Capital Budgeting Decisions

Chapter - 8

Chapter Objectives    

Understand the nature and importance of investment decisions. Distinguish between discounted cash flow (DCF) and non-discounted cash flow (non-DCF) techniques of investment evaluation. Explain the methods of calculating net present value (NPV) and internal rate of return (IRR). Show the implications of net present value (NPV) and internal rate of return (IRR).

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Chapter Objectives    

Describe the non-DCF evaluation criteria: payback and accounting rate of return and discuss the reasons for their popularity in practice and their pitfalls. Illustrate the computation of the discounted payback. Describe the merits and demerits of the DCF and Non-DCF investment criteria. Compare and contrast NPV and IRR and emphasise the superiority of NPV rule.
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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 of the long-term assets. Sale of a division or business (divestment) is also as an investment decision. Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and development programme have long-term implications for the firm s expenditures and benefits, and therefore, they should also be evaluated as investment decisions.
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Features of Long-term Investment Decisions    The exchange of current funds for future benefits. 5 . The funds are invested in long-term assets (more than 1 year). The future benefits will occur to the firm over a series of years.

Importance of Investment Decisions      Growth Risk Funding Irreversibility Complexity 6 .

Types of Investment Decisions  One classification is as follows:    Expansion of existing business Expansion of new business Replacement and modernisation  Yet another useful way to classify investments is as follows:    Mutually exclusive investments Independent investments Contingent investments 7 .

Investment Evaluation Criteria  Three steps are involved in the evaluation of an investment:    Estimation of cash flows Estimation of the required rate of return (the opportunity cost of capital) Application of a decision rule for making the choice 8 .

Investment Decision Rule     It should maximise the shareholders wealth. It should consider all cash flows to determine the true profitability of the project. It should provide for an objective and unambiguous way of separating good projects from bad projects. It should help ranking of projects according to their true profitability. 9 .

It should be a criterion which is applicable to any conceivable investment project independent of others. 10 . It should help to choose among mutually exclusive projects that project which maximises the shareholders wealth.Investment Decision Rule    It should recognise the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones.

Evaluation Criteria  A. Non-discounted Cash Flow Criteria    . Discounted Cash Flow (DCF) Criteria    Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) Payback Period (PB) Discounted Payback Period (DPB) Accounting Rate of Return (ARR) 11  B.

12 ‡ . The appropriate discount rate is the project s opportunity cost of capital. Appropriate discount rate should be identified to discount the forecasted cash flows.Net Present Value Method ‡ Cash flows of the investment project should be forecasted based on realistic assumptions.

e. ‡ 13 .. NPV > 0). The project should be accepted if NPV is positive (i.Net Present Value Method ‡ Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate.

The formula for the net present value can be written as follows: « C1 C3 Cn » C2   L   C0 NPV ! ¬ n ¼ 2 3 (1  k ) (1  k ) ½ ­ (1  k ) (1  k ) n Ct  C0 NPV ! § t t !1 (1  k ) 14 .Net Present Value Method  Net present value should be found out by subtracting present value of cash outflows from present value of cash inflows.

0. 0. 0. The opportunity cost of the capital may be assumed to be 10 per cent.10) (1+0. « Rs 900 Rs 800 Rs 700 Rs 600 Rs 500 » Rs 2.Calculating Net Present Value ‡ Assume that Project X costs Rs 2.10 ) + Rs 800( F2.10 ) + Rs 500( F5.10 ) + Rs 700( F3. 0.500 now and is expected to generate year-end cash inflows of Rs 900.500 Rs 2.909 + Rs 800 v 0.751 + Rs 600 v 0. 0.10) 2 3 4 5 ¼ (1+0.10) (1+0. Rs 700.10) ½ ­ [Rs 900( F1.500 [Rs 900 v 0.10 ) + Rs 600( F4.500 = + Rs 225 15 . Rs 800.725 Rs 2. Rs 600 and Rs 500 in years 1 through 5.683 + Rs 500 v 0.826 + Rs 700 v 0.620] Rs 2.10 )] Rs 2.10) (1+0.500 ¬ (1+0.

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. 16 .

Evaluation of the NPV Method  NPV is most acceptable investment rule for the following reasons:     Time value Measure of true profitability Value-additivity Shareholder value Involved cash flow estimation Discount rate difficult to determine Mutually exclusive projects Ranking of projects 17  Limitations:     .

0 ! 1 (1  r ) n t !1 n  t 2 (1  r ) 2  3 (1  r ) 3 L  n (1  r ) n 0 !§ (1  r )t t § t !1 (1  r ) t  0 !0 18 . This also implies that the rate of return is the discount rate which makes NPV = 0.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 over a long period.

