Presenting…

Discounted
&
Non discounted Cash Flow Techniques…

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 Capital Budgeting – Why?

Allocating scarce resources among competing uses requires a mechanism or

decision rule that separates those investments that are worth making from those that
are not.

The different proposals should be evaluated in terms of their economic worth to the
firm.

The economic worth can be measured in terms of cost and benefits of the proposals
to the firm. These costs and benefits are measured in terms of cash flows generated
by it.

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 Evaluation

Features which a capital budgeting evaluation technique should possess:

1.The criterion must be able to incorporate all the cash flows associated with the
proposal.

2.It should also incorporate the time value of money.

3.It should be capable of ranking different proposals in order of their worth to the
firm.

4.It should be objective and unambiguous in its approach

5.It must be in line with the objective of maximization of shareholders wealth.

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 Techniques
Capital
Budgeting
Techniques

Traditional Time adjusted,

or Or
Non - discounting Discounting

Accounting Internal
Pay back period Net Present Value Profitability Index
Rate of return Rate of Return

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6
 Pay Back Period

Payback Period is defined as the number of years required for the proposal’s
cumulative cash inflows to be equal to its cash outflows

Length of time required for a proposal to ‘break even’ on its net investment.

Computation:

a) When annual inflows are equal: When the cash inflows being generated by a
proposal are equal per time period, the payback period can be computed by
dividing the cash outflow by the number of annuity.

b) When annual cash inflows are unequal: In this case the cumulative cash inflows
are used to compute the payback period

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 Example 1

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 Pay Back period?

Solution:
Pay Back Period = Cash Outflow
Annuity
= 1,00,000
20,000
= 5 years
The initial cash outflow of Rs. 1,00,000 will be fully recovered within a period of 5
years and the cash inflows occurring thereafter are ignored

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 Example 2

A proposal requires a cash outflow of Rs. 20,000 and is expected to generate cash
inflows of Rs. 8,000, Rs. 6,000, Rs. 4,000, Rs. 2,000 and Rs. 2,000 over next 5 years
respectively. Compute its Payback Period.

Solution:
Year Annual Cash Flow Cumulative Cash Flow
1 Rs. 8,000 Rs. 8,000
2 Rs. 6,000 Rs. 14,000
3 Rs. 4,000 Rs. 18,000
4 Rs. 2,000 Rs. 20,000
The pay back period is 4 years

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 The Decision Rule

The Payback Period calculated for a proposal is to be compared with some

predetermined target period (set by management).

If the payback period is more than the target period, then the proposal should
be rejected otherwise it may be accepted.

Further if different proposals are to be ranked in order of priority, then the

proposal with the shortest payback period will be first in the priority list.

Alternatively, Payback Period reciprocal = (1 / Payback Period) x 100.

The higher the payback reciprocal (and hence, lower the payback period), the
more worthwhile the proposal is.

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 Advantages

1. This method is simple and easy. In particular, it can be adopted by a

small firm having limited man-power which does not have any special
skill to apply other sophisticated techniques.

2. It gives an indication of liquidity as it emphasizes earlier cash inflows.

3. It deals with the risk also. The project with a shorter payback period
will be less risky as compared to project with a longer payback period.
As the cash inflows which arise further in the future will be less certain
and hence more risky.

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 Disadvantages
1. The payback period entirely ignores many of the cash inflows which occur
after the payback period. This could be misleading and could lead to
discrimination against the proposal which generates substantial cash
inflows in later years.

2. It ignores the timing of the occurrence of the cash flows. It considers the
cash flows occurring at different points of time as equal in money worth and
ignores the time value of money.

3. The payback period also ignores the salvage value of the total economic life
of the project.

4. The payback period is more a method of capital recovery rather than a

measure of profitability of project.

5. The payback period is designed to cover the conventional projects that

involve large upfront investment followed by positive operating cash
inflows. It breaks down however when the investment is spread over time or
where there is no initial investment.
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 Suitability

1. In a politically unstable country, a firm may have a primary

consideration of recovering the initial cost at the earliest opportunity
and thus the payback period may be a suitable technique.

