Capital Budgeting

INVESTMENT DECISIONS
Learning Outcomes

 Appraise with the planning process to determine an

organization’s long term investments are worth pursuing.

 Differentiate between the different capital budget methods.

 Magnify the impact of future cash flows on investment

appraisal decision
 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
 Sale of a division or business (divestment) is also as an investment
decision.
 Expansion/Acquisition

 Lipton India and Brooke Bond.

 Bank of Mathura with ICICI Bank.

 BSES Ltd with Orissa Power Supply Company.

 Associated Cement Companies Ltd Damodar Cement.

Modernization
Replacement
Divestment
Divestment
Investment Decisions
Decisions

 Investment Decisions

 Change in the methods of sales distribution, or

 An advertisement campaign or

 Research and development programme

 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.
 Importance of Investment Decisions

• Growth

• Risk

• Funding

• Irreversibility

• Complexity
 Types of Investment Decisions

 Expansion of existing business

 Expansion of new business

 Replacement and modernisation

 Mutually exclusive investments

 Independent investments

 Contingent investments
 Investment Evaluation Criteria

 Steps involved in the evaluation of an investment:

1. Estimation of cash flows

2. Estimation of the required rate of return

3. Application of a decision rule for making the choice

 Investment Decision Rule

 Maximise the shareholders’ wealth.

 Consider all cash flows

 Objectivity

 Profitability Ranking

 Bigger cash flows are preferable to smaller ones

 Early cash flows are preferable to later ones.

 Help to choose among mutually exclusive projects

 A criterion which is applicable to any conceivable project

Evaluation Criteria

 Discounted Cash Flow (DCF) Criteria

 Net Present Value (NPV)

 Internal Rate of Return (IRR)

 Profitability Index (PI)

Evaluation Criteria

 Non-discounted Cash Flow Criteria

 Payback Period (PB)

 Discounted payback period (DPB)

 Accounting Rate of Return (ARR)

 Net Present Value Method

 Cash flows forecast on realistic assumptions.

 Appropriate discount rate.

 Opportunity cost of capital as the discount rate.

 Net present value

 The project should be accepted if NPV is positive (i.e., NPV >

0).
Net Present Value Method

 Formula:

 C1 C2 C3 Cn 
NPV        C0
 (1  k ) (1  k ) (1  k ) (1  k ) 
2 3 n

n
Ct
NPV    C 0
t 1 (1  k )
t
 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.
Solution
 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.

 Problem

A firm is considering replacing an old machine and has two types of

machines in view. The opportunity cost of capital is 10 percent. Calculate
NPV of two machines and indicate which machine should be accepted?

The cash flows in (in lakh) of two options are assessed as follows:

Year 0 1 2 3 4 5
Machine -80 20 25 25 30 30
A
Machine -60 - 25 30 20 20
B
 Calculate the NPV for the following project with the

following cash flows:

 An initial outlay of 35,400 followed by inflows of

6,500 for three years and then a single inflow in the

fourth year of 18,000 at a cost of capital of 9%.
 The CFO of Smith Company is interested in the NPV
associated with a production facility that the CEO wants
to acquire.
 In exchange for an initial 10 million payment, Smith
should receive payments of 1.2 million at the end of each
of the next 15 years.
 Smith has a corporate cost of capital of 9%.
 Evaluation of the NPV Method

 NPV is most Acceptable investment rule:

 Time value

 Measure of true profitability

 Value-additivity

 Shareholder value
 Evaluation of the NPV Method

 Limitations:

 Involved cash flow estimation

 Discount rate difficult to determine

 Mutually exclusive projects

 Ranking of projects
Value of NPV is:

a) Present value of cash inflows- Present value of cash

outflows
b) Present value of cash outflows- Present value of
cash inflows
c) Inflows- Outflows
d) None of the above
 In mutually exclusive projects, project which is
selected for comparison with others must have

a) higher net present value

b) lower net present value
c) zero net present value
d) all of above
 First step in calculation of net present value is to find
out

a) present value of equity

b) future value of equity
c) present value cash flow
d) future value of cash flow
 The term mutually exclusive investments mean:

a) Choose only the best investments.

b) Selection of one investment leaves the selection of
an alternative.
c) The elite investment opportunities will get chosen.
d) There are no investment options available.
 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.
NPV Profile and IRR

NPV Profile
 NPV And Discount Rate

 As discount rate increases NPV falls.

 The discount rate at which NPV is zero is called IRR .

Net Present Values & Discount Rate

80.00

60.00

NPV 40.00

20.00

-
0 10 20 28.23 35
(20.00)
Discount Rate (%)
NPV And IRR – Decision Rules A Comparison

As per NPV rule:

 The project is accepted as long as the discount rate is below 28.23%

because the net present value remains positive till then.
 It is rejected for discount rate beyond 28.23%.

As per IRR rule:

 The project is accepted as long as cost of capital remains below

28.23%, the IRR of the project.

 It is rejected if cost of capital exceeds 28.23%.

