CAPITAL BUDGETING DECISIONS

Should we
build this
plant?

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SEEMA CHAKRABARTI
CAPITAL BUDGETING 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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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

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AN EXAMPLE OF MUTUALLY
EXCLUSIVE PROJECTS

BRIDGE vs. BOAT to get

products across a river.

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 TYPES OF CASH FLOWS
Normal or Conventional Cash Flow :
 One change of signs.
 Cost (negative CF) followed by a series of positive
cash inflows.

• Non-normal or unconventional Cash Flow:

 Two or more changes of signs.
 Most common: Cost (negative CF), then string of
positive CFs,then cost to close project.
 Example: Nuclear power plant, strip mine.

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CAPITAL BUDGETING DECISIONS
These are generally:

Long-term decisions; involving large

expenditures.

Have long term consequences.

Difficult or expensive to reverse.

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 Capital Budgeting
Methods

Discounting Criteria Non Discounting Criteria

NPV BCR IRR PBP ARR

MIRR DPBP

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 NET PRESENT VALUE
NPV of a project is the sum of the present values
of all the cash flows positive as well as negative
that are expected to occur over the life of the
project.
The formula for NPV is:
 C1 C2 C3 Cn 
NPV      n
 C0
 (1  k ) (1  k ) (1  k ) (1  k ) 
2 3

n
Ct
NPV    C0
t 1 (1  k )
t

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 NET PRESENT VALUE

Where,
 Ct = cash flow at the end of year t
 n = Life of the project
 k = discount rate (given by the projects opportunity
cost of capital which is equal to the required rate of
return expected by investors on investments of
equivalent risk).
 C0 = Initial investment
 1 / (1 + k )t = known as discounting factor or PVIF
i.e present value interest factor. 9
CALCULATING NET PRESENT VALUE
Assume that Project X costs Rs 2,500 now and is
expected to generate year-end cash inflows of Rs
900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1
through 5. The opportunity cost of the capital may
be assumed to be 10 per cent.
 Rs 900 Rs 800 Rs 700 Rs 600 Rs 500 
NPV    2
 3
 4
 5
 Rs 2,500
 (1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10) 
NPV  [Rs 900(PVF1, 0.10 ) + Rs 800(PVF2, 0.10 ) + Rs 700(PVF3, 0.10 )
+ Rs 600(PVF4, 0.10 ) + Rs 500(PVF5, 0.10 )]  Rs 2,500
NPV  [Rs 900  0.909 + Rs 800  0.826 + Rs 700  0.751 + Rs 600  0.683
+ Rs 500  0.620]  Rs 2,500
NPV  Rs 2,725  Rs 2,500 = + Rs 225 10
 ACCEPTANCE RULE OF NPV
Accept the project when NPV is positive
NPV > 0
Reject the project when NPV is negative
NPV < 0
 May accept or reject the project when NPV is zero
NPV = 0
( A project will have NPV = 0, only when the project generates
cash inflows at a rate just equal to the opportunity cost of
capital)
The NPV method can be used to select between
mutually exclusive projects; the one with the higher
NPV should be selected.

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ADVANTAGES OF NPV METHOD
It considers time value of money.
It is a true measure of profitability as it uses the
present values of all cash flows (both outflows &
inflows) & opportunity cost as discount rate rather than
any other arbitrary assumption or subjective
consideration.
The NPVs of individual projects can be simply added to
calculate the value of the firm . This is known as
“Principle of value additivity”.
It is consistent with the shareholders wealth
maximization principle as whenever a project with
positive NPV is undertaken, it results in positive cash
flows and hence the increase in the value of the firm.
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DISADVANTAGES OF NPV METHOD
It is difficult to estimate the expected cash flows
from a project.
Discount rate to be used is very difficult to
determine.
Since this method does not consider the life of the
projects, in case of mutually exclusive projects
with different life, the NPV rule, tends to be
biased in favour of the longer term project.
Since NPV is expressed in absolute terms rather
than relative terms it does not consider the scale
of investment.
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 BENEFIT COST RATIO
It is calculated as:

Benefit-cost ratio = PVB / I

Where,
PVB = present value of benefits
I = Initial investments

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 ACCEPTANCE RULE FOR BCR

BCR > 1 = Accept

BCR = 1 = Indifferent

BCR < 1 = Reject

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 EVALUATION OF BCR METHOD
Advantages of BCR method:

 Since it considers the investment in the project, it is

considered to be preferable to NPV method.