2. It may be suitable if the firm has limited funds available and has no
ability or willingness to raise additional funds. In such a case the firm
may wish to undertake those projects which ensure early liquidity /
recovery.

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14
 ARR

ARR may be defined as the annualized net income earned on the average funds
invested in a project.

Computation:

a) Equal profits:

ARR = Annual Profit (after tax) x 100

Average investment in the project

b) Unequal profits:

ARR = Average Annual Profit (after tax) x 100

Average investment in the project

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 Average Investment
Average Investment is affected by the method of depreciation, salvage value and
the additional working capital required by the proposal.

Computation:

a) Initial Cash Outlay as average investment: The original cost of investment and
the installation expenses if any, is taken as the amount invested in the project..

b) Average annual book value after depreciation as average investment:

In case the firm has adopted a method of depreciation other than straight line
method: In this case, the opening and closing book values of the project for all
the years of its economic life are found out. Then, the average book values for all
the years are found out by taking simple arithmetic mean of the opening and
closing book values. And then, the average of all the yearly averages is
calculated. This average will be the average investment of the proposal.
In case, firm adopts straight line method of depreciation:

Avg. Investment = ½ (Initial Cost + Installation Exp. – Salvage Value) + Salvage Value

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 Example 3

ABC Ltd. Takes a project costing Rs. 1,20,000 with expected life of 5-years and
salvage value of Rs. 20,000. Calculate its average investment.

Solution:
Average Investment = ½ (1,20,000 – 20,000) + 20,000 = Rs. 70,000
The average investment can also be calculated as follows:
Year Opening BV Closing BV Average BV
1 Rs. 1,20,000 Rs. 1,00,000 Rs. 1,10,000
2 1,00,000 80,000 90,000
3 80,000 60,000 70,000
4 60,000 40,000 50,000
5 40,000 20,000 30,000
Total 3,50,000
Average Investment = Rs. 3,50,000 / 5 = Rs. 70,000
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 Average Investment

Additional Working Capital:

Sometimes the project requires additional working capital. Though this additional
working capital will be released back, when the proposal will be scrapped and
terminated, yet this amount of additional working capital is blocked throughout the
life of the project. So this should also be added to the average investment.

Therefore,

Average Investment = ½ (Initial Cost + Installation Expenses – Salvage Value) +

Salvage Value + Additional Working Capital

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 Example 4

ABC Ltd. Takes a project costing Rs. 1,20,000 with expected life of 5-years and
salvage value of Rs. 20,000. Further it requires an additional working capital of Rs.
20,000 and is expected to generate annual average profit (after tax) of Rs. 18,000.
Calculate its average investment.

Solution:
Average Investment = ½ (1,20,000 – 20,000) + 20,000 + 20,000
= Rs. 90,000
ARR = Annual Profit (after tax) x 100
Average Investment in the project
= 18,000 x 100
90,000
= 20%

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 The Decision Rule

The actual ARR is to be compared with a predetermined or a minimum required

rate of return or cut off rate (set by management).

If the actual ARR is higher than the minimum desired ARR, then the proposal
would be accepted otherwise it may be rejected.

Further if different proposals are to be ranked in order of priority, then the

proposal with the highest ARR will be first in the priority list. Obviously projects
having higher ARR would be preferred to projects with lower ARR.

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 Advantages

1. This method is easy to understand and use. What is required is only

the figure of accounting profits after taxes which should be easily
obtainable.

2. Total benefits associated with the project are taken into account while
calculating ARR unlike some methods like payback which do not use
the entire stream of incomes.

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 Disadvantages

This method uses accounting income instead of cash flows. Cash

flow approach is superior to accounting earnings for project
evaluation as it takes into account the reinvestment potential of a
project’s benefits

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23
 NPV
The NPV may be defined as the sum of the present values of all the cash inflows less
the sum of present values of all the cash outflows associated with a proposal.

A rate of discount must be specified and applied to both inflows and outflows in
order to find out their present values. When the present values of all inflows and
outflows are added, the resultant figure is denoted as net present value.

