Capital Budgeting Decision

Criteria 1: NPV(Net present value)

NPV = Presents value of future cash inflow- Initial Investment

Or
Present value of future cash inflow – present value of cash outflow

Decision : If NPV> 0 , we should accept the project.

If NPV < 0 , We should reject the project.
If NPV = 0 , Indifferent

Interest rate 10%

Year Cash Flow
0 (1,00,000)
1 30,000
2 40000
3 35000
4 45,000

NPV = Presents value of future cash inflow- Initial Investment

NPV. = [(30000/1.101)+ (40000/1.10 2) + (35000/1.10) 3+ (45000/1.10) 4] – 100000

= 117362.20 – 100000
= 17362.20
As the NPV is positive 17362.20, we should accept the project.

X = 17362. Y = (2320), Z = 20000

Interest rate 10%

Year Cash Flow
0 (1,00,000)
1 30,000
2 40000
2 (10000)
3 35000
4 45,000

NPV= Present value of future cash inflow – present value of cash outflow

= = [(30000/1.101)+ (40000/1.10 2) + (35000/1.10) 3+ (45000/1.10) 4] –

[100000 + (10000/1.10 2)
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NPV = 9097.44 Accept

Year Cash Flow

0 (1,00,000)
1 30,000
2 40000
3 (10000)
4 35000
5 45,000

[(30000/1.101)+ (40000/1.10 2) + (35000/1.10) 4+ (45000/1.10) 5] –

[100000 + (10000/1.10 3)

Criteria 2 : Internal Rate of return(IRR)

IRR is rate at which present value of cash inflow = initial investment

Decision criteria:
If IRR > required rate of return = Accept
If IRR < required rate of return = Reject
IRR = Required rate of return = Indifferent

Year Cash Flow

0 (1,00,000)
1 30,000
2 40000
3 35000
4 45,000

At 10% discount rate:

PV of future cash inflow = [(30000/1.101)+ (40000/1.10 2) + (35000/1.10) 3+ (45000/1.10) 4]
= 117362.20

At 15% discount rate:

PV of future cash inflow = [(30000/1.151)+ (40000/1.15 2) + (35000/1.15) 3+ (45000/1.15) 4]
= 105074.7
At 20% discount rate :

PV of future cash inflow = [(30000/1.201)+ (40000/1.20 2) + (35000/1.20) 3+ (45000/1.20) 4]

= 94733.8

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By using trail & error method:

Initial Investment 100000

15% 105074.7
20% 94733.8

Initial Investment 100000

10% 117362.20
20% 94733.8

Highest value – Medium value

Lowest interest rate +. (highest value – Lowest value). ( difference in interest rate)

= 15 + [(1056074.7 – 100000)/ (105074.7- 94733.8)] 5

= 15+2.45
= 17.45%

Profitability Index: (PI)

(Present value of cash inflow/ Initial investment)

PI> 1 = Accepts
PI< 1 = Rejects
PI= 1 = Indifferent

Payback Period: Payback period is a year in which your investment will return.

Even cash flow: (Initial Investment/ Annual Cash Flow)

Criteria : Lower the year is better

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Uneven cash flow:
Year Cash Flow Cumulative cash
flow
1 30,000 30,000
2 40000 70,000
3 35000 105000
4 45,000 150000

Initial Investment: 100000

2 years + 30,0000
35000
= 2+ 0.85
= 2.85 years

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