Chapter 3

Capital Budgeting
Evaluation Techniques

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 EVALUATION TECHNIQUES
(1) Traditional Techniques
(i) Pay back period method
(ii) Average rate of return method
(2) Discounted Cashflow (DCF)/Time-Adjusted (TA)
Techniques
(i) Net present value method
(ii) Internal rate of return method
(iii) Profitability index

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 Pay Back Method
The pay back method measures the number of years required for the CFAT
to pay back the initial capital investment outlay, ignoring interest
payment. It is determined as follows
(i) In the case of annuity CFAT: Initial investment/Annual CFAT.
(ii) In the case of mixed CFAT: It is obtained by cumulating CFAT till the
cumulative CFAT equal the initial investment.
Original/initial Investment (outlay) is the relevant cash outflow for a
proposed project at time zero (t = 0).
Annuity is a stream of equal cash inflows.
Mixed Stream is a series of cash inflows exhibiting any pattern other than
that of an annuity.
Although the pay back method is superior to the ARR method in that
it is based on cash flows, it also ignores time value of money
and disregards the total benefits associated with the investment proposal.

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Example 1
(i) In the case of annuity CFAT
An investment of Rs 40,000 in a machine is expected
to produce CFAT of Rs 8,000 for 10 years,
PB = Rs 40,000/Rs 8,000 = 5 years

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Example 2
Determine Pay Back Period from the following data of two machines, A and
B.
Particulars Machine A Machine B
Cost Rs 56,125 Rs 56,125
Annual estimated income
after depreciation and
income tax:
Year 1 3,375 11,375
2 5,375 9,375
3 7,375 7,375
4 9,375 5,375
5 11,375 3,375
36,875 36,875
Estimated life (years) 5 5
Estimated salvage value 3,000 3,000
Depreciation has been charged on straight line basis.

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(ii) In the case of mixed CFAT
Table 2 presents the calculations of pay back period for Example 2.
Table 2
Year Annual CFAT Cumulative CFAT
A B A B
1 Rs 14,000 Rs 22,000 Rs 14,000 Rs 22,000
2 16,000 20,000 30,000 42,000
3 18,000 18,000 48,000 60,000
4 20,000 16,000 68,000 76,000
5 25,000* 17,000* 93,000 93,000
* CFAT in the fifth year includes Rs.3,000 salvage value also.

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 Average Rate of Return Method
The ARR is obtained dividing annual average profits after
taxes by average investments.
Average investment = 1/2 (Initial cost of machine – Salvage
value) + Salvage value + net
working
capital.
Annual average profits after taxes = Total expected after tax
profits/Number of
years
The ARR is unsatisfactory method as it is based on
accounting profits and ignores time value of money.
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Example 2
Determine the average rate of return from the following data of two
machines, A and B.
Particulars Machine A Machine B
Cost Rs 56,125 Rs 56,125
Annual estimated income
after depreciation and
income tax:
Year 1 3,375 11,375
2 5,375 9,375
3 7,375 7,375
4 9,375 5,375
5 11,375 3,375
36,875 36,875
Estimated life (years) 5 5
Estimated salvage value 3,000 3,000
Depreciation has been charged on straight line basis.

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Solution
ARR = (Average income/Average investment) × 100.
Average income of Machines A and B =(Rs 36,875/5) = Rs 7,375.
Average investment = Salvage value + 1/2 (Cost of machine –
Salvage value) = Rs 3,000 + 1/2 (Rs 56,125 – Rs 3,000) = Rs
29,562.50.
ARR (for machines A and B) = (Rs 7,375/Rs 29,562.50) × 100 = 24.9
per cent.

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 Discounted Cashflow (DCF)/Time-
Adjusted (TA) Techniques

The DCF methods satisfy all the attributes of a good measure of

appraisal as they consider the total benefits (CFAT) as well as the
timing of benefits.
The present value or the discounted cash flow procedure
recognises that cash flow streams at different time periods differ in
value and can be compared only when they are expressed in terms
of a common denominator, that is, present values. It, thus, takes into
account the time value of money. In this method, all cash flows are
expressed in terms of their present values.

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The present value of the cash flows in Example 2 are illustrated in Table 3.
Table 3: Calculations of Present Value of CFAT.
Year Machine A Machine B
CFAT PV Present CFAT PV Present
factor value factor value
(0.10) (0.10)
1 2 3 4 5 6 7
1 Rs 14,000 0.909 Rs 12,726 Rs 22,000 0.909 Rs 19,998
2 16,000 0.826 13,216 20,000 0.826 16,520
3 18,000 0.751 13,518 18,000 0.751 13,518
4 20,000 0.683 13,660 16,000 0.683 10,928
5 25,000* 0.621 15,525 17,000* 0.621 10,557
68,645 71,521
*includes salvage value.

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 Net Present Value (NPV) Method
The NPV may be described as the summation of the present values of
(i) operating CFAT (CF) in each year and (ii) salvages value(S) and
working capital(W) in the terminal year(n) minus the summation
of present values of the cash outflows(CO) in each year. The present value
is computed using cost of capital (k) as a discount rate.
The decision rule for a project under NPV is to accept the project if the NPV
is positive and reject if it is negative. Symbolically,
(i) NPV > zero, accept, (ii) NPV < zero, reject
Zero NPV implies that the firm is indifferent to accepting or rejecting the
project.
The project will be accepted in case the NPV is positive.

