CHAPTER - 5

CAPITAL BUDGETING

CAPITAL BUDGETING
Capital budgeting is the process used to take investment decision. It is a process of planning whether an
organization’s long term investments such as new machinery, replacement machinery, new plants, new
products, and research development projects are worth the funding of cash through the firm’s
capitalization structure (debt, equity or retained earnings). It is the process of allocating resources for
major capital, or investment, expenditures. One of the primary goals of capital budgeting investments is
to increase the value of the firm to the shareholders. A collection of capital budgeting techniques
allowing the manager to choose among a variety of investment projects.

METHODS:
1. Payback
2. Discounted payback
3. Internal Rate of Return
4. Net Present Value
5. Profitability Index

PAYBACK PERIOD (PBP) is the time it takes to recover the initial cost of the investment. Payback is
usually measured in years.

Decision rule: Take the project with the shortest payback period.

Disadvantages:
• It ignores time value of money.
• It ignores risk
• It ignores cash inflows beyond the cutoff point.

Project A: Payback calculation

Period Cash flow Amount left to recover
0 - $5,045.00 - $5,045.00
1 $ 400 $4,645.00
2 $ 1250 $3,395.00
3 $ 900 $2,495.00
4 $ 3000 $0
PBP = 3+ (2495/3000) = 3.83 Years

Project B: Payback calculation

Period Cash flow Amount left to recover
0 - $9,687.23 - $9,687.23
1 $ 5200 $4,487.23
2 $ 4000 $487.23
3 $ 1000 $0
PBP = 2+ (2487.23/1000) = 2.49 Years

Project C: Payback calculation

Period Cash flow Amount left to recover
0 -$490.67 -$490.67
1 $ 100 $390.67
2 $ 200 $190.67
3 $ 150 $40.67
4 $ 100 $0

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 PBP = 3+ (40.67/100) = 3.41 Years
Ranking:
1. Project B: 2.49 years
2. Project C: 3.41 years
3. Project A: 3.83 years

All three projects are viable, but project B is the first to recover its initial cost.

DISCOUNTED PAYBACK PERIOD (DPBP) is the time it takes to recover the initial cost of the
investment. Payback uses nominal CF; DPBP uses discounted CF.

Decision rule: Take the project with the shortest discounted payback period.

Disadvantages: DPBP ignores cash inflows beyond the cutoff point.

The calculation of discounted payback is exactly the same as that of payback, except that instead of using
nominal cash flow, we use present values.

Project A: Discounted Payback calculation

Period Cash flow Discounted cash flow @ 7.7% Amount left to recover
0 -$5,045.00 -$5,045.00 -$5,045.00
1 $ 400 $371.40 $4,673.60
2 $ 1250 $1,077.65 $3,595.95
3 $ 900 $720.44 $2,875.51
4 $ 3000 $2,229.76 $645.75
5 $ 1000 $690.12 $0
DPBP = 4+ (645.75/690); DPBP = 4.94

Project B: Discounted Payback calculation

Period Cash flow Discounted cash flow @ 6% Amount left to recover
0 -$9,687.23 -$9,687.23 -$9,687.23
1 $ 5200 $4,905.66 $4,781.57
2 $ 4000 $3,559.99 $1,221.58
3 $ 1000 $839.62 $381.96
4 $ 200 $158.42 $223.55
5 $ 100 $74.73 $148.82
Notice that the project never recovers its initial cost. At the end of year 5 there is still $148.82 left.

Project C: Discounted Payback calculation

Period Cash flow Discounted cash flow @ 3% Amount left to recover
0 -$490.67 -$490.67 -$490.67
1 $ 100 $97.09 $393.58
2 $ 200 $188.52 $205.06
3 $ 150 $137.27 $67.79
4 $ 100 $88.85 $0
DPBP = 3+ (67.79/88.85) = 3.76 Years

INTERNAL RATE OF RETURN (IRR) is the discount rate that makes the present value of the project
equal to its initial cost.

Decision rule: Take the project if the IRR exceeds the required rate of return.

