Capital Budgeting Decision

Dr. Miklesh Prasad Yadav

Faculty, Indian Institute of Foreign
Trade
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
Any question before we proceed further?
Nature of Investment Decisions
 The investment decisions of a firm for a long term 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.
Types of Investment Decisions
 One classification is as follows:
 Expansion of existing business
 Expansion of new business
 Replacement and modernisation
 Yet another useful way to classify investments is as
follows:
 Mutually exclusive investments
 Independent investments
 Contingent investments
Cash flow vs profit
 Cash flow is not the same thing as profit, at
least, for two reasons.
 First, profit, as measured by an accountant, is based on
accrual concept.

 Second, for computing profit, expenditures are arbitrarily

divided into revenue and capital expenditures.
CF  (REV  EXP  DEP)  DEP  CAPEX
CF  Profit  DEP  CAPEX
Investment Evaluation Criteria
 Three steps 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.
Evaluation Criteria
 1. Non-discounted Cash Flow Criteria
 Payback Period (PB)
 Accounting Rate of Return (ARR)
 2. Discounted Cash Flow (DCF) Criteria
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Profitability Index (PI)
 Discounted payback period (DPB)
 1. 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.
2. 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.
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.
1. Net Present Value Method
 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).
 Present value of cash flows should be calculated using the
opportunity cost of capital as the discount rate.
 Net Present Value Method

 The formula for the net present value can be written

as follows:
 C1 C2 C3 Cn 
NPV        C0
 (1  k ) (1  k )
2 3 n
(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
2. 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
3.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.
4. 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

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.
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.
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