The figure can be positive or negative depending on whether there is a net inflow or
outflow from the project.

Computation:

NPV - C0

where, NPV = Net Present Value

CFi = Cash flows occurring at time 0,1,2…….,n
k = The discount rate, and
n = Life of the project in years
C0 = Initial Cost of the proposal at time T 0
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 Example 5
Calculation of the Net Present Value:
Time Cash Flows (Rs.) PVF (10%,T) Present Values (Rs.)
T0 - 1,70,000 1.000 - 1,70,000
T1 20,000 0.909 18,180

T2 50,000 0.826 41,300

T3 60,000 0.751 45,060
T4 40,000 0.683 27,320
T5 75,000 0.621 46,575
Total or NPV 8,435

NPV = -1,70,000 + 20,000 + 50,000 + 60,000 + 40,000 + 75,000

(1 + 0.10)0 (1 + 0.10)1 (1 + 0.10)2 (1 + 0.10)3 (1 + 0.10)4 (1 + 0.10)5

= Rs. 8,435

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 The Decision Rule

Accept the proposal if its NPV is positive and reject the proposal if the NPV is
negative.

NPV is the change expected in the wealth of the shareholder as a result of the
acceptance of a particular proposal.

Further if different proposals are to be ranked in order of priority, then the

proposal with the highest positive NPV will be first in the priority list. Obviously
projects having higher positive NPV would be preferred to projects with lower
positive NPV.
However, the proposals with negative NPV should be rejected as these entail
decrease in the wealth of the shareholders

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 Advantages

1. This technique recognizes the Time Value of money

2. This technique considers the entire cash flow stream, all the cash
inflows and outflows, irrespective of the timing of their occurrence

3. It is based on cash flows rather than the accounting profit.

4. The discount rate applied for discounting the future cash flows is in
fact, the minimum required rate of return which incorporates both the
pure return as well as the premium required to set off the risk.

5. NPV concept has a built-in earnings requirements in addition to the

recovery of the investment. Thus this cushion implicit is truly an
economic gain that goes beyond satisfying the required rate of return.

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 Disadvantages

1. It involves difficult calculations. It may not be able to overcome the

uncertainty involved with cash flows occurring after a sizeable time
gap.

2. It requires the predetermination of the required rate of return, k,

which is a difficult job. If the value of ‘k’ is not correct, then the
whole exercise of the NPV may give wrong results.

3. This technique does not provide a measure of project’s own rate of

return, rather it evaluates a proposal against an external variable
i.e., the minimum required rate of return.

4. The decision under this technique is based on a value which is an

absolute measure. It ignores the difference in initial outflows, size of
different proposals etc. while evaluating mutually exclusive
proposals.

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29
 PI

This technique is a variant of the NPV Technique. It is also known as Benefit – cost
ratio, or Present value Index.

It is also based upon the basic concept of discounting the future cash flows and is
ascertained by comparing the present value of the future cash inflows with the
present value of the future cash outflows.

Computation:

PI = Total Present Value of cash inflows or ÷C0

Total Present Value of cash outflows

where, CFi = Cash flows occurring at time 0,1,2…….,n

k = The discount rate, and
n = Life of the project in years
C0 = Initial Cost of the proposal at time T 0

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 Example 6
A firm is evaluating a proposal which requires a cash outlay of Rs. 40,000 at present
and of Rs. 20,000 at the end of third from now. It is expected to generate cash inflows
of Rs. 20,000, Rs. 40,000 and Rs. 20,000 at the end of 1 st, 2nd and 4th year respectively.
Given the rate of discount of 10%, calculate PI.

Calculation of the Profitability Index

Year Cash flows (Rs.) PVF (10%,n) Present Values (Rs.)
0 - 40,000 1.000 - 40,000
1 20,000 0.909 18,180
2 40,000 0.826 33,040
3 - 20,000 0.751 - 15,020
4 20,000 0.683 13,660
Present Value of cash outflows = Rs. 40,000 + 15,020 = 55,020
Present Value of cash inflows = Rs. 18,180 + 33,040 + 13,660 = 64,880
PI = Total Present Value of cash inflows = Rs. 64,880 = 1.18
Total Present Value of cash outflows Rs. 55,020
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 The Decision Rule

Accept the proposal if its PI is more than 1 and reject the proposal if the PI is
less than 1.