IRR Interpretation

 IRR as the rate of growth a project is expected to generate.

 While the actual rate of return that a given project ends up

generating will often differ from its estimated IRR rate,

 A project with a substantially higher IRR value than other available

options would still provide a much better chance of strong growth.
 Any project with an IRR greater than its cost of capital is a
profitable one, and thus it is in a company’s interest to undertake
such projects.

 Any project with an IRR that exceeds the RRR will likely be deemed
a profitable one.

 Highest difference between IRR and RRR

CALCULATION OF IRR

•Level Cash Flows

–An investment would cost Rs 25,000 and provide annual cash

inflow of Rs 10000,9000,8000 and 7000 in following 4 years.

–Calculate IRR of the investment.

Interpolation IRR

 Interpolate IRR as Follows:

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 if the firm has no shortage of funds.

NPV Vs IRR
PROBLEM
In Lakhs

YEAR PROJECT A PROJECT B

0 -100 -100
1 22 30
2 22 30
3 22 30
4 22 30
5 22 30
6 22 -
7 22 -

Cost of Capital is 10% for both the projects. Calculate NPV and IRR
Evaluation of IRR Method

 IRR method has following merits:

 Time value

 Profitability measure

 Acceptance rule

 Shareholder value
Evaluation of IRR Method

 IRR method may suffer from

 Multiple rates

 Mutually exclusive projects

 Value additivity
NPV & IRR

 Known And unKnown

 Relative and Absolute

 Wealth creation

 Reinvestment Rate

 Surplus and Break Even

 Decision Making Aid

 Addition and Non Addition

 PV vs. IRR NPV and IRR will generally give the same
decision

Exceptions
 Non-conventional cash flows
 Mutually exclusive projects
 Initial investments are substantially different
 Timing of cash flows is substantially different
 Will not reliably rank projects
 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 Problem

 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:

PROFITABILITY INDEX
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.

PROFITABILITY INDEX Problem

 The initial cash outlay of a project is Rs 200,000 and it can

generate cash inflow of Rs 70,000, Rs 70,000, Rs 60,000,

Rs50000 and Rs 40,000 in year 1 through 5.

 Assume a 10 percent rate of discount.

 Evaluation of PI Method

• Time value

• Value maximization

• Relative profitability
• Relative measure of a project’s profitability.

• Like NPV method, PI criterion also requires calculation of

cash flows and estimate of the discount rate.
PAYBACK

 Payback is the number of years required to recover the

original cash outlay invested in a project.

 Constant annual cash inflows,

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 12,500
PAYBACK

 Unequal cash flows

 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

 If it is less than the maximum or standard

Payback period set by management.

 As a ranking method,

 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 effects

– Risk shield

– Liquidity
Evaluation of Payback

• Serious limitations:

 Cash flows after payback

 Cash flows ignored

 Cash flow patterns

 Administrative difficulties

 Inconsistent with shareholder value

DISCOUNTED PAYBACK PERIOD

 On present value basis.

 Fails to cover inflows after the payback period.

Discounted Payback Illustrated

ACCOUNTING RATE OF RETURN

 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.

or
Example

• A project will cost Rs 40,000. Its stream of earnings before

depreciation, interest and taxes (EBDIT) during first year through
five years is expected to be Rs 10,000, Rs 12,000, Rs 14,000, Rs
16,000 and Rs 20,000.

• Assume a 50 per cent tax rate and

• Depreciation on straight-line basis.

Calculation of Accounting Rate of Return
Acceptance Rule

• Accept all those projects

• ARR is higher than the minimum rate established by the

management

• Rank a project as number one if it has highest ARR

• 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

Problems

 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.
 Calculate NPV for the given project.

 Also discuss whether the projected should be accepted or

rejected and also provide reason for the same?
Graham Incorporated uses discounted payback period for projects under
$25,000 and has a cut off period of 4 years for these small value projects.

Two projects, R and S are under consideration.

The anticipated cash flows for these two projects are listed below. If Graham
Incorporated uses an 8% discount rate on these projects are they accepted or
rejected? If they use 12% discount rate?

Cash Flows Project R Project S

Initial Cost $24,000 $18,000

Cash flow year one $6,000 $9,000

Cash flow year two $8,000 $6,000

Cash flow year three $10,000 $6,000

Cash flow year four $12,000 $3,000

Problem

Campbell Industries has four potential projects all with an initial cost of
$1,500,000. The capital budget for the year will only allow Swanson
industries to accept one of the four projects. Given the discount rates and
the future cash flows of each project, which project should they accept?

Cash Flows Project Q Project R Project S Project T

Year one $350,000 $400,000 $700,000 $200,000

Year two $350,000 $400,000 $600,000 $400,000

Year three $350,000 $400,000 $500,000 $600,000

Year four $350,000 $400,000 $400,000 $800,000

Year five $350,000 $400,000 $300,000 $1,000,000

Discount Rate 4% 8% 13% 18%