CAPITAL BUDGETING

DECISION
 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
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.
 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.
 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
• Yet another useful way to classify investments
is as follows:
– Mutually exclusive investments
– Independent investments
– Contingent investments
 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.
• 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
• Non-discounted Cash Flow Criteria
– Payback Period (PB)
– Accounting Rate of Return (ARR)
• Discounted Cash Flow (DCF) Criteria
– Discounted payback period (DPB)
– Net Present Value (NPV)
– Profitability Index (PI)
– Internal Rate of Return (IRR)
 PAYBACK PERIOD
• Payback period 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 PERIOD
• 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
– Liquidity
• Serious limitations:
Cash flows after payback are ignored
Ignores time value of money
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.

• 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
• An initial investment of Rs. 130,000 is expected to generate
annual cash inflow of Rs. 32,000 for 6 years. Depreciation is
allowed on the straight line basis. It is estimated that the
project will generate scrap value of Rs.10,500 at end of the
6th year. Calculate its accounting rate of return assuming that
there are no other expenses on the project.
• Solution
Annual Depreciation = (Initial Investment − Scrap Value) ÷
Useful Life in Years
Annual Depreciation = (130,000 − 10,500) ÷ 6 ≈ 19,917
Average Accounting Income = 32,000 − 19,917 = 12,083
Accounting Rate of Return = 12,083 ÷ 130,000 ≈ 9.3%
 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
 Net Present Value Method
• NPV = P.V. of all cash inflows – P.V. of cash
outflows
• The formula for the net present value can be
written as follows:

 C1 C2 C3 Cn 
NPV =  + + ++  − C0
 (1 + k ) (1 + k ) (1 + k ) (1 + k ) 
2 3 n

n
Ct
NPV =  − C0
t =1 (1 + k )
t
 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.
 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.
 Question

What is the relationship between

discount rate and NPV ?
 What NPV means & Why is it
Important?

• Addition to shareholders wealth.

BUT HOW ?

• 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.
 Evaluation of the NPV Method
• NPV is most acceptable investment rule for
the following reasons:
– Time value
– Value-additivity
– Shareholder value
• Limitations:
– Involved cash flow estimation
– Discount rate difficult to determine
– Mutually exclusive projects with unequal lives. How is it a
problem ?
– Gives an absolute amount.
– Ranking of projects may vary with discount rates.
 Equivalent Annual NPV (EANPV)
• EANPV = NPV / PVAF(n,k%)
• Example –
Project A Project B
Investment 10000 8000
Annual CFAT 3000 4000
Life (n) 10 years 7 years
K 12% 12%
PVAF(n, k%) 5.65 4.564
PV of C.I. 3000*5.65 4000*4.564
16950 18256
NPV 6950 10256
EANPV 6950/5.65 10256/4.564
1230 2247
 Ranking Vary
Example –

Project A Project B
Cash outflow 50 50
CFAT - 1 year 100 30
CFAT - 2 year 25 100

NPV @
NPV @ 5% Rank 10% Rank
Project A 67.92 2 61.57 1
Project B 69.27 1 59.91 2
 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 Value: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.
 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
• 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
ANSWER = ?
 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.
 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
 Evaluation of IRR Method
• IRR method has following merits:
✓Time value
✓Profitability measure – considers all cash flows
✓ not require k for calculation.
✓Shareholder value
✓Give same results like NPV (conventional project)
WHY ??
• IRR method may suffer from
Multiple rates in case of unconventional projects
 No Value additivity
Can’t be used if we have varying opportunity cost of
capital
 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.
 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.
 Problem of Multiple IRRs
• Un-conventional Projects:
• 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
• The NPV and IRR rules give conflicting ranking to the
projects under the following conditions:
– The timing cash flow pattern of the projects may differ.
– 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.
Scale of investment
Project life span
 Is this statement true ?

• Two independent projects may also be

mutually exclusive if a financial constraint is
imposed.
CAPITAL BUDGETING
UNDER
CAPITAL RATIONING
 Investment Decisions Under Capital
Rationing
• Capital rationing refers to a situation where the firm is
constrained for external, or self-imposed, reasons to obtain
necessary funds to invest in all investment projects with
positive NPV.
• Under capital rationing, the management has to decide to
obtain that combination of the profitable projects which yields
highest NPV within the available funds.

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 Why Capital Rationing?
• There are two types of capital rationing:

1. External capital rationing: imposed by capital markets

2. Internal capital rationing: self-imposed by the

company internally

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 Profitability Index
• The objective of the NPV rule under capital constraint should be
to maximise NPV per rupee of capital rather than to maximise
NPV.

• Projects should be ranked by their profitability index, and top-

ranked projects should be undertaken until funds are exhausted.

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 Single period constraint

Cash Flows (Rs. 000)

Project C0 C1 C2 C3 NPV(10%) PI
L -50 30 25 20 12.94 1.26
M -25 10 20 10 8.12 1.32
N -25 10 15 15 7.75 1.31
 Limitations of Profitability Index
• Multi-period capital constraints
• Project indivisibility

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 Multi-period capital constraints
• The NPV and profitability index of the following four
projects are shown. Given the budget constraint of Rs
50,000 in year 0 and 1.

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 Project indivisibility
Capital constraint - 1000000

Project C0 NPV PI Rank

A 500000 110000 1.22 1

B 150000 -7500 0.95 6

C 350000 70000 1.2 2

D 450000 81000 1.18 4

E 200000 38000 1.19 3

F 400000 20000 1.05 5

 Programming Approach to Capital
Rationing
• Capital rationing presents a situation of
maximising net present value of several projects
subject to funds constraint. Hence, programming
approach can be used for decision making.
– Linear Programming (LP)
– Integer Programming (IP)

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 Linear programming
• It assumes that projects are infinitely divisible.
• It means decision variables can take even
fractional values.
Integer programming
• It assumes that project are non divisible, either
we can accept a project or reject it. It means
decision variable can take only 2 values 0 or 1.
• It can also incorporate many other constraints.
• Example – mutually exclusive projects.
 Example
• Let us consider four projects – L, M, N and O,
given earlier. The company has budget
constraint of Rs 50 each in year 0 and year 1.

• We need to maximise NPV subject to budget

constraints. Since investments will be positive,
we will put as constraints.

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 Example

Maximize NPV
NPV = 12.94 X L + 8.12 X M + 7.75 X N + 6.88 X O
Subject to:

The LP Solution of the problem:

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 More constraints - Example
• Project M and N are mutually exclusive – ??

• Project N can be delayed by 1 year. Such delay

would increase cash outlay by 10% and reduce
NPV to 6.75
 Limitation
• complicated mathematical models

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