Capital Budgeting

Decisions
Accepting projects that yields a return higher
than the hurdle rate
Capital Budgeting Decisions
Capital budgeting decisions relate to selection of
a long-term asset or investment proposal or
course of action that generally involves use of
funds today but generate regular and
recurring benefits in future.
❑ Benefit may be in the form of increased revenue or
reduced cost
❑ Capital budgeting decisions could relate to:
– Additions
– Modifications
– Replacements
– Disposals Narain
Capital Budgeting Decision Process

Decisions involved in capital budgeting

projects:
1. Estimate costs and benefits from the
project
2. Convert these costs and benefits to a
single figure
3. Compare this against a predetermined
amount, rate or time period
4. Make a choice
Narain
Assumptions in Capital Budgeting
1. All cash flows take place at the end of the time
period
2. No change in the risk i.e. size and timing of cash flow
are known with certainty
3. Perfect capital markets
4. Projects are infinitely divisible but exhibit decreasing
return to scale
5. Cash flows are in independent of each other overtime
and other investment decisions
6. Rational decision parties
7. It is a well-behaved project or conventional cash flow
projects Narain
Problems involved in Capital Budgeting

1. Estimating future costs – both initial

and operating
2. Forecasting of benefits
3. Determination of cost of capital or
required rate of return
4. Treatment of time element – economic
life of project
5. Treatment of risk element
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Cost – Benefit measurement
❑ Profit is not a theoretical superior basis of
measurement
❑ Cash Flow is considered to be the superior
basis of measurement
– Is not affected by the Accounting conventions
– Objective and verifiable
❑ Cash Flow models can also be taken at
different levels of analysis –
– Operating Free Cash Flow
– Free Cash Flow to Equity
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Proforma Cash Flow Statement
1. Cash flow from operations
Profit before tax
+ Depreciation & other non-cash items
+ Interest & other non-operating items
- Income tax paid
- Increase in Working Capital
2. Cash flow from investing
Cash paid to acquire Fixed Asset
Cash received for disposing Fixed Asset
3. Cash flow from financing
Interest/Dividend paid
Capital funds raised Narain
 Cash Flows of the Project
❑ Incremental Non-Financing Cash Flows After Tax
❑ Only the cash flows which are incremental in nature
and directly attributable to the project are relevant
❑ Net of tax effect – tax liability or tax shield
❑ Depreciation & Amortisation – non cash items but
affects taxes
❑ Indirect overheads – ignore if not affected by the
project
❑ Effect on other projects – consider with the projects
flows
❑ Opportunity costs – consider with the project flows
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Cash Flows of the Project
❑ Financial charges – ignore in the project flows
– Investment & Financing decisions are
considered separately
– Avoids double counting as these charges are
reflected in the hurdle rate
❑ Changes in working capital – consider with
the project flows
– Only changes are considered
– Need arise because account books are kept on
accrual basis
Narain
Cash flow computation
With the help of following projected Income Statement,
calculate the cash inflow:
Net Sales Revenue 475000
Cost of goods sold 200000
General expenses 100000
Depreciation 50000 350000
Profit before interest and taxes 125000
Interest 25000
Profit before tax 100000
Tax @30% 30000
Profit after tax 70000
Narain
Cash flow computations
The cost of a new plant is Rs. 5,00,000. It
has an estimated life of 5 years after
which it would be disposed off (scrap
value is nil). Profit before depreciation,
interest and taxes (EBITDA) is estimated
to be Rs. 1,75,000 p.a.
Find out the yearly cash flow from the plant,
if tax rate is assumed to be 30% and
depreciation is provided on straight line
basis. Narain
Cash flow computations
ABC Ltd. is evaluating a capital budgeting proposal
for which relevant figures are as follows:
Cost of Plant Rs. 10,00,000
Installation cost Rs. 5,000
Economic life 5 years
Scrap value (net of taxes) Rs. 80,000
Profit before depreciation and tax Rs. 5,00,000 p.a.
Tax rate 30%
Compute cash flows for the relevant period
assuming written down method of providing
depreciation for tax purposes is 40%.
Narain
Illustration 3
A machine has a book value of Rs. 90,000. and
remaining life of 5 years. It is depreciable @
20%. Its present salvage value is its book
value but nil after 5 years.
It can be replaced with a new machine worth
Rs. 4,00,000. It will have a salvage value of
Rs. 2,50,000 after 5 years. The new machine
will save Rs. 1,00,000 p.a. in manufacturing
costs. It will depreciate @ 33.33%. The tax
rate is 35%.
Determine the post tax incremental cash flow.
Narain
Exercise
A machine purchased for Rs. 96,000 has a book
value of Rs. 24,000 and remaining life of 4
years. It is depreciable @ 50%. Its present
salvage value is Rs. 20,000 but nil after 4
years.
It can be replaced with a new machine worth Rs.
1,30,000. It will have a salvage value of Rs.
8,000 after 4 years. The new machine will save
Rs. 60,000 p.a. in manufacturing costs. It will
depreciate @ 40%. The tax rate is 35%.
Determine the post tax incremental cash flow.
Narain
Illustration
Find incremental CFAT from the following information:
Purchase price of the new asset 10,00,000
Installation costs 2,00,000
Depreciation on new asset 20%
Scrap value of the new asset after 4 years 3,50,000
Annual revenues from new asset 21,50,000
Annual cash expenses on new asset 9,50,000
Current book value of old asset 4,00,000
Present scrap value of old asset 5,00,000
Annual revenue from old asset 19,25,000
Annual cash expenses on old asset 11,25,000
Scrap value of the old asset after 4 years 50,000
Depreciation on old asset 25%
Planning period 4 years
Tax rate 30%
What if new asset also result in an increase in Working Capital of Rs. 2,50,000 ?
Exercise
A company is considering to install a machine costing Rs.
5,00,000 with an additional investment of Rs. 1,50,000 for
its installation. The salvage value at the end of year 10 is
estimated at Rs. 2,50,000. The machine is estimated to
generate a sales revenue of Rs. 20,00,000 in the first year
and the sales are expected to grow at 5% p.a. for the
remaining life of the machine. The profit after tax is
expected at 10% of the sales while the working capital
requirement are expected to be 5% of the sales.
Compute the cash flows assuming SLM depreciation and
additional working capital is required at the beginning of
each year and is fully salvageable.
 Solution
❑ Initial investment outlay – Rs. 7,50,000
❑ First Year CFAT – Rs. 2,35,000
❑ Second Year CFAT – Rs. 2,44,750
❑ Third Year CFAT – Rs. 2,54,987
❑ Fourth Year CFAT – Rs. 2,65,737
❑ Fifth Year CFAT – Rs. 2,77,024
❑ Sixth Year CFAT – Rs. 2,88,875
❑ Seventh Year CFAT – Rs. 3,01,319
❑ Eighth Year CFAT – Rs. 3,14,385
❑ Ninth Year CFAT – Rs. 3,28,104
❑ Tenth Year CFAT – Rs. 7,55,396 Narain
CAPITAL BUDGETING EVALUATION
TECHNIQUES