19 . This process will be repeated unless the net present value becomes zero. On the other hand. If the calculated present value of the expected cash inflow is lower than the present value of cash outflows. a higher value should be tried if the present value of inflows is higher than the present value of outflows. a lower rate should be tried.Calculation of IRR  Uneven Cash Flows: Calculating IRR by Trial and Error  The approach is to select any discount rate to compute the present value of cash inflows.

430 AF6.000 + Rs 5. r AF6.000 and provide annual cash inflow of Rs 5.430( Rs 20.430( AF6.000 ! Rs 5.Calculation of IRR  Level (Equal) Cash Flows   Let us assume that an investment would cost Rs 20.000 ! ! 3.430 for 6 years.683 Rs 5. The IRR of the investment can be found out as follows: !  Rs 20. r ) Rs 20.r ) = 0 20 .

580 7.1 NPV Profile 21 .649 550 0 (1.942) (3.NPV Profile and IRR A 1 NPV Profile 2 3 4 5 6 7 8 9 B C D E F G H Discount Cash Flow rate -20000 0% 5430 5% 5430 10% 5430 15% 5430 16% 5430 20% 5430 25% NPV 12.561 3.974) IR R Figure 8.

NPV Profile and IRR 22 .

IRR and NPV rules will give the same results if the firm has no shortage of funds.Acceptance Rule     Accept the project when r > k. Reject the project when r < k. 23 . In case of independent projects. May accept the project when r = k.

Evaluation of IRR Method  IRR method has following merits:     Time value Profitability measure Acceptance rule Shareholder value Multiple rates Mutually exclusive projects Value additivity 24  IRR method may suffer from:    .

25 .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.

000(PV 1.68       26 .Profitability Index ‡ The initial cash outlay of a project is Rs 100. 0.1235 . Rs 50.000.12.00.000. Assume a 10 per cent rate of discount.000 0.826 s 50.350   PV ! s 40.10 ) 0.000 and it can generate cash inflow of Rs 40.000 0.909 s 30.350 ! 1 .751 s 20.000(PV 2.000(PV 3.000 s 12.000 s 20. The PV of cash inflows at 10 per cent discount rate is: NPV ! s 112. 0.10 ) s 30. 0.10 ) s 50.000 and Rs 20. s 1.000 0. 0.10 ) s 40.000 in year 1 through 4.000(PV 4.000 PI ! s 1. Rs 30.350  s 100.

PI = 1 The project with positive NPV will have PI greater than one. PI < 1  May accept the project when PI is equal to one. PI > 1  Reject the project when PI is less than one. 27 . PI less than 1 means that the project s NPV is negative.Acceptance Rule   The following are the PI acceptance rules:  Accept the project when PI is greater than one.

A project with PI greater than one will have positive NPV and if accepted. it is a relative measure of a project s profitability.Evaluation of PI Method     It recognises the time value of money. It is consistent with the shareholder value maximisation principle. it will increase shareholders wealth. estimation of cash flows and discount rate pose problems. 28 . since the present value of cash inflows is divided by the initial cash outflow. PI criterion also requires calculation of cash flows and estimate of the discount rate. In the PI method. Like NPV method. In practice.

If the project generates constant annual cash inflows. That is: Payback  Initial Investment nnual Cash Inflow C0 C Assume that a project requires an outlay of Rs 50. the payback period can be computed by dividing cash outlay by the annual cash inflow.000 4 years 29 .000 s 12.Payback   Payback is the number of years required to recover the original cash outlay invested in a project. The payback period for the project is: PB s 50.000 and yields annual cash inflow of Rs 12.500 for 7 years.

000. Rs 4.000. Suppose that a project requires a cash outlay of Rs 20.000/3.000.000 during the next 4 years. What is the project s payback? 3 years + 12 × (1.000) months 3 years + 4 months 30 . and generates cash inflows of Rs 8. and Rs 3. the payback period can be found out by adding up the cash inflows until the total is equal to the initial cash outlay.000.Payback ‡ ‡ Unequal cash flows In case of unequal cash inflows. Rs 7.

As a ranking method.Acceptance Rule  The project would be accepted if its payback period is less than the maximum or standard payback period set by management. which has the shortest payback period and lowest ranking to the project with highest payback period.  31 . it gives highest ranking to the project.

Evaluation of Payback  Certain virtues:      Simplicity Cost effective Short-term effects Risk shield Liquidity Cash flows after payback Cash flows ignored Cash flow patterns Administrative difficulties Inconsistent with shareholder value 32  Serious limitations:      .

 33 . The project generates equal annual cash inflows.Payback Reciprocal and the Rate of Return  The reciprocal of payback will be a close approximation of the internal rate of return if the following two conditions are satisfied:  The life of the project is large or at least twice the payback period.

