Capital Budgeting

Capital budgeting (or investment appraisal) is the process of determining the viability to long-
term investments on purchase or replacement of property plant and equipment, new product line or
other projects.

Capital budgeting consists of various techniques used by managers such as:

1. Payback Period
2. Discounted Payback Period
3. Net Present Value
4. Accounting Rate of Return
5. Internal Rate of Return
6. Profitability Index

All of the above techniques are based on the comparison of cash inflows and outflow of a project
however they are substantially different in their approach.

A brief introduction to the above methods is given below:

 Payback Period measures the time in which the initial cash flow is returned by the
project. Cash flows are not discounted. Lower payback period is preferred.
 Net Present Value (NPV) is equal to initial cash outflow less sum of discounted cash
inflows. Higher NPV is preferred and an investment is only viable if its NPV is positive.
 Accounting Rate of Return (ARR) is the profitability of the project calculated as
projected total net income divided by initial or average investment. Net income is not
discounted.
 Internal Rate of Return (IRR) is the discount rate at which net present value of the
project becomes zero. Higher IRR should be preferred.
 Profitability Index (PI) is the ratio of present value of future cash flows of a project
to initial investment required for the project.

1. Payback Period

Payback period is the time in which the initial cash outflow of an investment is expected to be
recovered from the cash inflows generated by the investment. It is one of the simplest investment
appraisal techniques.

Formula

The formula to calculate payback period of a project depends on whether the cash flow per period from
the project is even or uneven. In case they are even, the formula to calculate payback period is:
 Initial Investment
Payback Period =
Cash Inflow per Period

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and
then use the following formula for payback period:

B
Payback Period = A +
C
In the above formula,
A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A

Both of the above situations are applied in the following examples.

Decision Rule

Accept the project only if its payback period is LESS than the target payback period.

Examples

Example 1: Even Cash Flows

Company C is planning to undertake a project requiring initial investment of $105 million. The project
is expected to generate $25 million per year for 7 years. Calculate the payback period of the project.

Solution
Payback Period = Initial Investment ÷ Annual Cash Flow = $105M ÷ $25M = 4.2 years

Example 2: Uneven Cash Flows

Company C is planning to undertake another project requiring initial investment of $50 million and is
expected to generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3, $19 million in
Year 4 and $22 million in Year 5. Calculate the payback value of the project.

Solution
(cash flows in millions) Cumulative
Year Cash Flow Cash Flow
0 (50) (50)
1 10 (40)
2 13 (27)
3 16 (11)
4 19 8
 5 22 30
Payback Period = Year cash flows + ((Cumulative Cash Flow) ÷ Annual Cash flow)
= 3 + (|-$11M| ÷ $19M)
= 3 + ($11M ÷ $19M)
≈ 3 + 0.58
≈ 3.58 year

Advantages and Disadvantages

Advantages of payback period are:

1. Payback period is very simple to calculate.
2. It can be a measure of risk inherent in a project. Since cash flows that occur later in a project's
life are considered more uncertain, payback period provides an indication of how certain the
project cash inflows are.
3. For companies facing liquidity problems, it provides a good ranking of projects that would
return money early.
Disadvantages of payback period are:
1. Payback period does not take into account the time value of money which is a serious
drawback since it can lead to wrong decisions. A variation of payback method that attempts to
remove this drawback is called discounted payback period method.
2. It does not take into account, the cash flows that occur after the payback period.

2. Discounted Payback Period

One of the major disadvantages of simple payback period is that it ignores the time value of money. To
counter this limitation, an alternative procedure called discounted payback period may be followed,
which accounts for time value of money by discounting the cash inflows of the project.

Formulas and Calculation Procedure

In discounted payback period we have to calculate the present value of each cash inflow taking the
start of the first period as zero point. For this purpose the management has to set a suitable discount
rate. The discounted cash inflow for each period is to be calculated using the formula:

Actual Cash Inflow

Discounted Cash Inflow =
(1 + i)n

Where,
i is the discount rate;
n is the period to which the cash inflow relates.