Disadvantages:
• Reinvestment rate assumption is unrealistic

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 • Multiple IRR
• IRR cannot rank mutually exclusive projects
IRR Calculation:
Project A:
Set: Initial cost (A) = PV (project A):
$5,045 = $400/(1+IRR) + $1,250/(1+IRR)2 + $900/(+IRR)3 + $3,000/(1+IRR)4 + $1,000/(1+IRR)5
IRR(A) = 8%
Since IRR (A) > 7.7%, accept project (A)

Project B:
$490.67 = $100/(1+IRR) + $400/(1+IRR)2 + $150/(1+IRR)3 + $100/(1+IRR)4 + $50/(1+IRR)5
IRR (B) = 8%
Since IRR (B) > 3%, accept project B

Project C:
$9,687.23 = $5,200/(1+IRR) + $4,000/(1+IRR)2 + $1,000/(1+IRR)3 + $200/(1+IRR)4 + $100/(1+IRR)5
IRR(C) = 5%.
Since IRR(C) < 6%, reject project C

NET PRESENT VALUE (NPV) is the difference between the present value of a project and its initial cost.

NPV = Present value – Initial Cost

Decision rule: If NPV is positive, take the project.

Disadvantages: Very complex analysis, too many variables to forecast, as it will be seen later.

NPV Calculation:
In order to calculate NPV, we must first estimate the PV of total cash flows; then we subtract the initial
cost of the project.

Project A:
PV (A) =$400/(1.077) + $1,250/(1.077)2 + $900/(1.077)3 + $3,000/(1.077)4 + $1,000/(1.077)5
Initial cost (A) = $5,045
NPV (A) = $44.36

Project B:
PV (B) =$100/(1.03) + $400/(1.03)2 + $150/(1.03)3 + $100/(1.03)4 + $50/(1.03)5
Initial cost (B) = $490.67
NPV (B) = $64.2

Project C:
PV(C) =$5,200/(1.06) + $4,000/(1.06)2 + $1,000/(1.06)3 + $200/(1.06)4 + $100/(1.06)5
Initial cost (C) = $9,687.23
NPV (C) = -$148.81

When Required Rate = IRR, then NPV = 0

Remember that IRR is the discount rate that makes the PV of the project equals its initial cost. In other
words, IRR is the rate that makes the NPV of the project equal to zero.

Consider the present value of our projects at the IRR.

If the discount rate is equal to 8%,

NPV (A) = $400/(1.08) + $1,250/(1.08)2 + $900/(1.08)3 + $3,000/(1.08)4 + $1,000/(1.08)5 - $5,045
NPV(A) = 0

When the discount rate equals 8%:

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 NPV (B) = $100/(1.08) + $400/(1.08)2 + $150/(1.08)3 + $100/(1.08)4 + $50/(1.08)5 - $490.67
NPV (B) = 0
When the discount rate equals 5%:
NPV(C) = $5,200/ (1.05) + $4,000/(1.05)2 + $1,000/(1.05)3 + $200/(1.05)4 + $100/(1.05)5 - $9,687.23
NPV(C) = 0

THE PROFITABILITY INDEX (PI) is the ratio of project PV to initial cost.

PI = PV/Initial cost

Decision rule: Take the project if PI > 1

Disadvantages: PI cannot rank mutually exclusive projects.

PI Calculation:
Project A:
PI (A) = PV (A)/Initial cost = 5,089.36/$5,045
PI (A) = $400/ (1.077) + $1,250/ (1.077)2 + $900/(1.077)3 + $3,000/(1.077)4 + 1,000/(1.077)5/$5,045
PI (A) = 1.0088

Project B:
PI (B) = $100/ (1.03) + $400/(1.03)2 + $150/(1.03)3 + $100/(1.03)4 + $50/(1.03)5 /$490.67
PI (B) = 1.131

Project C:
PI(C) = $5,200/(1.06) + $4,000/(1.06)2 + $1,000/(1.06)3 + $200/(1.06)4 + $100/(1.06)5 /$9,687.23
PI(C) = 0.9846

Only A and B are viable

Why can’t PI rank the projects?

Consider the following example:
Project X Project Y
Present Value $25,000,000 $3,000
Initial cost $24,000,000 $1,000
PI 1.042 3
NPV $1,000,000 $2,000.00

PI(x) < PI(y)

But NPV(x) > NPV(y)

In project valuation, measures of absolute wealth are more appropriate than measures of relative
efficiency.

