Capital Budegting Techniques:

1. Payback period
2. Discounted Payback period
3. Net present Value
4. Profitability Index

Net Present Value

Net present value (NPV) is a method used to determine the current value of all future cash
flows generated by a project, including the initial capital investment. It is widely used in capital
budgeting to establish which projects are likely to turn the greatest profit.

If NPV is positive then, project can be chosen as it results in earnings for the investor. For
mutually exclusive projects, project with higher NPV should be selected.

For example:
Cost of Capital = 10%

0 1 2 3 Return
Cashflows -100,000 20,000 40,000 50,000 10,000
NPV -100,000 = = = =
20,000/(1+0.1)1 40,000/(1+0.1)2 50,000/(1+0.1)3 (11,194.6)
= 18,181.81 =33,057.85 =37,565.74

NPV = 20,000/(1+0.1)1 + 40,000/(1+0.1)2 + 50,000/(1+0.1)3 -100,000 = (11,194.6)

KEY TAKEAWAYS
 Net present value, or NPV, is used to calculate today’s value of a future stream of
payments.
  If the NPV of a project or investment is positive, it means that the discounted present
value of all future cash flows related to that project or investment will be positive, and
therefore attractive.
 To calculate NPV you need to estimate future cash flows for each period and determine
the correct discount rate. 

The Formula for NPV

NPV = Cashflow/ (1+i)n – Initial Cash outflow

Where:
Cash outflow = Initial Investment
i = Required return or discount rate
n = time period

Advantages:
 It involves time value of money
 It involves discount rate
 It takes into consideration all the cash flows which will incur during the project life

Disadvantages:
 Comparatively more difficult to calculate than other capital budgeting techniques
 Discount rate assumed is usually hypothetical

The Bottom Line

Net present value discounts all the future cash flows from a project and subtracts its required
investment. The analysis is used in capital budgeting to determine if a project should be
undertaken when compared to alternative uses of capital or other projects.
 Project A
0 1 2 3 4 5
-50 16 16 16 16 20
 
Cost of capital (i) = 10%

NPV = 13.11

Project B

0 1 2 3 4 5 6 7 8
-200 30 30 30 30 30 30 30 35
Cost of Capital = 12%

NPV = - 48.95

Individual Project Mutually Exclusive Projects

Project A Accepted Accepted
Project B Rejected

Interpretation:

Individual Project:

Project A can be accepted as an individual project as its NPV is positive. This ensures that the
shareholder is making a real time return.

Project B is rejected as an individual project as its NPV is negative. This means that shareholder is
actually losing money on its investment.

Mutually Exclusive:

Project A is accepted as a mutually exclusive project as its NPV is more than project B. this means that in
project A shareholder will be making higher real time return.
Q3) - Book

0 1 2 3
-100 40 80 120

RRR = 20%

Calculate NPV

NPV = $ 58.33

Interpretation:

NPV (Net present value) is the present value of all cashflows after tax. Since NPV is positive, project
should be accepted as it increases shareholders wealth by generating revenues.

Profitability Index (PI)

It is the ratio of present value of future cashflows to the initial investment.

Formula:

Present value of all future cashflows / initial investment

If PI > 1 then invest

If PI < 1 then reject

PI will be greater than 1 if NPV is positive

PI will be less than 1 if NPV is negative

0 1 2 3 4 5 6 7
Cashflows (375) 115 115 115 115 115 115 165
PV of future 104.55 95.04 86.40 78.55 71.41 64.92 84.67
cashflows
Cost of capital = 10%
PV of future cash flows = 104.55+95.04=86.40+78.55+71.41+64.92+84.67 = 585.53

PI = Present value of future cashflows / initial investment

PI = 585.53 / 375 = 1.56

Interpretation:

If PI is equal to $1.56 it means that the project will earn $1.56 for every $1 invested

Advantages Of Profitability Index (PI)

1. PI considers the time value of money.

2. PI considers analysis all cash flows of entire life.

3. PI makes the right in the case of different amount of cash outlay of different project.

4. PI ascertains the exact rate of return of the project.

Disadvantages Of Profitability Index(PI)

1. It is difficult to understand interest rate or discount rate.

2. It is difficult to calculate profitability index if two projects having different useful life.

Lets assume that Project A has PI of $1.56 and project B has PI of $ 2.38.

Individual Project Mutually Exclusive Project

Project A Accept
Project B Accept Accept