Further if different proposals are to be ranked in order of priority, then the

proposal with the highest positive PI will be first in the priority list. Obviously
projects having higher positive PI would be preferred to projects with lower
positive PI.
However, the proposals having PI of less than 1 should be rejected.

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 Advantages

1. This technique recognizes the Time Value of money

2. This technique considers the entire cash flow stream, all the cash
inflows and outflows, irrespective of the timing of their occurrence

3. It is based on cash flows rather than the accounting profit.

4. The discount rate applied for discounting the future cash flows is in
fact, the minimum required rate of return which incorporates both the
pure return as well as the premium required to set off the risk.

5. PI concept has a built-in earnings requirements in addition to the

recovery of the investment. Thus this cushion implicit is truly an
economic gain that goes beyond satisfying the required rate of return.

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 Disadvantages

1. It involves difficult calculations. It may not be able to overcome the

uncertainty involved with cash flows occurring after a sizeable time
gap.

2. It requires the predetermination of the required rate of return, k,

which is a difficult job. If the value of ‘k’ is not correct, then the
whole exercise of the PI may give wrong results.

3. This technique does not provide a measure of project’s own rate of

return, rather it evaluates a proposal against an external variable
i.e., the minimum required rate of return.

4. The decision under this technique is based on a value which is an

absolute measure. It ignores the difference in initial outflows, size of
different proposals etc. while evaluating mutually exclusive
proposals.

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 NPV vs PI

1. Due to the built –in mechanism, the PI technique can discriminate between
the projects having large outlays and projects having small outlays.

Example 7: A firm is evaluating two proposals, A & B having costs of Rs.

1,00,000 and Rs. 80,000 respectively. The present value of the inflows of
these projects are Rs. 1,20,000 and Rs. 1,00,000. Consequently both the
proposals have NPV of Rs. 20,000 and therefore are alike but in terms of PI
technique project B is better. [PI(A) = 1.20 and PI(B) = 1.25

2. Similarly NPV and PI may give contradictory decisions even if the net
monetary benefits and the initial cost are different

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36
 IRR

The IRR of a proposal is defined as the discount rate which produces a zero NPV i.e.,
the IRR is the discount rate which will equate the present value of cash inflows with
the present value of cash outflows

This discount rate is ascertained by the trial and error method

Computation:

CO0 + SV +WC
(1+r)n

where, CFi = Cash flows occurring at time 0,1,2…….,n

k = The discount rate, and
n = Life of the project in years
C0 = Initial Cost of the proposal at time T 0

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 Equal Cash flows
Steps in computation of IRR when future cash flows are in the form of annuities:

1. Determine the payback period of the proposed investment.

2. In Table of ‘Present value of an annuity’, look for the payback period that is equal
to or closest to the life of the project.
3. In the year row, find two PV values or discount factor (DFr) closest to PB period
but one bigger and other smaller than it.
4. From the top row of the table, note interest rate (r) corresponding to these PV
values (DFr)
5. Determine the actual IRR by interpolation.

IRR = r – ( PB – DFr)
DFrL – DFrH

where, PB = Payback Period

DFr = Discount factor for interest rate r, and
DFrL= Discount factor for lower interest rate
DFrH= Discount factor for higher interest rate

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 Example 8

A project costs Rs. 36,000 and is expected to generate cash inflows of Rs. 11,200
annually for 5 years. Calculate IRR.