Disadvantages of BCR method:

 It does not provide for a means through which a

number of smaller projects can be combined to be
compared to a bigger project.

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 Internal Rate of Return: IRR

0 1 2 3

CF0 CF1 CF2 CF3

Cost Cash Inflow

IRR is the rate of return that equates PV of cash

inflows with investment outlay of a project
. This is the same as forcing NPV = 0.

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 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 after one period. This
also implies that the rate of return is the discount
rate which makes NPV = 0.
The formula for calculating IRR is:
C1 C2 C3 Cn
C0      
(1  r ) (1  r ) 2 (1  r )3 (1  r ) n
n
Ct
C0  t 1 (1  r )t
n
Ct
 t 1 (1  r ) t
 C0  0
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 INTERNAL RATE OF RETURN
METHOD
Where,

 Ct = cash flow at the end of year t

 n = Life of the project
 r = discount rate
 C0 = Initial investment
 1 / (1 + r )t = known as discounting factor or PVIF
i.e present value interest factor.

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 CALCULATION OF IRR
Level or even Cash Flows:
 Let us assume that an investment would cost Rs
20,000 and provide annual cash inflow of Rs 5,430
for 6 years.
 The IRR of the investment can be found out as
follows:
NPV   Rs 20,000 + Rs 5,430(PVAF6,r ) = 0
Rs 20,000  Rs 5,430(PVAF6, r )
Rs 20,000
PVAF6, r   3.683
Rs 5,430
IRR = 16% approx.( Refer to PVAF table @ 3.685 for 6 yrs
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 NPV Profile and IRR
A B C D E F G H
1 NPV Profile
Discount
2 Cash Flow rate NPV
3 -20000 0% 12,580
IR
4 5430 5% 7,561
R
5 5430 10% 3,649
6 5430 15% 550
7 5430 16% 0
8 5430 20% (1,942)
9 5430 25% (3,974)
Figure 8.1 NPV Profile

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 CALCULATION OF IRR
Uneven or non–normal Cash Flows: Calculating
IRR by Trial and Error
 The approach is to select any discount rate to
compute the present value of cash inflows. If the
calculated present value of the expected cash
inflow is lower than the present value of cash
outflows, a lower rate should be tried. On the other
hand, a higher value should be tried if the present
value of inflows is higher than the present value of
outflows. This process will be repeated unless the
net present value becomes zero.
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 CALCULATION OF IRR
A project costs Rs.16000 and is expected to generate
cash inflows of Rs. 8000, Rs.7000 & Rs.6000 at the
end of each year for next 3 years.

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 ACCEPTANCE RULE FOR IRR
Accept the project when r (IRR) > k (WACC).
Reject the project when r (IRR) < k (WACC).
May accept the project when r = k.
In case of independent projects, IRR and NPV rules
will give the same results if the firm has no shortage
of funds.
In case of projects with equal IRR & different NPV,
select project with higher NPV as it is consistent with
firm’s wealth maximisation objective.

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ADVANTAGES OF IRR METHOD
It considers time value of money.
It is a true measure of profitability as it uses the
present values of all cash flows(both outflows &
inflows) rather than any other arbitrary assumption or
subjective consideration.
In case of conventional independent projects NPV &
IRR methods gives the same decision.
Whenever a project with higher IRR than WACC is
undertaken, it results in the increase in the
shareholder’s return. Hence, the value of the firm also
increases.

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 PROBLEMS WITH IRR
Lending & Borrowing projects: Project with initial outflow
followed by inflows is a lending type project whereas a project
with initial inflow followed by outflows is a borrowing project.
Since IRR does not differentiate between lending and
borrowing projects, a higher IRR may not always be a desirable
thing.

Multiple IRR: In case of projects with non-normal or

unconventional cash flows more than one IRR are generated
which are misleading.

Mutually Exclusive projects: In case of mutually exclusive

projects the results of NPV & IRR methods may conflict each
other. This is because the IRR method does consider the scale
of investment.

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 PROBLEMS WITH IRR
Different short term & Long term interest rates: Since
the cash flows are discounted at the opportunity cost
of capital, there arises a confusion regarding what
rate is to be used for discounting, if the short term
and long term lending rates are different.

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 LENDING & BROWING PROJECTS
Lending projects: Project with initial outflow
followed by inflows is a lending type project.

Borrowing projects: Project with initial inflow

followed by outflows is a borrowing project.

Cash Flows (Rs.)