INDEPENDENT AND MUTUALLY EXCLUSIVE PROJECTS

Independent projects are projects in which decision regarding acceptance of one project does not affect
decision regarding others. Since all independent projects can all be accepted if they add value, NPV and
IRR conflict doesn’t arise. The company can accept all projects with positive NPV.

Mutually exclusive projects are projects in which acceptance of one project excludes the others from
consideration. In such a scenario the best project is accepted. NPV and IRR conflict, which can sometimes
arise in case of mutually exclusive projects, becomes critical. The conflict either arises due to the relative
size of the project or due to the different cash flow distribution of the projects.

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Since NPV is an absolute measure, it will rank a project adding more dollar value higher regardless of
the original investment required. IRR is a relative measure, and it will rank projects offering best
investment return higher regardless of the total value added.
Example:
Project A requires $10 million investments and generates $10 million each in year 1 and year 2. It has
NPV of $7.4 million @ 10% discount rate and IRR of 61.8%. Project B requires $1 million investment and
generates $2 million in Year 1 and $1 million in Year 2. Its NPV @ 10% and IRR turn out to be $1.6 million
and 141.4%. Based on NPV one would conclude that Project A is better, but IRR offers a contradictory
view. This conflict arose mainly due to the size of the project.

Whenever there is a conflict in ranking of projects based on NPV and IRR, it is safer to always prefer the
NPV ranking. This is due to the realistic assumption and theoretical soundness of the method.

However, IRR is a great complement to NPV. It helps see a more complete picture.

ILLUSTRATIONS
Question – 1:
The following cash flows are for two different investments. Given that the discount rate for both the
projects are 12.5%. Calculate the a) Payback and b) Discounted payback for both the cash flows.

Year Project A Project B

0 - 290 - 475
1 90 50
2 90 150
3 90 200
4 90 200
5 90 300
Solution – 1:
a) Project A Project B
PBP =3+ (20/90) PBP = 3+ (75/250)
= 3.22yrs = 3.375yrs
b)
Yea Project A Discounted @ 12.5% recovere Project B Discounted @ 12.5% recovered
r d
0 - 290 - - - 475 - -
1 90 88.9 88.9 50 44.44 44.44
2 90 79 167.9 150 118.5 162.94
3 90 70.23 238.13 200 140.46 303.4
4 90 62.43 0 200 124.86 428.26
5 90 55.49 - 300 166.48 0

Project A Project B
PBP =3+(51.87/62.43) PBP = 4+ (46.74/166.48)
= 3.83 yrs = 4.28 yrs

Question – 2:
Ms Granger has been offered to invest $ 100,000 in a new project that her friend has undertaken. The
friend has offered that as a return to her investment today, she will receive $ 27,500 each year for the next
5 years. If Ms Granger’s required rate of return is 18%, should she invest in the project? (Find NPV)

Solution – 2:
NPV = - 100,000 + 27500/1.18 +27500/1.18^2 +27500/1.18^3 + 27500/1.18^4 + 27500/1.18^5

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 = - 100,000 +23,305 +19750 +16737+14184 +12021
= - 100,000+ 85997
= - 14,003
She should not invest as NPV is negative. [Annuity can also be used as all the cash flows are same]
Question – 3:
Bingley Company is considering acquiring a certain machine costing $22,000 which will save $ 8500 in
cash every year up to its 4 year life. The machine will have no value at the end of 4 years. Should the
company buy the machine if the cost of capital is 16%?

Solution – 3:
NPV = - 52,000 + 8500/1.16 +8500/1.16^2 +8500/1.16^3 + 8500/1.16^4
= - 52,000 +7328 + 6317+5446 +4694
= - 22,000+ 23,785
= 1785

She should not invest as NPV is positive

Question – 4:
Your boss has asked you to evaluate a project with the following cash flows. He wants to know the rate
of return (IRR) the company can earn from investing in this project. The hurdle rate for the company is
10%. Should the investment be made?