Usually the above formula is split into two components which are actual cash inflow and present value
factor ( i.e. 1 / ( 1 + i )^n ). Thus discounted cash flow is the product of actual cash flow and present
value factor.
The rest of the procedure is similar to the calculation of simple payback period except that we have to
use the discounted cash flows as calculated above instead of actual cash flows. The cumulative cash
flow will be replaced by cumulative discounted cash flow.
B
Discounted Payback Period = A +
C

Where,
A = Last period with a negative discounted cumulative cash flow;
B = Absolute value of discounted cumulative cash flow at the end of the period A;
C = Discounted cash flow during the period after A.

Note: In the calculation of simple payback period, we could use an alternative formula for situations
where all the cash inflows were even. That formula won't be applicable here since it is extremely
unlikely that discounted cash inflows will be even.

The calculation method is illustrated in the example below.

Decision Rule

If the discounted payback period is less that the target period, accept the project. Otherwise reject.

Example

An initial investment of $2,324,000 is expected to generate $600,000 per year for 6 years. Calculate
the discounted payback period of the investment if the discount rate is 11%.

Solution

Step 1: Prepare a table to calculate discounted cash flow of each period by multiplying the actual cash
flows by present value factor. Create a cumulative discounted cash flow column.

Discounted Cash Cumulative

Year Cash Flow Present Value Factor
Flow Discounted
n CF PV$1=1/(1+i)n
CF×PV$1 Cash Flow

0 $ −2,324,000 1.0000 $ −2,324,000 $ −2,324,000

1 600,000 0.9009 540,541 − 1,783,459

2 600,000 0.8116 486,973 − 1,296,486

3 600,000 0.7312 438,715 − 857,771

4 600,000 0.6587 395,239 − 462,533

5 600,000 0.5935 356,071 − 106,462

6 600,000 0.5346 320,785 214,323

Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 ≈ 5.32 years

Advantages and Disadvantages

Advantage: Discounted payback period is more reliable than simple payback period since it accounts
for time value of money. It is interesting to note that if a project has negative net present value it won't
pay back the initial investment.
Disadvantage: It ignores the cash inflows from project after the payback period.

3. Net Present Value (NPV)

Net present value is the present value of net cash inflows generated by a project including salvage
value, if any, less the initial investment on the project. It is one of the most reliable measures used in
capital budgeting because it accounts fortime value of money by using discounted cash inflows.

Before calculating NPV, a target rate of return is set which is used to discount the net cash inflows from
a project. Net cash inflow equals total cash inflow during a period less the expenses directly incurred
on generating the cash inflow.

Calculation Methods and Formulas

The first step involved in the calculation of NPV is the determination of the present value of net cash
inflows from a project or asset. The net cash flows may be even (i.e. equal cash inflows in different
periods) or uneven (i.e. different cash flows in different periods). When they are even, present value
can be easily calculated by using the present value formula of annuity. However, if they are uneven,
we need to calculate the present value of each individual net cash inflow separately.

In the second step we subtract the initial investment on the project from the total present value of
inflows to arrive at net present value.

Thus we have the following two formulas for the calculation of NPV:

When cash inflows are even:

1 − (1 + i)-n
NPV = R × − Initial Investment
i
In the above formula,
R is the net cash inflow expected to be received each period;
i is the required rate of return per period;
n are the number of periods during which the project is expected to operate and generate cash
inflows.
When cash inflows are uneven:
NPV = R1 + R2 + R3 + ... − Initial Investment
 (1 + i)1 (1 + i)2 (1 + i)3
Where,
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period;
R3 is the net cash inflow during the third period, and so on ...

Decision Rule

Accept the project only if its NPV is positive or zero. Reject the project having negative NPV. While
comparing two or more exclusive projects having positive NPVs, accept the one with highest NPV.

Examples

Example 1: Even Cash Inflows: Calculate the net present value of a project which requires an initial
investment of $243,000 and it is expected to generate a cash inflow of $50,000 each month for 12
months. Assume that the salvage value of the project is zero. The target rate of return is 12% per
annum.

