Capital Budgeting

Dr. Satish Kumar

 Capital budgeting

• They have long-term consequences

• They often involve substantial outlays

• It is very difficult or expensive to reverse them

 Project classification
• Mandatory projects

• Replacement projects

• Expansion projects

• Diversification projects

• Research and development projects

• Miscellaneous projects
 Investment criteria
Investment
criteria

Discounting Non-Discounting
criteria criteria

Net present Benefit cost Internal rate Payback Accounting

value ratio of return period rate of return
 1. Payback period
• It is the length of time required to recover the initial on the project.

• The shorter the time, the better.

• For instance, if a project costs Rs. 600,000, and it generates Rs.

100,000, Rs. 150,000, Rs. 150,000, and Rs. 200,000 in the first,
second, third and fourth years, respectively, then the payback time is
4 years.

• This is simple both in concept and application.

 Limitations of payback period
• It does not consider time value of money
• It ignores the cash flows beyond the payback period.

Year Project A Project B

0 -100,000 -100,000
1 50,000 20,000
2 30,000 20,000
3 20,000 20,000
4 10,000 40,000
5 10,000 50,000
6 5,000 60,000

• It is a measure of capital recovery, not profitability

 Discounted payback period
• It considers the time value of money concept.

• Find out the discounted payback for a project which involves an initial
investment of Rs. 10,00,000 and provides an annual cash inflow of Rs.
400,000 for 4 years. The cost of capital is 12%.

At n = 3 years, PVIFA = 2.402

At n = 4 years, PVIFA = 3.037

Therefore, n = 3.15 years

• Limitations of discounted payback period?

 2. Accounting rate of return
• It is also known as average accounting return or average rate of
return.
• It is defined as the average profit after tax or net income divided by
the average book value of investments.
• If a project involves an initial investment of Rs. 500,000 and PAT
generated in 5 years is given below, what will be ARR?

Year PAT
1 100,000
2 150,000
3 50,000
4 0
5 -50,000
 2. Accounting rate of return

1. It is simple to calculate.

2. It is based on accounting information which is readily available

3. It considers returns over the entire life of the project, and therefore, serves as a
measure of profitability, not recovery.
 Limitations of ARR
• It does not consider time value of money

• It is based upon accounting profit, not cash flows

• It is internally inconsistent

• The numerator measures the profit after tax which belongs

to only equity shareholders, however, its denominator
represents fixed investment which may include debt as
well.
 3. Net present value
NPV is the sum of the present value of all cash flows – positive as well as
negative.
NPV = PV of all cash inflows – initial investment

Year Cash flows

0 -10,00,000 If NPV is positive, accept the project
1 200,000
2 200,000 If NPV is negative, reject the project
3 300,000
If NPV is zero, indifferent
4 300,000
5 350,000

= Rs. – 5273
 Properties of NPV
• NPVs are additive, i.e., the NPV of a package of projects is
simply the sum of NPVs of individual projects in the package.

• The value of a firm can be expressed as sum of the present

value of projects in place (assets in place) as well as the NPV
of prospective projects (growth opportunities)

• When the firm terminates an existing project with a negative

NPV, the value of the firm increases by that amount and vice-
versa.
 Limitations of NPV
• NPV is expressed in absolute terms rather than
relative terms.

• NPV does not take into account the life of the project
when mutually exclusive projects with different lives
are being considered. Thus, it is skewed (biased)
towards project with longer life.
 4. Benefit cost ratio
It is also known as profitability index

PVB is the present value of benefits and I is the initial investment

Year Cash flows NBCR = BCR – 1 = 1.145 – 1 = 0.145

0 - 100,000
1 25,000 BCR NBCR Rule
2 40,000 >1 >0 Accept
3 40,000 <1 <0 Reject
4 50,000 =1 =0 Indifferent
Cost of capital is 12%
 Benefit cost ratio
• Since this criteria measures the NPV per rupee of outlay, it can
easily discriminate between large and small investments, and
hence is preferable over NPV.

• Under unconstrained conditions, the BCR criterion will accept

and reject the same projects as NPV.

• When the capital budget is limited in the current period, the

BCR may rank the projects correctly in the order of decreasing
efficient use of capital.
 5. Internal rate of return (IRR)
• It is that discount rate at which the NPV of the project is equal to zero.
• In other words, it is the discount rate which equates the present value of
future cash flows with the initial investment.

Year Cash flows

0 - 100,000 NPV
1 30,000 45,000
2 30,000
3 40,000
4 45,000
0
At 15%, PV = 100,801 0 15.37% Discount rate
At 16%, PV = 98,636

IRR = 15.37%
 NPV vs IRR
• Do the NPV and IRR lead to identical decisions?

• Only when 2 conditions are met

– The cash flows must be conventional
– Projects must be independent

• What are the limitations of IRR?

– When the cash flows are not conventional
 Year Cash flows
Consider the following project
0 - 160,000
The IRR equation for this project is 1 10,00,000
2 -10,00,000

The simple computation tells us that this equation has two roots, viz., 1.25 and 5.00

It means, the IRR corresponding to these roots will be 25% and 400%, i.e., the
NPV is zero at two discount rates

NPV

Discount rate
25% 400%
 Modified internal rate of return (MIRR)
1. Calculate the present value of all the cash outflows (PVC), using the cost of capital.

2. Calculate the terminal value (TV) of all the cash inflows expected from the project

3. Compute MIRR using the formula as below

Consider the project as shown below, and find the MIRR if the cost of capital is 15%

Year 0 1 2 3 4 5 6
Cash flows -120 -80 20 60 80 100 120
 Evaluation
1. MIRR is superior to IRR in that it assumes the project cash flows are
reinvested at the cost of capital whereas IRR assumes the cash flows are
reinvested at project’s own IRR

2. Problems of multiple IRRs do not arise with the use of MIRR

3. If two mutually exclusive projects are of the same size, NPV and MIRR
leads to the sane decision, irrespective of variations in their life

4. If two mutually exclusive projects are of different sizes, NPV is

preferable.