1. The payback period is 3.214 (Rs. 36,000/ Rs. 11,200)

2. According to the table, discount factors closest to 3.214 for 5 years are 3.274
(rate of interest is 16%) and 3.199 (rate of interest is 17%)

3. Substituting the values in the equation, we get,

IRR = 16 – (3.274 – 3.214) = 16.8%

3.274 – 3.199

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 Unequal Cash flows
Steps in computation of IRR when future cash flows are not equal:
Example 9: Suppose a firm is evaluating a proposal costing Rs. 1,60,000 and
expected to generate cash inflows of Rs. 40,000, Rs. 60,000, Rs. 50,000, Rs. 50,000
and Rs. 40,000 at the end of each of next 5 years respectively. There is no salvage
value. IRR will be approximated as follows:

Step 1: Find out the weighted average of cash inflows

Year Cash Inflow (Rs.) CF Weight (W) CF X W
1 40,000 5 2,00,000
2 60,000 4 2,40,000
3 50,000 3 1,50,000
4 50,000 2 1,00,000
5 40,000 1 40,000
Total 15 7,30,000 Continued….
Weighted average = 7,30,000/ 15 = Rs. 48,667
40
 Unequal cash flows
Step 2: Consider the weighted average as the annuity of cash inflows and find out the
payback period. For this case, the Payback period is Rs. 1,60,000/ 48,667 = 3.288
Step 3: The closest figures given in the PVAF Table for a value nearest to 3.288 in 5
years row are at 15% (3.352) and at 16% (3.274)
Step 4: The NPV of the proposal for both of these approximate rates are:
Year Cash inflow PVF (16%, 5 yrs.) PVF (15%, 5 yrs.) PV (16%) PV (15%)
1 40,000 0.862 0.870 34,480 34,800
2 60,000 0.743 0.756 44,580 45,360
3 50,000 0.641 0.658 32,050 32,900
4 50,000 0.552 0.572 27,600 28,600
5 40,000 0.476 0.497 19,040 19,880
Total 1,57,750 1,61,540
At 16%, NPV = Rs. 1,57,750 – Rs. 1,60,000 At 15%, NPV = Rs. 1,61,540 – Rs.1,60,000
= Rs. -2,250 = Rs. 1,540
41
 Unequal cash flows

Step 5: Find out the exact IRR by interpolating between 15% and 16%.

IRR = 15% + 1,61,540 – 1,60,000 = 15.40%

1,61,540 – 1,57,750

So, the IRR of the Project is 15.40%

42
 The Decision Rule

The actual IRR, r, is to be compared with a predetermined or a minimum

required rate of return or cut off rate, k, (set by management).

If the actual IRR is higher than the minimum desired IRR, then the proposal
would be accepted otherwise it may be rejected.

Further if different proposals are to be ranked in order of priority, then the

proposal with the highest IRR will be first in the priority list. Obviously projects
having higher IRR would be preferred to projects with lower IRR.

43
 Advantages

1. This technique recognizes the Time Value of money

2. It is a profit oriented concept and helps selecting those proposals

which are expected to earn more than the minimum required rate of
return.

3. The IRR has an appeal for those who want to analyze a proposal in
terms of its percentage return.

4. This technique considers the entire cash flow stream, all the cash
inflows and outflows, irrespective of the timing of their occurrence

5. It is based on cash flows rather than the accounting profit.

44
 Disadvantages
1. It involves difficult calculations, a tedious and complicated trial and error
procedure.

2. It requires the predetermination of the required rate of return, k, which is a

difficult job. If the value of ‘k’ is not correct, then the whole exercise may give
wrong results.

3. It makes an implied assumption that the future cash inflows of a proposal are
reinvested at a rate equal to the IRR

4. Since IRR is a scaled measure, it tends to be biased towards the smaller

projects which are much more likely to yield high percentage returns over the
larger projects.

5. This technique may give dubious results in some cases. For instance when
there is more than one IRR for a project and it is not clear which one the
decision maker should use or where IRR cannot be computed or if computed
is likely to be meaningless.

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QUESTIONS ?

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Thank you
Centum U – Institute of Management & Creative Studies
37 Link Road, Lajpat Nagar,
New Delhi-110024
Tel: 91-11-46120700-04, Toll Free: 1800-103-4457
E-mail: singh_rana@yahoo.com

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