Computing the yield on projects to be compared

with the hurdle rate
Basic Terminology
❑ Independent vs. Mutually Exclusive
Projects
❑ Accept-Reject vs. Ranking
Approaches
❑ Unlimited Funds vs. Capital
Rationing
❑ Conventional vs. Non-conventional
Cash Flow Patterns
Narain
Criteria of Evaluative Tools

1. Simplicity

2. Sufficiency

3. Objectivity

4. Consistency

5. Reasonable
Narain
Desirable features of evaluation
techniques in Capital Budgeting

1. Simple to understand & easy to use

2. Should consider total benefits over the
economic life of the project
3. Benefits based on Cash Flows rather than
Accounting Profit
4. Should be consistent with the objective of
shareholder’s wealth maximisation
5. Internally consistent assumption of
reinvestment rate.
Narain
Evaluation Techniques
Non-discounted cash flow techniques
1. Accounting Rate of Return
2. Payback Period
Discounted cash flow techniques
1. Net Present Value
2. Internal Rate of Return
3. Profitability Index
4. Project Duration
5. Net Terminal Value
6. Adjusted Present Value
7. Equity Present Value Narain
Evaluation Techniques
Mathematical Programming techniques
1. Linear Programming
2. Integer Programming
or Zero-one Programming
3. Goal Programming

