CAPITAL BUDGETING

CHAPTER 3
LEARNING OBJECTIVES
 Understand the nature and importance of investment decisions
 Explain the methods of calculating net present value (NPV)
and internal rate of return (IRR)
 Show the implications of net present value (NPV) and
internal rate of return (IRR)
 Describe the non-DCF evaluation criteria: payback and
accounting rate of return
 Illustrate the computation of the discounted payback
 Compare and contrast NPV and IRR and emphasize the
superiority of NPV rule
Nature of Investment Decisions
 The investment decisions of a firm are generally known as the
capital budgeting, or capital expenditure decisions.

 The firm’s investment decisions would generally include

expansion, acquisition, modernisation and replacement of the
long-term assets. Sale of a division or business (divestment) is also
as an investment decision.

 Decisions like the change in the methods of sales distribution, or

an advertisement campaign or a research and development
programme have long-term implications for the firm’s
expenditures and benefits, and therefore, they should also be
evaluated as investment decisions.
Features of Investment Decisions
 The exchange of current funds for future benefits.

 The funds are invested in long-term assets.

 The future benefits will occur to the firm over a

series of years.
Importance of Investment Decisions
 Growth  

 Risk 

 Funding  

 Irreversibility

 Complexity  
Types of Investment Decisions
 One classification is as follows:
  Expansion of existing business
  Expansion of new business
  Replacement and modernisation
 Yetanother useful way to classify investments is as
follows:
  Mutually exclusive investments
  Independent investments
  Contingent investments
Investment Evaluation Criteria
 Threesteps are involved in the evaluation of an
investment:
1. Estimation of cash flows
2. Estimation of the required rate of return (the
opportunity cost of capital)
3. Application of a decision rule for making the choice
 Investment Decision Rule
 It should maximise 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 recognise 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 maximises the shareholders’ wealth.
 It should be a criterion which is applicable to any conceivable
investment project independent of others.
Evaluation Criteria
 1. Non-discounted Cash Flow Criteria
   Payback Period (PB)
   Discounted payback period (DPB)
   Accounting Rate of Return (ARR)
 2. Discounted Cash Flow (DCF) Criteria
   Net Present Value (NPV)
   Internal Rate of Return (IRR)
   Profitability Index (PI)
Net Present Value Method
 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 outflows from present value of cash inflows. The
project should be accepted if NPV is positive (i.e., NPV > 0).
 Net Present Value Method

 The formula for the net present value can be written

as follows:
 C1 C2 C3 Cn 
NPV    2
 3
 n   C0
 (1  k ) (1  k ) (1  k ) (1  k ) 
n
Ct
NPV   t
 C0
t 1 (1  k )
Calculating Net Present Value
 Assume that Project X costs Rs 2,500 now and is expected to
generate year-end cash inflows of Rs 900, Rs 800, Rs 700, Rs
600 and Rs 500 in years 1 through 5. The opportunity cost of
the capital may be assumed to be 10 per cent.
Why is NPV Important?
 Positive net present value of an investment represents the maximum
amount a firm would be ready to pay for purchasing the opportunity
of making investment, or the amount at which the firm would be
willing to sell the right to invest without being financially worse-
off.

 The net present value can also be interpreted to represent the

amount the firm could raise at the required rate of return, in addition
to the initial cash outlay, to distribute immediately to its
shareholders and by the end of the projects’ life, to have paid off all
the capital raised and return on it.
 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 the higher NPV should be selected.
Evaluation of the NPV Method
 NPV is most acceptable investment rule for the
following reasons:
 Time value
 Measure of true profitability
 Value-additivity
 Shareholder value
 Limitations:
 Involved cash flow estimation
 Discount rate difficult to determine
 Mutually exclusive projects
 Ranking of projects
INTERNAL RATE OF RETURN METHOD