3 DISCOUNTED PAYBACK I LLUSTRATED C0 o cash lo s Q o cash lo s -4.000 826 4.9 yrs NPV at 10% ± 987 ± 1.727 0 0 1.000 -4.000 1.000 2.000 -4.000 Cash Flows (Rs) C1 C2 3.421 34 .304 C3 1.000 751 1. The discounted payback period still fails to consider the cash flows occurring after the payback period.000 751 C4 1.000 683 2.000 3.Discounted Payback Period   The discounted payback period is the number of periods taken in recovering the investment outlay on the present value basis.366 Simple PB 2 yrs 2 yrs Discounted PB ± 2.000 -4.6 yrs ± 2.

The average investment would be equal to half of the original investment if it were depreciated constantly.Accounting Rate of Return Method  The accounting rate of return is the ratio of the average after-tax profit divided by the average investment. 35 . ARR Average income Average investment  A variation of the ARR method is to divide average earnings after taxes by the original cost of the project instead of the average cost.

Acceptance Rule  This method will accept all those projects whose ARR is higher than the minimum rate established by the management and reject those projects which have ARR less than the minimum rate.  36 . This method would rank a project as number one if it has highest ARR and 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 Cash flows ignored Time value ignored Arbitrary cut-off  Serious shortcoming    37 .

e.  38 .Conventional and Nonconventional Cash Flows  A conventional investment has cash flows the pattern of an initial cash outlay followed by cash inflows. Non-conventional investments have more than one change in the signs of cash flows. + + + ++ +. i. + + +. has cash outflows mingled with cash inflows throughout the life of the project. on the other hand. for example. Conventional projects have only one change in the sign of cash flows. A non-conventional investment. for example.. the initial outflow followed by inflows.

which are economically independent of each other. NPV and IRR methods result in same accept-or-reject decision if the firm is not constrained for funds in accepting all profitable projects.NPV Versus IRR  Conventional Independent Projects: In case of conventional investments. 39 .

Cash Flows (Rs) Project X Y 40 C0 -100 100 C1 120 -120 IRR 20% 20% NPV at 10% 9 -9 . Both are conventional projects. and project with initial inflow followed by outflows is a borrowing type project.NPV Versus IRR Lending and borrowing-type projects: Project with initial outflow followed by inflows is a lending type project.

Problem of Multiple IRRs  A project may have both lending and borrowing features together. NV(R P s) 20 5 NVR 6 P s3 0 -2 0 5 -5 0 0 -7 0 5 0 5 0 10 0 10 5 20 0 20 5 D u t Rte(% isco n a ) 41 . IRR method. when used to evaluate such nonconventional investment can yield multiple internal rates of return because of more than one change of signs in cash flows.

42 .Case of Ranking Mutually Exclusive Projects    Investment projects are said to be mutually exclusive when only one investment could be accepted and others would have to be excluded. Two independent projects may also be mutually exclusive if a financial constraint is imposed. The cash outlays of the projects may differ. while those of others may decrease or vice-versa. the cash flows of one project may increase over time. That is. The NPV and IRR rules give conflicting ranking to the projects under the following conditions:    The cash flow pattern of the projects may differ. The projects may have different expected lives.

Timing of Cash Flows Project M N C0 ± 1.680 ± 1.510 NPV at 9% 301 321 IRR 23% 17% 43 .680 Cash Flows (Rs) C1 C2 1.400 140 700 840 C3 140 1.

000 V at 10 364 9.500 120.000 -100.080 I 50% 20% 44 .Scale of Investment Cas roject A B C0 -1.000 lo ( s) C1 1.

Project Life Span Cash Flows (Rs) Project X Y C0 ± 10.000 0 C2 ± 0 C3 ± 0 C4 ± 0 C5 ± 20.000 ± 10.000 C1 12.495 IRR 20 15 45 .120 NPV at 10% 908 2.

whereas the NPV method is thought to assume that the cash flows are reinvested at the opportunity cost of capital. 46 .Reinvestment Assumption  The IRR method is assumed to imply that the cash flows generated by the project can be reinvested at its internal rate of return.

the use of the IRR rule creates problems. If the opportunity cost of capital varies over time.Varying Opportunity Cost of Capital  There is no problem in using NPV method when the opportunity cost of capital varies over time. as there is not a unique benchmark opportunity cost of capital to compare with IRR. 47  .

NPV Versus PI A conflict may arise between the two methods if a choice between mutually exclusive projects has to be made.000 50.000 2. Follow NPV method: Project PV of cash inflows Initial cash outflow NPV PI 100.000 50.000 30.50 48 .000 20.000 2.00 Project D 50.

4. 8.Assignment  Problems at the Back: 1 to 20 except 11. 8. 17. 20  Illustrated Solved Problems at the Back: 8.2.5 49 .1. 12. 8.

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