Narain
Accounting Rate of Return
It compares the average annual profits to average
investment
❑The steps to determine the ARR is:
1. Determine after tax expected Profits for the
life of the project
2. Take the average of these profits for the life of
the project
3. Determine average investment over the life of
the project like: Average investment = Net working
capital + (Initial outlay + Salvage value)/2
4. Divide the two average figures to get the ARR
❑ It ignore the time value of money
Narain
Illustration
A company takes a project costing Rs.
1,20,000 with expected life of 5-years
and the salvage value of Rs. 20,000.
The project requires an additional
working capital of Rs. 20,000 and is
expected to generate annual average
profit after tax of Rs. 18,000.
What is the Accounting Rate of Return of
this project?
Narain
 Exercise 1

Determine the average rate of return from the following

data of two machines, A and B Machine A Machine B
Cost 56,125 56,125
EATDA
Year 1 3,375 11,375
Year 2 5,375 9,375
Year 3 7,375 7,375
Year 4 9,375 5,375
Year 5 11,375 3,375
36,875 36,875
Estimated life (in years) 5 5
Estimated Salvage Value 3,000 3,000
Narain
Payback Period
It is exact time which cash benefits take to payback the
original cost normally disregarding the salvage value.
❑ Cash flow benefits in this case is cash flow after tax
ignoring interest & other financial expenses
❑ It minimises the risk to the investor
❑ Under capital rationing, the cash earned may be used
for other profitable projects
❑ It yields same results as NPV method for the annuity
type cash flows
❑ It is very useful where the quality of data about costs
and benefits is poor
Narain
Illustration
A project requires a cash outflow of Rs. 20,000
and is expected to generate cash inflows over
next five years as follows:
Years 1 2 3 4 5
CFAT 8,000 6,000 4,000 2,000 2,000
What is the payback period of this project?
What is the payback period of the project if
the project requires Rs. 18,500 as the cash
outflow?
Narain
Exercise 2
❑A proposal requires a cash outflow
of Rs. 1,00,000 and is expected to
generate cash inflows of Rs. 20,000
p.a. for 6 years. What is its
payback period?

Narain
Exercise 3
Determine the payback period of the following
projects: Annual CFAT Cumulative CFAT

Project A Project B Project A Project B

Outlay 9,000 9,000

CFAT: 1 3,000 8,000 3,000 8,000

2 4,000 4,000 7,000 12,000

3 8,000 3,000 15,000 15,000

4 2,000 2,000 17,000 17,000

Narain
Exercise 4
Determine the payback period of the following
projects: Project A Discounted cash Cumulative
flows @ 10% Cash flows
Outlay 9,000

CFAT: 1 3,000 2,727 2,727

2 4,000 3,306 6,033

3 8,000 6,011 12,044

4 2,000 1,366 13,410

Narain
Payback Period
❑ It cannot be considered as a measure of
profitability
– There is no need to estimate the costs
and benefits data for period beyond the
maximum payback period
❑ It does not differentiate the timings of
benefits within the recovery period
❑ It is biased against projects with longer
gestation period.
Narain
Net Present Value
NPV is the summation of the present values of cash
inflows (CFAT) over the years minus the initial
outflow.
❑ Steps to compute the NPV are:
1. Determine the series of cash outflow and
inflow
2. Choose a suitable discount rate: financing
decision
3. Apply this rate to discount the future cash
flows
4. Decision rule: Accept project if NPV>0, reject
otherwise
Narain
 Illustration 1.7
Determine the acceptance of the project whose cash
flows are given as follows if the project has to have a
minimum return of 10%:
Year Cash Flows
0 -22,000
1 10,000
2 8,000
3 6,000
4 4,000
5 2,000 Narain
Exercise

A proposed investment having an after-tax cost

of Rs. 25,000 is expected to produce after-tax
cash inflows as follows:
Period 1 2 3 4 5
Cash Flow 5,000 5,000 7,500 7,500 10,000

If the firm’s hurdle rate (cost of capital) is

12%, should the investment be made using
NPV method of project evaluation?
PVF 1 2 3 4 5
12% 0.8929 0.7972 0.7118 0.6355 0.5674
Narain
Exercise

ABC is considering two investments, each of which

requires an initial investment of Rs. 1,80,000. The
total operating cash inflows after taxes and
inflation adjustments for each project are:
Year 1 2 3 4 5 6 7
Project X 30,000 50,000 60,000 65,000 40,000 30,000 16,000
Project Y 60,000 1,00,000 65,000 45,000 - - -