 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.
 CALCULATION OF IRR
 Uneven Cash Flows: Calculating IRR by Trial and
Error
 The approach is to select any discount rate to compute
the present value of cash inflows. If the calculated
present value of the expected cash inflow is lower than
the present value of cash outflows, a lower rate should
be tried. On the other hand, a higher value should be
tried if the present value of inflows is higher than the
present value of outflows. This process will be repeated
unless the net present value becomes zero.
CALCULATION OF IRR
 Level Cash Flows
 Let us assume that an investment would cost Rs 20,000
and provide annual cash inflow of Rs 5,430 for 6 years
 The IRR of the investment can be found out as follows

NPV   Rs 20,000 + Rs 5,430(PVAF6,r ) = 0

Rs 20,000  Rs 5,430(PVAF6,r )
Rs 20,000
PVAF6,r   3.683
Rs 5,430
NPV Profile and IRR

NPV Profile
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
 IRR method has following merits:
 Time value
 Profitability measure
 Acceptance rule
 Shareholder value

 IRR method may suffer from

Multiple rates
Mutually exclusive projects
Value additivity
 PROFITABILITY INDEX
 Profitability index is the ratio of the present value
of cash inflows, at the required rate of return, to the
initial cash outflow of the investment.
 The formula for calculating benefit-cost ratio or
profitability index is as follows:
 PROFITABILITY INDEX
 The initial cash outlay of a project is Rs 100,000 and it can
generate cash inflow of Rs 40,000, Rs 30,000, Rs 50,000
and Rs 20,000 in year 1 through 4. Assume a 10 percent
rate of discount. The PV of cash inflows at 10 percent
discount rate is:
Acceptance Rule
 The following are the PI acceptance rules:
 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 recognises the time value of money.

 Value maximization: It is consistent with the shareholder value

maximisation 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 inflows is divided by the initial cash outflow, 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.
 PAYBACK
 Payback is the number of years required to recover the
original cash outlay invested in a project.
 If the project generates constant annual cash inflows, the
payback period can be computed by dividing cash outlay by
the annual cash inflow. That is:

Initial Investment C0
Payback = 
Annual Cash Inflow C
Example
Assume that a project requires an outlay of Rs
50,000 and yields annual cash inflow of Rs
12,500 for 7 years. The payback period for the
project is:
Rs 50,000
PB   4 years
Rs 12,000
 PAYBACK
 Unequal cash flows In case of unequal cash inflows, the
payback period can be found out by adding up the cash inflows
until the total is equal to the initial cash outlay.
 Suppose that a project requires a cash outlay of Rs 20,000, and
generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and
Rs 3,000 during the next 4 years. What is the project’s
payback?
3 years + 12 × (1,000/3,000) months
3 years + 4 months
Acceptance Rule
 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 highest payback
period.
Evaluation of Payback
 Certain virtues:
 Simplicity
 Cost effective
 Short-term effects
 Risk shield
 Liquidity

 Serious limitations:
 Cash flows after payback
 Cash flows ignored
 Cash flow patterns
 Administrative difficulties
 Inconsistent with shareholder value
Payback Reciprocal and the Rate of
Return
 The reciprocal of payback will be a close
approximation of the internal rate of return if the
following two conditions are satisfied:
1. The life of the project is large or at least twice the
payback period.
2. The project generates equal annual cash inflows.
DISCOUNTED PAYBACK
PERIOD
 The discounted payback period is the number of periods
taken in recovering the investment outlay on the present
value basis.
 The discounted payback period still fails to consider the
cash flows occurring after the payback period.

Discounted Payback Illustrated

ACCOUNTING RATE OF
RETURN METHOD
 The accounting rate of return is the ratio of the average after-
tax profit divided by the average investment. The average
investment would be equal to half of the original investment if
it were depreciated constantly.
or

A variation of the ARR method is to divide average earnings

after taxes by the original cost of the project instead of the
average cost.
Example
A project will cost Rs 40,000. Its stream of earnings
before depreciation, interest and taxes (EBDIT)
during first year through five years is expected to be
Rs 10,000, Rs 12,000, Rs 14,000, Rs 16,000 and Rs
20,000. Assume a 50 per cent tax rate and
depreciation on straight-line basis.
Calculation of Accounting Rate
of Return
Acceptance Rule
 This method will accept all those projects whose
ARR is higher than the minimum rate established
by the management and reject those projects which
have ARR less than the minimum rate.