Project Co C1 IRR NPV at 10%

X -100 110 10% 0

Y 100 -110 10% 0
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 LENDING &BORROWING PROJECTS
Cash Flows (Rs.)
Project Co C1 IRR NPV at 5%

X -100 110 10% 4.72

Y 100 -110 10% -4.72

Cash Flows (Rs.)

Project Co C1 IRR NPV at
15%

X -100 110 10% -4.3

Y 100 -110 10% 4.3 29
 PROBLEM OF MULTIPLE IRRS
 A project may have both lending and borrowing
features together. IRR method, when used to
evaluate such non-conventional investment can
yield multiple internal rates of return because of
more than one change of signs in cash flows.

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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 NPV and IRR rules give conflicting ranking to the
projects under the following conditions:
 The cash flow pattern of the projects may differ.
That is, the cash flows of one project may increase
over time, while those of others may decrease or
vice-versa.
 The cash outlays of the projects may differ.
 The projects may have different expected lives.
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 RANKING MUTUALLY EXCLUSIVE PROJECTS
(Timing of Cash Flows)   
Cash Flows (Rs) NPV
Project C0 C1 C2 C3 at 9% IRR
M – 1,680 1,400 700 140 301 23%
N – 1,680 140 840 1,510 321 17%

Discount Rate Project M Project N

0 560 810
5 409 520
10 276 276
15 159 70
20 54 -106
25 -40 -257
30 -125 32
-388
 RANKING MUTUALLY EXCLUSIVE PROJECTS
(Timing of Cash Flows)
NPV

1000 ___ Project M

800 ---- Project N
600

400 NPV INR 276/-

200

-200 5% 10% 15% 20% 25% 30%

-400
Discount Rate

10% discount is k/as Fisher’s

intersection. 33
 RANKING MUTUALLY EXCLUSIVE PROJECTS
(Scale of Investment) 
Cash Flow (Rs) NPV
Project C0 C1 at 10% IRR
A -1,000 1,500 364 50%
B -100,000 120,000 9,080 20%

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 RANKING MUTUALLY EXCLUSIVE PROJECTS
(Project Life Span)  
Cash Flows (Rs)
Project C0 C1 C2 C3 C4 C5 NPV at 10% IRR

X – 10,000 12,000 – – – – 908 20%

Y – 10,000 0 0 0 0 20,120 2,495 15%

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 Modified Internal Rate of Return
(MIRR)
The modified internal rate of return (MIRR) is
the compound average annual rate that is calculated
with a reinvestment rate different than the project’s
IRR.
Both NPV & IRR methods assume that the entire
cash flow generated during the life time of the
project is reinvested at project cost of capital (i.e k)
& internal rate of return (i.e r) respectively in each of
the above two methods.
But, in MIRR the cashflows are assumed to be
reinvested at cost of capital ( k) instead of internal
rate of return ( r )as in IRR method. 36
 PAY BACK PERIOD
It is the number of years required to recover a
project’s cost, or how long does it take to get the
business’s money back?

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 PAY BACK PERIOD

0 1 2 2.4 3

CF -100 10 60 100 80
Cumulative -100 -90 -30 0 50

Payback = 2 + 30/80 = 2.375 years

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 PAY BACK PERIOD
Strengths of Payback:

1. Provides an indication of a project’s risk and

liquidity.
2. Easy to calculate and understand.

Weaknesses of Payback:

1. Ignores the time value of money.

2. Ignores CFs occurring after the payback period.
3. It is a measure of capital recovery & not
profitability. 39
 DISCOUNTED PAYBACK PERIOD
(DPBP)
Discounted Payback: Uses discounted
rather than raw CFs.
0 1 2 3

CFt -100 10 60 80

PVCFt -100 9.09 49.59 60.11

Cumulative -100 -90.91 -41.32 18.79

Discounted
payback = 2 + 41.32/60.11 = 2.7 yrs

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 ACCOUNTING RATE OF RETURN
The accounting rate of return is the ratio of the
average after-tax profit divided by the 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.

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 ACCEPTANCE RULE OF ARR
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.

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.

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 ACCOUNTING RATE OF RETURN

The ARR method has certain advantages as:

 It is very simple to understand.

 Dependency on accounting data which is readily

available.

 Shows the profitability of the project.

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 ACCOUNTING RATE OF RETURN
The disadvantages of ARR include:

 It is based on accounting profit rather than cash

flows.

 Time value of money is ignored.

 It is inconsistent in the sense that the numerator

represents the profit belonging to equity and
preference shareholders whereas the fixed assets
used in denominator rarely if ever represents
contribution equal to equity & preference
shareholders.
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