ABC’s cost of capital is 8%. Rank these

investments by their excess present values.
Which is the most profitable?
Narain
Evaluating NPV method
❑ It is theoretically most superior method of evaluating
projects under the given assumptions.
❑ It is based on total benefits over the economic life of
the project
❑ It is consistent with the objective of maximisation of
shareholder’s wealth –
If inputs are chosen correctly, the total market value
of the firm’s stock should change by an amount equal
to the NPV of the project
❑ This method does contain the abilities to customise it
for relaxing assumptions & advanced sensitivities
Narain
Profitability Index
Profitability Index measure the present value of the
returns per unit of investment
❑ It is a variant of NPV method
PV of project's cash inflows
PI =
Initial Ouflow
❑ Accept the project if PI>1, reject otherwise
❑ Unlike NPV method, it is a relative measure.
Therefore, it can give conflicting ranking of projects
❑ This method is more suitable in the case of capital
rationing

Narain
Illustration 1.8

Evaluate the following two projects based on the

Profitability Index criterion if the minimum required
rate of return is 10%

Project A Project B
Cash 50,000 35,000
outflow
Cash inflows
1 40,000 30,000
2 40,000 30,000
Narain
Exercise

A proposed investment having an after-tax cost

of Rs. 25,000 is expected to produce after-tax
cash inflows as follows:
Period 1 2 3 4 5
Cash Flow 5,000 5,000 7,500 7,500 10,000
If the firm’s hurdle rate (cost of capital) is
12%, should the investment be made using
Profitability Index method of project
evaluation?
PVF 1 2 3 4 5
12% 0.8929 0.7972 0.7118 0.6355 0.5674
Narain
Exercise
ABC is considering two investments, each of which
requires an initial investment of Rs. 1,80,000. The
total cash inflows, that is, profits after taxes and
depreciation charges for each project are:
Year 1 2 3 4 5 6 7
Project X 30,000 50,000 60,000 65,000 40,000 30,000 16,000
Project Y 60,000 1,00,000 65,000 45,000 - - -

ABC’s cost of capital is 8%. Rank these

investments by their profitability indices. Which is
the most profitable?
PVF 1 2 3 4 5 6 7
8% 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 0.5835
Internal Rate of Return
Internal rate of return of a project is that discount rate which
equates the aggregate present value of the cash inflows
(CFAT) of the project with the initial outflow of the project
i.e. NPV=0
❑ The decision rule is :
– Accept project only if IRR > required return
❑ Steps to computing IRR –
1. Determine the project cash outflow and inflows
2. Take initial guestimate of the probable IRR rate
3. Compute NPV for such initial rates
4. Improve the discount rate until NPV=0
5. Use intrapolation whenever needed
Narain
Illustration

A firm is considering following two projects for

the purpose of adoption in the next budget
year. Their cash flow estimates are given
below:
Year 0 1 2 3 4
Project A (45,555) 15,000 15,000 15,000 15,000
Project B (64,320) 20,000 25,000 28,000 24,000
Calculate the internal rate of return of both the
projects if required rate of return on the
projects are 10%.

Narain
Illustration 1.9

Determine the acceptability of the project using

IRR method with following cash flows if the
minimum required rate of return is 20%.
Cash outflow: 35,330
Year 1 2 3 4 5 6
CFAT 10,000 12,000 14,000 16,000 18,000 20,000

Narain
Illustration

A firm is considering two projects, with a capital

outlay of Rs. 1,00,000 each and the following
cash inflows. Compute their internal rates of
returns.
Year 1 2 3 4
Project A 33,620 33,620 33,620 33,620
Project B - - - 1,36,050

Narain
Exercise
You are required to analyse following two projects, each
with a cost of Rs. 10,000 and cost of capital is 5%. The
projects’ expected net cash flows are as follows:
Year 1 2 3 4
Project X 6,500 3,000 3,000 1,000
Project Y 3,500 3,500 3,500 3,500

What is their Internal rate of return?

