Capital Budgeting:

Evaluation Techniques
 Financial Decisions
1. Where to invest? – Investment Decisions
– Long-term investment (Capital Budgeting Decisions)
– Short-term investment (Working capital decisions)

2. How to finance the investment – Financing Decisions

– Debt
– Equity (Payout or retain – Dividend decision)

BOTTOM LINE – CREATE VALUE

What is Long-term Investment/Capital budgeting?
• Long-term investments for
• Dabur
• ITC Hotels
• Pantaloon

• Critical in defining a company’s business and its success

 Issues to Ponder before Long-term Investing
• Involves large outlays
• Invest today and get returns
• Irreversible
• Uncertainty – Risk
 Types of Capital Investment Projects
1. Revenue-enhancing projects
• Creating new business
• Expansion of existing business  New products or new markets
• Mergers and acquisitions
2. Cost-reducing projects
• Reducing the cost of doing business
• Modernization
• Replacement of existing machine
3. Mandatory investments
• Safety or environment projects
 Projects
• Independent project: A project whose acceptance or rejection
is independent of the acceptance or rejection of other projects.
• Mutually exclusive projects: Projects are mutually exclusive when
accepting one investment means rejecting others, even though the
latter may pass the acceptance criteria.
• Examples
 Steps to Capital Budgeting
1. Estimating cash flows (outflows & inflows)

2. Estimating discounting rate – Required rate of return, Cost of

capital also called Weighted average cost of capital (WACC)

3. Evaluating the project for making a decision – Using various

evaluation techniques
 Evaluation Techniques
1. Payback Period – Ignores TVM
2. Discounted Payback Period
3. Net Present Value (NPV)
4. Internal Rate of Return (IRR)
5. Modified Internal Rate of Return (MIRR)
6. Profitability Index (PI)

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 Payback Period
• Number of years required to recover a project’s cost  “How long
does it take to get our money back?”
• Calculated by adding project’s cash inflows to its cost until the
cumulative cash flow for the project turns positive.

• Acceptance rule:
If Payback period < Cut-off Period: Accept
If Payback period > Cut-off Period: Reject

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 Calculating Payback
Project L’s Payback Calculation
0 1 2 3

CFt -100 10 60 80
Cumulative -100 -90 -30 50

PaybackL = 2 + 30 / 80
= 2.375 years

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 Strengths and Weaknesses of Payback

• Strengths
– Easy to calculate and understand.
– Provides an indication of a project’s risk and liquidity.

• Weaknesses
– Ignores the time value of money.
– Ignores CFs occurring after the payback period.

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 Discounted Payback Period
• Uses discounted cash flows rather than raw cash flows

0 10% 1 2 3

CFt -100 10 60 80
PV of CFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79

Disc PaybackL = 2 + 41.32 / 60.11 = 2.7 years

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 Net Present Value (NPV)
• NPV is the present value of the project’s free cash flows discounted at
the cost of capital.
• Value of project = NPV

N
CFt
NPV  
t 0 ( 1  r )
t

• r = discount rate/ Cost of Capital (COC) also called known as Weighted

Average Cost of Capital (WACC)
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 NPV – Selection Criteria
• Independent project 
– If NPV > 0, Accept the project
– If NPV < 0, Reject the project

• Mutually exclusive project 

– Accept the project with the highest NPV, provided that NPV
>0

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 NPV and Wealth Creation
• NPV = PV of inflows – Cost  Net gain in wealth
• NPV  Tells us how much the project contributes to the shareholder
wealth

• Higher the NPV  More value the project adds  Higher the stock
price

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 Internal Rate of Return (IRR)
• IRR is the discount rate that forces PV of inflows equal to cost  NPV =
0
• IRR is an estimate of project’s rate of return

N
CFt
0
t  0 (1  IRR)
t

• Calculated in three ways – Trial & error, Excel, Financial calculator

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 IRR – Selection Criteria
• Independent project 
– If IRR > Discount rate (WACC), Accept the project
– If IRR < Discount rate (WACC), Reject the project

• Mutually exclusive project 

– Accept the project with the highest IRR, provided that IRR > Discount
rate (WACC)

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 IRR and Wealth Creation
• If IRR > WACC  the difference will be additional returns for the
stockholders  will lead to an increase in the stock price.

• Higher the IRR  More returns the project adds  Higher the stock
price

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 Comparison of NPV and IRR Formula

N
CFt
NPV   r = Discount rate (WACC) (given)

t 0 ( 1  r )
t Calculate NPV

N
CFt
0 NPV = 0 (given)
t  0 (1  IRR)
t Calculate r = IRR

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 NPV and IRR
• Both are logically appealing but NPV and IRR can give conflicting
conclusions when mutually exclusive projects are evaluated.
• A project may have more than one IRR

• NPV is considered better than IRR in such situations

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 Cash Flow Pattern
• Normal cash flow – A series of out flows followed by a series of inflows
– + + + + + + or – – – – + + + +

• Non normal cash flow – a series of outflows followed by a series of

inflows followed by outflow followed by inflows
– + + + + + – or – + + + – + + +

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 Find Project P’s NPV and IRR
• Project P has cash flows (in 000s):
CF0 = – $800, CF1 = $5,000, and CF2 = – $5,000

0 1 2
WACC = 10%

-800 5,000 -5,000

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 Multiple IRRs

NPV

IRR2 = 400%
450
0 WACC
100 400
IRR1 = 25%
-800

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 Reasons for Multiple IRRs
• At very low discount rates, the PV of CF2 is large and negative, so NPV
< 0.
• At very high discount rates, the PV of both CF1 and CF2 are low, so CF0
dominates and again NPV < 0.
• In between, the discount rate hits CF2 harder than CF1, so NPV > 0.