Solution

We have,

Initial Investment = $243,000

Net Cash Inflow per Period = $50,000
Number of Periods = 12
Discount Rate per Period = 12% ÷ 12 = 1%

Net Present Value

= $50,000 × (1 − (1 + 1%)^-12) ÷ 1% − $243,000
= $50,000 × (1 − 1.01^-12) ÷ 0.01 − $243,000
≈ $50,000 × (1 − 0.887449) ÷ 0.01 − $243,000
≈ $50,000 × 0.112551 ÷ 0.01 − $243,000
≈ $50,000 × 11.2551 − $243,000
≈ $562,754 − $243,000
≈ $319,754

Example 2: Uneven Cash Inflows: An initial investment on plant and machinery of $8,320 thousand
is expected to generate cash inflows of $3,411 thousand, $4,070 thousand, $5,824 thousand and
$2,065 thousand at the end of first, second, third and fourth year respectively. At the end of the fourth
year, the machinery will be sold for $900 thousand. Calculate the present value of the investment if
the discount rate is 18%. Round your answer to nearest thousand dollars.
Solution
PV Factors:
Year 1 = 1 ÷ (1 + 18%)^1 ≈ 0.8475
Year 2 = 1 ÷ (1 + 18%)^2 ≈ 0.7182
Year 3 = 1 ÷ (1 + 18%)^3 ≈ 0.6086
Year 4 = 1 ÷ (1 + 18%)^4 ≈ 0.5158

The rest of the problem can be solved more efficiently in table format as show below:

Year 1 2 3 4
Net Cash Inflow $3,411 $4,070 $5,824 $2,065
Salvage Value 900
Total Cash Inflow $3,411 $4,070 $5,824 $2,965
× Present Value Factor 0.8475 0.7182 0.6086 0.5158
Present Value of Cash Flows $2,890.68 $2,923.01 $3,544.67 $1,529.31
Total PV of Cash Inflows $10,888
− Initial Investment − 8,320
Net Present Value $2,568 thousand

Advantage and Disadvantage of NPV

Advantage: Net present value accounts for time value of money. Thus it is more reliable than other
investment appraisal techniques which do not discount future cash flows such payback period and
accounting rate of return.
Disadvantage: It is based on estimated future cash flows of the project and estimates may be far
from actual results.

4. Accounting Rate of Return (ARR)

Accounting rate of return (also known as simple rate of return) is the ratio of estimated accounting
profit of a project to the average investment made in the project. ARR is used in investment appraisal.

Formula

Accounting Rate of Return is calculated using the following formula:

Average Accounting Profit

ARR =
Average Investment

Average accounting profit is the arithmetic mean of accounting income expected to be earned during
each year of the project's life time. Average investment may be calculated as the sum of the beginning
and ending book value of the project divided by 2. Another variation of ARR formula uses initial
investment instead of average investment.

Decision Rule

Accept the project only if its ARR is equal to or greater than the required accounting rate of return. In
case of mutually exclusive projects, accept the one with highest ARR.

Examples

Example 1: An initial investment of $130,000 is expected to generate annual cash inflow of $32,000
for 6 years. Depreciation is allowed on the straight line basis. It is estimated that the project will
generate scrap value of $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%

Example 2: Compare the following two mutually exclusive projects on the basis of ARR. Cash flows
and salvage values are in thousands of dollars. Use the straight line depreciation method.

Project A:

Year 0 1 2 3
Cash Outflow -220
Cash Inflow 91 130 105
Salvage Value 10

Project B:

Year 0 1 2 3
Cash Outflow -198
Cash Inflow 87 110 84
Salvage Value 18
Solution
Project A:

Step 1: Annual Depreciation = ( 220 − 10 ) / 3 = 70

Step 2: Year 1 2 3
Cash Inflow 91 130 105
Salvage Value 10
Depreciation* -70 -70 -70
Accounting Income 21 60 45
Step 3: Average Accounting Income = ( 21 + 60 + 45 ) / 3
= 42
Step 4: Accounting Rate of Return = 42 / 220 = 19.1%

Project B:

Step 1: Annual Depreciation = ( 198 − 18 ) / 3 = 60

Step 2: Year 1 2 3
Cash Inflow 87 110 84
Salvage Value 18
Depreciation* -60 -60 -60
Accounting Income 27 50 42
Step 3: Average Accounting Income = ( 27 + 50 + 42 ) / 3
= 39.666
Step 4: Accounting Rate of Return = 39.666 / 198 ≈ 20.0%

Since the ARR of the project B is higher, it is more favorable than the project A.