Net Present n CFt Sn + Wn n COt

= ∑ + - ∑
Value t=1 (1+k)t (1+k)n t=1 (1+k)t

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Example 6
In Example 2 we would accept the proposals of purchasing machines A and
B as their net present values are positive. The positive NPV of machine A is
Rs 12,520 (Rs 68,645 – Rs 56,125) and that of B is Rs 15,396 (Rs 71,521 – Rs
56,125).
In Example 2, if we incorporate cash outflows of Rs 25,000 at the end of the
third year in respect of overhauling of the machine, we shall find the
proposals to purchase either of the machines are unacceptable as their net
present values are negative. The negative NPV of machine A is Rs 6,255 (Rs
68,645 – Rs 74,900) and of machine B is Rs 3,379 (Rs 71,521 – Rs 74,900).
As a decision criterion, this method can also be used to make a choice
between mutually exclusive projects. On the basis of the NPV method, the
various proposals would be ranked in order of the net present values. The
project with the highest NPV would be assigned the first
rank, followed by others in the descending order. If, in our example, a
choice is to be made between machine A and machine B on the basis of the
NPV method, machine B having larger NPV (Rs 15,396) would be preferred
to machine A (NPV being Rs 12,520).

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 Internal Rate of Return (IRR)
Method
The IRR is defined as the discount rate (r) which equates the
aggregate present value of the operating CFAT received each year
and terminal cash flows (working capital recovery and salvage
value) with aggregate present value of cash outflows of an
investment proposal.

Internal Rate of n CFt Sn + Wn n COt

= ∑ + - ∑
Return t=1 (1+r)t (1+r)n t=1 (1+r)t
The project will be accepted when IRR exceeds the
required rate of return.

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 IRR for an Annuity

The following steps are taken in determining IRR for an annuity.

Determine the pay back period of the proposed investment.
In Table A-4 (present value of an annuity) look for the pay back
period that is equal to or closest to the life of the project.
In the year row, find two PV values or discount factor (DFr)
closest to PB period but one bigger and other smaller than it.
From the top row of the table, note interest rate (r) corresponding
to these PV values (DFr).

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Determine actual IRR by interpolation. This can be done either directly using
Equation 1 or indirectly by finding present values of annuity (Equation 2).
PB – DFrH
IRR = Hr -
DFrL - DFrH
Where PB = Pay back period
DFr = Discount factor for interest rate r.
DFrL = Discount factor for lower interest rate
DFrH = Discount factor for higher interest rate.
r = Either of the two interest rates used in the formula
PVco - PVCFATH
Alternatively, IRR = Hr - × ∆r (Equation 2)
∆PV
Where PVCO = Present value of cash outlay
PVCFAT = Present value of cash inflows (DFr x annuity)
r = Either of the two interest rates used in the formula
∆ r = Difference in interest rates
∆ PV = Difference in calculated present values of inflows

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Example 7
A project costs Rs 36,000 and is expected to generate cash
inflows of Rs 11,200 annually for 5 years. Calculate the IRR of the
project.
Solution
(1) The pay back period is 3.214 (Rs 36,000/Rs 11,200)
(2) According to Table A-4, discount factors closest to 3.214 for
5 years are 3.274 (16 per cent rate of interest) and 3.199 (17 per
cent rate of interest). The actual value of IRR which lies between
16 per cent and 17 per cent can, now, be determined using
Equations 1 and 2.
Substituting the values in Equation 1 we get: IRR = 16 + [(3.274-
3.214)/(3.274-3.199)] = 16.8 per cent.
Alternatively (starting with the higher rate), IRR = 17 – [(3.214-
3.199)/(3.274-3.199)] = 16.8 per cent.
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Instead of using the direct method, we may find the actual IRR by
applying the interpolation formula to the present values of cash
inflows and outflows (Equation 2). Here, again, it is immaterial whether
we start with the lower or the higher rate.
PVCFAT (0.16) = Rs 11,200 × 3.274 = Rs 36,668.8
PVCFAT (0.17) = Rs 11,200 × 3.199 = Rs 35,828.8
36,668.8 – 36,000
IRR = 16 + × 1 = 16.8 %
36,668.8 – 35,828.8
Alternatively (starting with the (PVCO – PVCFATH)
higher rate), IRR = ×∆r
∆ PV
Hr -
36,000 – 35,828.8
IRR = 17 - × 1 = 16.8 %
840

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 Profitability Index (PI) or Benefit-
Cost Ratio (B/C Ratio)
The profitability index/present value index measures the present
value of returns per rupee invested. It is obtained dividing
the present value of future cash inflows (both operating
CFAT and terminal) by the present value of capital cash outflows.

Profitability Present value cash inflows

Index =
Present value of cash outflows

The proposal will be worth accepting if the PI exceeds one.

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Example 8
When PI is greater than, equal to or less than 1, the net present value is
greater than, equal to or less than zero respectively. In other words, the
NPV will be positive when the PI is greater than 1; will be negative when the
PI is less than one. Thus, the NPV and PI approaches give the same results
regarding the investment proposals.
The selection of projects with the PI method can also be done on the basis
of ranking. The highest rank will be given to the project with the highest PI,
followed by others in the same order.
In Example 4 (Table 3) of machine A and B, the PI would be 1.22 for machine
A and 1.27 for machine B:
Rs 68,645
PI (Machine A) = = 1.22
Rs 56,125
Rs 71,521
PI (Machine B) = = 1.27
Rs 56,125
Since the PI for both the machines is greater than 1, both the machines are
acceptable.

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9-20