• Result: 2 IRRs
• So IRR can be Modified to  Modified IRR (MIRR)

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 Modified Internal Rate of Return (MIRR)
• Rearrange the project cash flows so that there is only one IRR
• How?
• By modifying the project cash flows so that there is just one change in
the sign of the cash flows over the life of the project
• Discount all the negative cash flows after the initial cash outflow back to
year 0 and add then to the initial cash flow
• Discount at what rate?
• WACC or IRR?

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 Reinvestment Rate Assumption
• NPV method assumes CFs are reinvested at the WACC
• IRR method assumes  CFs are reinvested at IRR
• Assuming CFs are reinvested at the opportunity cost of capital is more
realistic so for MIRR use WACC

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 Calculating MIRR
• MIRR  Assumes cash flows are reinvested at the WACC
• Estimate PV of cash outflows at WACC
• Estimate FV of cash inflows (called terminal value) at WACC
• MIRR – Discount rate at which PV of a project’s terminal value (TV) = PV
of costs
𝒏 𝑺𝒖𝒎 𝒐𝒇 𝑭𝑽 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘𝒔
𝑴𝑰𝑹𝑹 = −𝟏
𝑺𝒖𝒎 𝒐𝒇 𝑷𝑽 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑶𝒖𝒕𝒇𝒍𝒐𝒘𝒔

• Selection criterion:
– If MIRR > WACC, Accept the project
– If MIRR < WACC, Reject the project
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 Calculating MIRR
0 1 2 3
10%
-100.0 10.0 60.0 80.0
10%
10% 66.0
12.1
MIRR = 16.5%
-100.0 158.1
PV outflows $158.1 TV inflows
$100 =
(1 + MIRR)3
MIRR = 16.5%

Excel: =MIRR (CF0:CFn,Finance_rate,Reinvest_rate)

We assume that both rates = WACC
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 Advantages of MIRR
1. Interim cash inflows are reinvested at cost of capital (a more realistic
rate assumption)
2. MIRR eliminates the multiple IRR problem as there can be never more
than one MIRR

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 Profitability Index (PI)
• Profitability Index (PI) also called Benefit-Cost Ratio (BCR)

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠

𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝐼𝑛𝑑𝑒𝑥 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

• Acceptance Rule:
Accept the project if PI > 1
Reject the project if PI < 1
• It is a useful tool for ranking projects as it allows you to quantify the
amount of value created per unit of investment

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 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:

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 Features of a Sound Method

• Consider Time Value of Money

• Consider the entire cash flow
• Consistent with the Wealth Maximization principle

• NPV is the best method as it is inline with the central goal of financial
management – maximizing shareholder wealth

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 NPV Profiles
• Calculate project’s NPVs at a number of different discount rates/ costs of
capital and Plot them on a graph

NPV Profile

Two distinct point to be noted:

1. At zero discount rate (cost of capital),
NPV = Sum of undiscounted cash flows
2. Rate at which NPV is equal to zero is the IRR33
 NPV vs IRR
Independent projects:
• If an independent project with normal cash flows is evaluated  NPV
and IRR criteria always lead to the same accept/ reject decision

Mutually exclusive projects:

• If a mutually projects with normal cash flows are evaluated  NPV and
IRR criteria may give conflicting results

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 Conditions of Conflict between NPV and IRR
Condition 1: Timing difference
• When cash flows in one project come during early years and in case of
the second they come during the later years

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 Conditions of Conflict between NPV and IRR
Condition 2: Project size (or scale) difference
• If the amount invested in one project is larger than the other

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 Conditions of Conflict between NPV and IRR
Condition 3: Project life span difference
• When the life of the projects is different

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 Conflict of NPV and IRR
• If r > crossover rate, no conflict occurs
• If r < crossover rate, a conflict arises
• Crossover rate (breakeven discount rate) – Rate at which NPV of both
projects are same

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 Crossover Rate

NPV Profiles of Projects M and N NPV versus IRR

The NPV profiles of two projects intersect at 10% discount rate. This is called Crossover
rate or Fisher’s intersection.
 Evaluation of NPV, IRR, MIRR
• Independent project: NPV, IRR, MIRR all are equally good
• Mutually exclusive project: When scale of operation differs, NPV is best
as it is in line with maximizing value
• Final conclusion:
– MIRR is superior to the regular IRR as it is an indicator of a project’s
“true” rate of return
– NPV is better than IRR and MIRR when choosing among competing
projects

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Who is the Winner?

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 Who is the Winner?

Net Present Value

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