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referred to as a capital investment or just project) is that

it involves a current outlay (or current and future

outlays) of funds in the expectation of receiving a stream

of benefits in future

• Long-term consequences

• Substantial outlays

• Difficulty in reversing

CAPITAL BUDGETING PROCESS

• Decision Making

• Implementation

• Performance Review

PROJECT CLASSIFICATION

• Mandatory Investments

• Replacement Projects

• Expansion Projects

• Diversification Projects

• Miscellaneous Projects

Techniques of

Capital Budgeting

Traditional Modern

Accounting or Average Net Present Value Profitability Index

Payback Period (IRR)

Rate of Return (NPV) (PI)

The Payback Period Method

• How long does it take the project to “pay

back” its initial investment?

• Payback Period = number of years to recover

initial costs

• Minimum Acceptance Criteria:

– Set by management

• Ranking Criteria:

– Set by management

The Payback Period Method

• Advantages:

– Easy to understand and calculate

– Emphasizes earlier cash inflows

• Disadvantages:

– Ignores the time value of money

– Ignores cash flows after the payback period

PAYBACK PERIOD

Saurabh Inc’s Capital Project

Year Cash flow Cumulative cash flow

0 -100

1 20 20

2 20 40

3 20 60

4 20 80

5 20 100

6 20

7 20

Accounting or Average Rate of Return

Average Net Income

AAR

Average Book Value of Investment

Criteria set by management

Average Accounting Return

• Advantages:

– The accounting information is usually available

– Easy to calculate

• Disadvantages:

– Ignores the time value of money

– Uses an arbitrary benchmark cutoff rate

– Based on book values, not cash flows and market

values

AVERAGE RATE OF RETURN

Average PAT

Average Book Value of Investment (Beginning)

Investment(Beg)

1 100 14

2 80 17.5

3 65 20.12

4 53.75 22.09

5 45.31 23.57

ARR = = 28.31%

1/5 (14+17.5 +20.12+22.09+23.57)

1/5(100+80+65+53.75+45.31)

NET PRESENT VALUE

(-)

PRESENT VALUE OF CASH OUTFLOWS

DECISION REGARDING PROJECT FOR

NET PRESENT VALUE

NPV Decision

Positive Accept

Negative Reject

Zero May or may not

NET PRESENT VALUE

The net present value of a project is the sum of the present value of all the cash

flows associated with it. The cash flows are discounted at an appropriate discount

rate (cost of capital)

Saurabh Inc’s Capital Project( Cost of Capital=15%)

Year Cash flow Discount factor Present

value

0 -100.00 1.000 -100.00

1 34.00 0.870 29.58

2 32.50 0.756 24.57

3 31.37 0.658 20.64

4 30.53 0.572 17.46

5 79.90 0.497 39.71

Sum = 31.96

Pros Cons

• Reflects the time value of money • Is an absolute measure and not

a relative measure

• Considers the cash flow in its entirety

BENEFIT COST RATIO

OR

PROFITABILITY INDEX

I

• PVB = present value of benefits

• I = initial investment

let us consider a project which is being evaluated by a firm that

has a cost of capital of 12 percent.

Initial investment : Rs 100,000

Benefits: Year 1 25,000

Year 2 40,000

Year 3 40,000

Year 4 50,000

The benefit cost ratio measures for this project are:

25,000 + 40,000 + 40,000 + 50,000

(1.12) (1.12)2 (1.12)3 (1.12)4

BCR = = 1.145

100,000

DECISION REGARDING PROJECT FOR

BENEFIT COST RATIO

>1 Accept

<1 Reject

=1 May or may not

INTERNAL RATE OF RETURN

Net Present Value

Discount rate

The internal rate of return (IRR) of a project is the discount rate that makes its NPV equal to

zero. It is represented by the point of intersection in the above diagram

• Assumes that the • Assumes that the net

discount rate (cost present value is zero

of capital) is known.

• Calculates the net • Figures out the discount rate

present value, given that makes net present value zero

the discount rate.

CALCULATION OF IRR

You have to try a few discount rates till you find the one that makes the NPV

zero

Year Cash Discounting Discounting Discounting

flow rate : 20% rate : 24% rate : 28%

Discount Present Discount Present Discount Present

factor Value factor Value factor Value

1 34.00 0.833 28.32 0.806 27.40 0.781 26.55

2 32.50 0.694 22.56 0.650 21.13 0.610 19.83

3 31.37 0.579 18.16 0.524 16.44 0.477 14.96

4 30.53 0.482 14.72 0.423 12.91 0.373 11.39

5 79.90 0.402 32.12 0.341 27.25 0.291 23.25

CALCULATION OF IRR

Smaller Bigger Smaller

discount + X discount – discount

Sum of the absolute values of the

rate rate rate

NPV at the smaller and the bigger

discount rates

5.13

24% + 28% - 24% = 26.24%

5.13 + 4.02

DECISION REGARDING PROJECT FOR

INTERNAL RATE OF RETURN

IRR Decision

>Cost of Capital Accept

may not

IRR Vs. NPV Vs. PI

1. IRR > COST OF CAPITAL

NPV + ve

PI > 1

2. IRR < COST OF CAPITAL

NPV - ve

PI < 1

23

IRR Vs. NPV Vs. PI(Contd.)

3. IRR = COST OF CAPITAL

NPV = 0

PI = 1

accepted

24

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