: Unconventional cash flows

At 10% NPV =0
At 20% NPV=0
At 30%, NPV =0
………

– This is a case of multiple IRRs..

 Profitability Index

• The profitability index is a variation of the net present

value method.

• It is used to make comparisons of mutually exclusive

projects with different sizes and is computed by
dividing the present value of the cash inflows by the
present value of the cash outflows.

• A profitability index of 1 or greater is required for the

project to be acceptable
 Profitability Index

• Therefore, the profitability index for that project was 1.14

= 260,190/228,000.

• It is possible for one project to have a higher profitability

index while another project has a higher NPV
– An organization must determine how to choose when
the criteria give conflicting results
 Accounting rate of return

• Analysts compute the accounting rate of return by

dividing the average accounting income by the average
level of investment.

• Analysts use the accounting rate of return to approximate

the return on investment
 Accounting rate of return
Accounting
YEAR CAH FLOW Depreciation profit
(in Th. Rs.) Rs. Rs. 000s
1 59 38 21.00
2 122.6 38 84.60
3 62.2 38 24.20
4 58 38 20.00
5 16.92 38 -21.08
6 14.38 38 -23.62
– 105.10

•AVG profit :17.52 ( in th. Rs.)

•AVG capital employed:228/2
•ARR=(Average accounting profit/ Average capital employed) X 100
=17.52/114
=15.37%
 Accounting rate of return

• If the accounting rate of return exceeds the target rate of

return, then the project is acceptable.

• Like the payback method the accounting rate of return

method has a drawback:
– By averaging, it does not consider the timing of cash
flows.

• This method is an improvement over the payback method

in that it considers cash flows in all periods
 Problem

• A manufacturer of sports equipment is considering whether to

invest in one of the two automated processes, the Lara or
Carling, both of which give rise to staffing and other cost savings.
Relevant data is as follows:
• Lara Carling
• Investment outlay (40,000) (50,000)
• Year 1 annual savings 16,000 17,000
• Year 2 annual savings 16,000 17,000
• Year 3 annual savings 16,000 17,000
• Year 4 annual savings 12,000 17,000
• Should the company invest in either of the two proposals and if so
, which is preferable?
 Answer

• Lara Carling
• NPV 4,252 (467)
• IRR 19.3 13.5
• PI 1.1 .99
• Payback 2.5 2.9
• Acc rate of ret. 25 18
 Survey conducted on BT 500
( 500 Most valuable companies: Business Today)

Results of the study:

study
• IRR most popular (4.36)
• Payback also popular (3.79)
• NPV (3.73)
• Large firms are more likely to use NPV than small firms.
• Small firms are more likely to use Pay back than large firms
• High growth firms are more likely to use to use IRR than the
low growth firms.
• The firms use DCF methodology for capital budgeting
decisions today more than the previous times.