Which project should be accepted if they are
independent?
Which project should be accepted if they are mutually
exclusive?
Evaluating IRR method

❑ It has intuitive appeal to those who want to

analyse the project in terms of rate of return
❑ Determination of IRR does not depend on
the required rate of return
❑ It is consistent with NPV method for
independent projects
❑ IRR method is based on the reinvestment
assumption by which cash flows of the
project are reinvested at the IRR itself: use
MIRR Narain
 Pitfalls of IRR
1. It is a relative measure of evaluation, not the absolute one.
Projects Cash flow0 Cash Flow1 IRR NPV @ 10%
A -1,000 +1,500 50% +364
B +1,000 -1,500 50% -364
❑ We need to modify the acceptance criterion of IRR
method for borrowing and lending Projects
❑ What to do in case project is both borrowing &
lending?
Period 0 1 2 3
Cash Flows +1,000 -3,600 +4,320 -1,728
Hurdle rate = 10% IRR=20% NPV=-0.75
Pitfall 2: Computational Hazards

❑ Multiple rate of IRR

Period 0 1 2
Cash flow -160 1,000 -1,000

IRR= 25% and 400% NPV at 10% = -77

❑ No IRR

Period 0 1 2
Cash flows 1,000 -3,000 2,500
❑ IRR= Not defined NPV at 10% = 339
Narain
Pitfall 3: Mutually Exclusive Projects
❑ Mutually exclusive projects are those projects
from which only one of them is to be chosen
– Technically or Financially
❑ Inconsistent ranking of projects based on the
IRR criterion and other evaluation criterion
– Size-disparity
– Time-disparity
– Life-disparity

Narain
Size Disparity Problem
❑ Try this:
Printer Outlay CFAT1 IRR NPV @ 10%
Inkjet 10,000 20,000 100% 8,182
LaserJet 20,000 35,000 75% 11,818
❑ Which project will you prefer?
❑ The difference lies in the implicit compounding rate of
interest
– IRR – funds are compounded at the project IRR
– NPV – funds are compounded at the discount rate
❑ Use incremental project analysis if IRR has to be computed

Narain
Time Disparity Problem

❑ Try this:
Machine CF0 CF1 CF2 CF3 CF4 IRR NPV @
10%
A -10,500 6,000 5,000 4,000 1,500 26% 3,117
B -10,500 3,000 4,000 5,000 6,000 22% 3,388
C -6,000 2,700 2,700 2,700 17% 715

❑ Which of the projects will you prefer?

❑ Project A has lower payback period, which can be
preferred in the case of capital rationing
❑ Use incremental project analysis if IRR has to be
computed

Narain
Life Disparity Problem
❑ Try this:
Machine Outlay CF1 CF2 IRR NPV @ 10%
P 2,000 2,400 - 20% 182
Q 2,000 - 2,650 15% 190
❑ The key question here is:
What happens at the end of the shorter-lived
project?
– If we replace the project with identical project
– may use Equivalent Annual NPV
– If we reinvest in some other project – use NPV
❑ Use incremental project analysis if IRR has to be
computed
Narain
Pitfall 4: Term structure of required return

❑ It is assumed so far that the hurdle rate is

same for all cash flows.
❑ What to do when we have required returns
for every year of cash flows?
❑ Can use weighted average required rate of
return which is complex
❑ However, we can use the generalised NPV:
n
CFi
Generalised NPV = 
i =0 (1 + ri ) i

Narain
INDIAN PRACTICES

Which is the most important

project choice criteria?

Narain
 RELATIVE IMOPTANCE OF THE FOLLOWING PROJECT CHOICE CRITERIA

58.20%
BREAK-EVEN-ANALYSIS
35.10%
PROFITABILITY INDEX (PI) 85.00%

INTERNAL RATE OF RETURN (IRR)

66.30%
NET PRESENT VALUE METHOD (NPV)
34.60%
ACCOUNTING RATE OF RETURN
67.50%
PAYBACK PERIOD
 CAPITAL BUDGETING TECHNIQUES…
International usage
RESPONSE TO THE QUESTION: HOW FREQUENTLY YOU USE THE FOLLOWING TECHNIQUES?
% ALWAYS OR ALMOST ALWAYS
US UK
INTERNAL RATE OF RETURN 75.61 53.13
NET PRESENT VALUE 74.93 46.97
PAYBACK PERIOD 56.74 69.23
HURDLE RATE 56.94 26.98
SENSITIVITY ANALYSIS 51.54 42.86
EARNINGS MULTIPLE APPROACH 38.92 39.06
DISCOUNTED PAYBACK PERIOD 29.45 25.40
WE INCORPORATE THE REAL OPTIONS OF A PROJECT
26.56 29.03
WHEN EVALUATING IT
ACCOUNTING RATE OF RETURN 20.29 38.10
VALUE AT RISK 13.66 14.52
ADJUSTED PRESENT VALUE 10.78 14.06
PROFITABILITY INDEX 11.87 15.87
Narain
THANKS FOR YOUR TIME!