 This method would rank a project as number one if

it has highest ARR and lowest rank would be
assigned to the project with lowest ARR.
Evaluation of ARR Method
 The ARR method may claim some merits
 Simplicity
 Accounting data
 Accounting profitability
 Serious shortcomings
Cash flows ignored
Time value ignored
Arbitrary cut-off
Conventional & Non-Conventional
Cash Flows
A conventional investment has cash flows the pattern of an
initial cash outlay followed by cash inflows. Conventional
projects have only one change in the sign of cash flows; for
example, the initial outflow followed by inflows, i.e., – + + +.

A non-conventional investment, on the other hand, has cash

outflows mingled with cash inflows throughout the life of the
project. Non-conventional investments have more than one
change in the signs of cash flows; for example, – + + + – ++ –
+.
 NPV vs. IRR
 Conventional Independent Projects:
In case of conventional investments, which are
economically independent of each other, NPV and IRR
methods result in same accept-or-reject decision if the
firm is not constrained for funds in accepting all
profitable projects.
 NPV vs. IRR
Lending and borrowing-type projects:
•

Project with initial outflow followed by inflows is a

lending type project, and project with initial inflow
followed by outflows is a lending type project, Both are
conventional projects.
 Problem of Multiple IRRs
 A project may have both
lending and borrowing
features together. IRR
method, when used to
evaluate such non-
conventional investment can
yield multiple internal rates
of return because of more
than one change of signs in
cash flows.
Case of Ranking Mutually
Exclusive Projects
 Investment projects are said to be mutually exclusive when
only one investment could be accepted and others would
have to be excluded.
 Two independent projects may also be mutually exclusive if
a financial constraint is imposed.
 The NPV and IRR rules give conflicting ranking to the
projects under the following conditions:
 The cash flow pattern of the projects may differ. That is, the cash
flows of one project may increase over time, while those of others
may decrease or vice-versa.
 The cash outlays of the projects may differ.
 The projects may have different expected lives.
Timing of cash flows  
The most commonly found condition for the conflict between
the NPV and IRR methods is the difference in the timing of cash
flows. Let us consider the following two Projects, M and N.
 Cont…

NPV Profiles of Projects M and N NPV versus IRR

The NPV profiles of two projects intersect at 10 per cent discount

rate. This is called Fisher’s intersection.
Incremental approach
 It is argued that the IRR method can still be used to choose
between mutually exclusive projects if we adapt it to calculate
rate of return on the incremental cash flows.

 The incremental approach is a satisfactory way of salvaging

the IRR rule. But the series of incremental cash flows may
result in negative and positive cash flows. This would result in
multiple rates of return and ultimately the NPV method will
have to be used.
Scale of investment  
Project life span  
REINVESTMENT ASSUMPTION

 The IRR method is assumed to imply that the cash

flows generated by the project can be reinvested at
its internal rate of return, whereas the NPV method
is thought to assume that the cash flows are
reinvested at the opportunity cost of capital.
MODIFIED INTERNAL RATE OF
RETURN (MIRR)
 The modified internal rate of return (MIRR) is
the compound average annual rate that is calculated
with a reinvestment rate different than the project’s
IRR.
VARYING OPPORTUNITY
COST OF CAPITAL
 There is no problem in using NPV method when
the opportunity cost of capital varies over time.
 If the opportunity cost of capital varies over time,
the use of the IRR rule creates problems, as there is
not a unique benchmark opportunity cost of capital
to compare with IRR.
NPV VERSUS PI

 A conflict may arise between the two methods if a

choice between mutually exclusive projects has to
be made. NPV method should be followed.