Perio Cash flow

d
0 -$ 100,000
1 35,000
2 35,000
3 35,000
4 35,000

Solution – 4:
0 1 2 3 4

-100,000 35,000 35,000 35,000 35000

Let us try with 10%,

PV = (35000/1.10) + (35000/1.10^2) + (35000/1.10^3)+(35000/1.10^4)
= 31818 + 28926 + 26296 + 23905
= $ 110945

Let us try with 20%,

PV = (35000/1.20) + (35000/1.20^2) + (35000/1.20^3)+(35000/1.20^4)
= 29167 + 24306 + 20255 + 16879
= $90607

Interpolation:

.10 110945

IRR 100000

.20 90607

Difference between, 20%-.10%=.10%

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 110945 – 90607 = 20338
IRR - 0.10 = 10945
x/0.10 = 10945/20338
x = 0.0538 + 0.10
= 0.1538
IRR = 15.38%
Question – 5:
Your boss has asked you to evaluate a project with the following cash flows. He wants to know the rate
of return (IRR) the company can earn from investing in this project. The hurdle rate for the company is
10%. Should the investment be made?

Perio Cash flow

d
0 -$ 100,000
1 43,000
2 43,000
3 43,000

Solution – 5:
0 1 2 3

-100,000 43,000 43,000 43,000

Let us try with 10%,

PV = (43000/1.10) + (43000/1.10^2) + (43000/1.10^3)
= 39090.91 + 35537.19 + 32306.54
= $106934.64

Let us try with 15%,

PV = (43000/1.15) + (43000/1.15^2) + (43000/1.15^3)
= 37391.30 + 32514.18 + 28273.20
= $98178.68

Interpolation:
.10 106935

IRR 100000

.15 98179

Difference between, .15%-.10%=.05%

106935 – 98179=8756
IRR – 0.10 = 6935
x/.05 = 6935/8756
x = 0.0396 + 0.10
= 0.1396
IRR = 13.96%

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ON CAMPUS TASK

Ronald wants to buy a new showroom which he wants to use for a commercial purpose. He wants to
rent out the showroom. He has two options. He can buy Showroom A requiring an investment of $1600
and will generate $ 400 each starting from the third year. This is because showroom A is still under
construction and will not be ready to rent out before year 3. If he buys Showroom B it can be rented out
from year 1. However, if he buys showroom A , he can rent it till the 6th year and will sell it in the 7 th
year for $400. On the other hand, he can rent showroom B for 4 years and then sell it on the 5 th year for
$50.
a) Determine the cash flows for each project and show it in a table.
Periods Cash flow A ($) Cash flow B ($)
0
1
2
3
4
5
6
7

b) PBP
Period Cash flow A Left to recover Cash flow B Left to recover
0
1
2
3
4
5
6
PBP

c) Discounted Payback calculation

Discounted Left to Cash flow Discounte Left to
Period Cash flow A
@ 4.6% recover B d @ 3% recover
0
1
2
3
4
5
6
7
DPBP

d) NPV ___________________________________________________________________________________
e) IRR _____________________________________________________________________________________
f) PI _____________________________________________________________________________________
g) If the projects are mutually exclusive, which one should Ronald invest in?
_________________________________________________________________________________________
_______________________________________________________________________________________

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 EXERCISES
1. Calculate the NPV for the following projects with a discount rate of 12%:
 Project 1 costs $100,000 and earns $50,000 each year for three years.
 Project 2 costs $200,000 and earns $150,000 in the first year, and then $75,000 for each of the next
two years.
 Project 3 costs $25,000 and earns $20,000 each year for three years.

The projects are mutually exclusive.

a) Calculate the NPV of all 3 projects. Which one should we accept?
b) Calculate the IRR for the 3 projects. Which has the highest IRR? If the hurdle rate 10%, which one
will you accept?
c) Calculate also the PI for each of the 3 projects. Which one should be accepted?
2. Briarcliff Stove Company is considering a new product line to supplement its range line. It is
anticipated that the new product line will involve cash investment of $700,000 at time 0. After-
tax cash inflows of $250,000 are expected in year 1 and 2, $300,000 in year 3, $350,000 in year 4,
and $400,000 each year thereafter through year 8.
a) If the required rate of return is 15 percent, what is the net present value of the project? Is it
acceptable?
b) What is its internal rate of return?
c) What would be the case if the required rate of return was 10 percent?
d) What is the project’s payback period?
3. Carbide Chemical Company is considering purchasing a new more efficient machine. It has
determined that the relevant after-tax incremental operating cash flows of this are as follows:

a) 0 1 2 3 4 5 6 7 8
− $86,890 $106,474 $91,612 $84,801 $84,801 $75,400 $66,000 $92,400
$404,424
What is the project’s net present value if the required rate of return is 14 percent?
b) Is the project acceptable?

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