Advantages and Disadvantages

Advantages
1. Like payback period, this method of investment appraisal is easy to calculate.
2. It recognizes the profitability factor of investment.
Disadvantages
1. It ignores time value of money. Suppose, if we use ARR to compare two projects having equal
initial investments. The project which has higher annual income in the latter years of its useful life
 may rank higher than the one having higher annual income in the beginning years, even if the
present value of the income generated by the latter project is higher.
2. It can be calculated in different ways. Thus there is problem of consistency.
3. It uses accounting income rather than cash flow information. Thus it is not suitable for projects
which having high maintenance costs because their viability also depends upon timely cash
inflows.

5. Internal Rate of Return (IRR)

Internal rate of return (IRR) is the discount rate at which the net present value of an investment
becomes zero. In other words, IRR is the discount rate which equates the present value of the future
cash flows of an investment with the initial investment. It is one of the several measures used for
investment appraisal.

Decision Rule

A project should only be accepted if its IRR is NOT less than the target internal rate of return. When
comparing two or more mutually exclusive projects, the project having highest value of IRR should be
accepted.

IRR Calculation

The calculation of IRR is a bit complex than other capital budgeting techniques. We know that at IRR,
Net Present Value (NPV) is zero, thus:

NPV = 0; or

PV of future cash flows − Initial Investment = 0; or

CF1 CF2 CF3

+ + + ... − Initial Investment = 0
( 1 + r )1 ( 1 + r )2 ( 1 + r )3

Where,
r is the internal rate of return;
CF1 is the period one net cash inflow;
CF2 is the period two net cash inflow,
CF3 is the period three net cash inflow, and so on ...

But the problem is, we cannot isolate the variable r (=internal rate of return) on one side of the above
equation. However, there are alternative procedures which can be followed to find IRR. The simplest of
them is described below:
1. Guess the value of r and calculate the NPV of the project at that value.
2. If NPV is close to zero then IRR is equal to r.
3. If NPV is greater than 0 then increase r and jump to step 5.
4. If NPV is smaller than 0 then decrease r and jump to step 5.
5. Recalculate NPV using the new value of r and go back to step 2.

Example

Find the IRR of an investment having initial cash outflow of $213,000. The cash inflows during the first,
second, third and fourth years are expected to be $65,200, $96,000, $73,100 and $55,400
respectively.

Solution
Assume that r is 10%.
NPV at 10% discount rate = $18,372
Since NPV is greater than zero we have to increase discount rate, thus
NPV at 13% discount rate = $4,521
But it is still greater than zero we have to further increase the discount rate, thus
NPV at 14% discount rate = $204
NPV at 15% discount rate = ($3,975)
Since NPV is fairly close to zero at 14% value of r, therefore
IRR ≈ 14%

6. Profitability Index

Profitability index is an investment appraisal technique calculated by dividing the present value of
future cash flows of a project by the initial investment required for the project.

Formula:

Profitability Index
Present Value of Future Cash Flows
=
Initial Investment Required

Net Present Value

=1+
Initial Investment Required

Explanation:

Profitability index is actually a modification of the net present value method. While present value is an
absolute measure (i.e. it gives as the total dollar figure for a project), the profibality index is a relative
measure (i.e. it gives as the figure as a ratio).

Decision Rule
Accept a project if the profitability index is greater than 1, stay indifferent if the profitability index is
zero and don't accept a project if the profitability index is below 1.

Profitability index is sometimes called benefit-cost ratio too and is useful in capital rationing since it
helps in ranking projects based on their per dollar return.

Example

Company C is undertaking a project at a cost of $50 million which is expected to generate future net
cash flows with a present value of $65 million. Calculate the profitability index.

Solution
Profitability Index = PV of Future Net Cash Flows / Initial Investment Required
Profitability Index = $65M / $50M = 1.3
Net Present Value = PV of Net Future Cash Flows − Initial Investment Rquired
Net Present Value = $65M-$50M = $15M.

The information about NPV and initial investment can be used to calculate profitability index as follows:

Profitability Index = 1 + (Net Present Value / Initial Investment Required)

Profitability Index = 1 + $15M/$50M = 1.3