CAPITAL BUDGETING

Concerned with budgeting of the capital. Its about spending the capital. Thus it deals with the investment decisions of the company. Investment decisions include the expansion, acquisition, modernization and replacement of long term assets.

In this part of the course we learn the methods

used to evaluate any project that the

company intends to undertake.

METHODS

Discounted Cash Flow Methods Net Present Value (NPV) IRR (Internal Rate of Return)

Non-Discounted Cash Flow Pay-Back Period ARR (Accounting Rate of Return)

Benefit-Cost Ratio (Profitability Index) Discounted Payback Period method

NET PRESENT VALUE (NPV)

Present Value of Inflows Present value of Outflows

Evaluating the Project

Accept if NPV >0 Reject if NPV <0 May Accept if NPV = 0

A project costs Rs. 81,000 and is expected to generate net cash inflows of Rs.40,000, Rs.35,000, Rs30,000 over its life of three years. Compute the NPV of the project if the discounting rate is 15%. Should the project be accepted?

-26.87

INTERNAL RATE OF RETURN (IRR) Is the rate of return that equates the NPV of a project to zero
Present Value of Inflows

Present value of Outflows

=0

Evaluating the Project

If r is the required rate and K is the IRR, then

Accept the project if K>r Reject the project if K<r May accept if K= r

A project costs Rs. 81,000 and is expected to generate net cash inflows of Rs.40,000, Rs.35,000, Rs30,000 over its life of three years. Compute the IRR of the project. Should the project be accepted if the required rate is 16%?

14.98%

Benefit Cost Ratio (BCR)

Also called Profitability Index BCR = PV of future cash flows Initial Investment

Evaluating the Project

Accept if BCR >1 Reject if BCR <1 May Accept if BCR = 1

A project costs Rs. 81,000 and is expected to generate net cash inflows of Rs.40,000, Rs.35,000, Rs30,000 over its life of three years. Compute the BCR or PI of the project if the discounting rate is 14%. Should the project be accepted ?
1.02

Discounted Pay Back Period

Pay back period is defined as the number of years required to recover the original investment in a project

A project involves an initial outlay of 40,000. The cash inflow in the first second and third year from the project are 10,000, 20,000 and 20,000 respectively. Compute the pay back period. If the discount rate is 10%, compute the discounted pay back period.
2 and 6 months 2 years, 11months, 14 days

ARR (Accounting Rate Of Return)

ARR = Average Income/ Average Investment

ARR = EBIT (1-t) /n

(I0 + In)/2

A company invests Rs.30,000 in a project. The table below shows the sales and profit that are derived from the project. Compute the companys ARR, assuming the tax rate is 35%.
Year 1 Sales Operating expenses EBDIT Dep EBIT 50,000.00 30,000.00 20,000.00 10,000.00 10,000.00 Year 2 60,000.00 35,000.00 25,000.00 10,000.00 15,000.00 Year 3 70,000.00 38,000.00 32,000.00 10,000.00 22,000.00

67.89%

Problems in IRR
Consider a project with the following cash inflow/outflow profile:
Year Cash flow 0 -1000 1 4000 2 -3750

Compute the IRR of the project. If the required rate of return is 60%, then should the company take up the project?

50% and 150%

Thus in non-conventional cash flows sometimes IRR method would give two rates. The problem is which rate to take for the purpose of evaluating the project.

Use the NPV method to find whether the project should be accepted at a discount rate of 60%.
35.15

Thus a positive NPV gives an un-biased answer in terms of rejection or acceptance of a project. There are some rates at which the project is acceptable and others at which the project becomes un-acceptable.

Lets plot the NPV against various values of discount rate to see the discount rates at which the project becomes un-acceptable.

200 100 0 -1000%

NPV

50%

100%

150%

200%

-200 -300 -400 -500 -600 -700 -800 Discount rate

Problem with IRR: Ranking of Mutually exclusive Projects

Project M N 0 -1680 -1680 1 1400 140 2 700 840 3 140 1510

Compute the IRR of the two projects. Which project should be chosen? M(IRR) =23%, N(IRR)=17% Compute the NPV of the two projects at a discount rate of 9%. Based on NPV method which project should be chosen?

M(NPV) =301, N(NPV)=321

Lets plot the NPV of the two projects against the discounting rates

M(IRR)=23%, N(IRR)=17%
1000 800 600 400
NPV

Intersection Point

200 0 0% -200 -400 -600 Discount Rate 2% 5% 8% 10% 12% 14% 20% 25% 30%

M N

Scale of Investment
Project A 0 -1000 1 1500

-100000

120000

Compute the IRR of the two projects. Also compute the NPV of two projects at a discount rate of 10%
NPV at 10% 364 9080 IRR 50% 20%

Project X

0 -10000

1 12000

2 0

3 0

4 0

5 0

-10000

20120

Rank the projects in terms of NPV and IRR

NPV at 10% 908 2495

IRR 20% 15%

Thus NPV and IRR methods could give conflicting results in case of mutually exclusive projects in the following cases:

1. When the cash flows pattern among the cash flows differs

2. When the scale of investment required is different.

3. When the project have different expected lives