Capital Budgeting - I

Gourav Vallabh
XLRI
Jamshedpur
Evaluation Techniques

 The methods of appraising capital

expenditure proposals can be classified into
two broad categories:
1. Traditional
 Average rate of return method
 Pay back period method
2. Time-adjusted
 Net Present Value Method
 Internal Rate of Return Method
 Net Terminal Value Method
 Profitability Index
Average Rate of Return Method
(ARR)
 ARR =Average annual Profits after taxes *100
Average investment over the life of the Project
Average Investment=Net Working Capital +Salvage
Value+1/2(Initial Cost of Machine – Salvage Value)
Machine A Machine B
Cost Rs 56125 Rs 56125
Income after dep & tax
Year 1 3375 11375
2 5375 9375
3 7375 7375
4 9375 5375
5 11375 3375

Estimated Life 5 5
Estimated Salvage 3000 3000
 Pay Back Method
 How many years will it take for the cash
benefits to pay the original cost of an
investment.
 There are 2 ways of calculating the PB
period:
1. When the cash flow stream is in the nature of Annuity
2. When the cash flows are not uniform, In such case, PB
is calculated by the process of cumulating cash flows till
the time when the cumulative cash flows become equal
to the original investment outlay
Problem
Calculate Pay Back Period if the Cost of
Project is 60000

Year Annual Cash Flow After Tax

A B
1 Rs. 14000 Rs 22000

2 16000 20000
3 18000 18000
4 20000 16000
5 25000 17000
The Naïve rate of return
When a manager who relies on the
payback criterion speaks of rate of
return, this normally refers to
something other than time-adjusted
return on investment.
Naïve rate of return = 1/Payback (in years)
Unrecovered Investment
 A concept related to payback, but
taking the time-value of money into
account, is unrecovered investment.
 It suggests that how long it will take for
the firm to recover its investment in the
project plus the cost of the funds
committed to the project.
Comprehensive Example

Consider the following two projects. They have

net after tax cash flows depreciation charges as
shown. It is assumed that the class life asset
depreciation range is used with a switch from
DDB to SYD method in year 2. Project D has
zero salvage, E has a salvage of $ 20,000. The
depreciable lifetime for D is five years, for E it is
eight years. Note that project D’s economic life
is a year longer then the deprecation life used.
cont….
 Project D Project E

Initial Outlay $ 1,00,000 $ 1,00,000

Cash flow/depreciation for year:
1 25,000/40,000 40,000/25,000
2 35,000/24,000 30,000/18,750
3 40,000/18,000 20,000/16,071
4 40,000/12,000 20,000/13,393
5 40,000/6,000 20,000/6,786
6 40,000/0 20,000/0
7 - 20,000/0
8 - 20,000/0
Calculate
a) Pay Back Period
b) Average return on average investment
c) Unrecovered investment at the end of year 3 ( Assume firm’s cost
of capital as 10%)
Discounted Cashflow (DCF)/Time-
Adjusted (TA) Techniques - NPV
Definitions and Introduction –
 NPV has been defined as the present value of

benefits, minus the present value of costs.

 It has also been claimed that NPV measures a

projects contribution to wealth and is,

therefore, the criterion for project desirability.
 Our focus is on absolute desirability.
Example – Simple Cash Flows
 If you invest Rs. 1500 today, you will
receive Rs. 1000 at the end of each
year for 2 years. If you could invest
elsewhere to earn a 10% return, What
is NPV?
Example - Complex Cash Flows

Time Cash Flows (Rs.)

Now -1000

End of year 1 +1000

End of year 2 -2000

End of year 3 +3000
Example - Perpetuities
 DB Ltd. paid Rs 5100 for C Ltd.,
perpetual cash flows were anticipated.
Suppose the required return is 15% and
C will generate Rs 700 at the end of
each year. Calculate the NPV if g = 0,
and g = 4% respectively.
NPV and Wealth Creation:
Perfect Financial Markets
All Equity Financing:
 In perfect market conditions, there is no difference

between making the decisions for ourselves or

making it for our shareholders.
 Cash Flow from an investment is also cash available

to distribute to the shareholders or reinvest on their

behalf.
 Value of the investment opportunity was the same

in perfect markets, whether the equity portion of its

funding came from retention of earnings or the sale
of new stock.
Example
 B Ltd. is financed entirely with equity,
and B’s stockholders could earn a 12%
return elsewhere. B is considering an
investment that requires an initial outlay
of Rs 1500 and generates the year end
cash inflows of Rs 1200 and Rs 800 in
year 1 and year 2 respectively.
NPV and Wealth Creation:
Perfect Financial Markets
Debt – Equity Mix and NPV:
 In continuation of the example in the

previous slide. B Ltd were to buy a asset

but maintain debt equal to 50% of value.
Stockholders could earn 14% elsewhere
with the same risk they are taking by
investing in the company, and bondholders
could earn 10% elsewhere.
 Solution
Cash Flow from investment (1500) 1200 800
PV of remaining Cash Flows 1709.1 714.2 0
Debt (50% of PV of 854.59 357.1 0
remaining cash flows)
Borrow (Repay) 854.59 (497. (357.
45) 1)
Cash Flow from Equity 645.4 617 407

NPV @ 14% = 209.18

NPV and Wealth Creation:
Perfect Financial Markets
Conclusion:
 The NPV computed using WACC as the

discount rate is the amount by which the

wealth of the shareholders is increased if the
company acquires investment.
 The above conclusion rests on the assumption

that debt remains a constant percentage of the

present value of the future benefits.
 It was also assumed that the financial markets

were perfect.
Income Taxes, NPV and
wealth creation – Example
 Assume that for B Ltd., applicable tax
rate is 40% and depreciation allowable
is Rs 900 and Rs 600 in year 1 and year
2 respectively.
 Solution
After tax cash flows from (1500) 1080 720
investment
PV of remaining cash flows 1576.8 654.5 0
of WACC ie 10%
Debt 788.43 327.2 0
Borrow (Repay) 788.43 (461.1) (327.2)
Cash Flow to (from) equity (711.5) 571.55 373.08
NPV @ 14% = 76.86
 Overall Conclusion

WEALTH GAIN TO THE

NPV OF AFTER TAX CASH SHAREHOLDERS, BASED
FLOWS ON THE ANALYSIS OF
FROM THE INVESTMENT, THE CASH FLOWS TO
BEFORE CONSIDERING AND FROM THE
THE IMPACT SHAREHOLDERS,
OF FINANCING CHOICE, CONSIDERING THE
DISCOUNTED AT THE WACC SHAREHOLDERS
OPPORTUNITY COST.
Economic Profit and NPV
 NPV = Present value of Economic
Profits.
 A competitive advantage is necessary to
create an economic profits.
 The relationship between economic
profit and NPV is important because it
highlights the role of competitive
advantage in creating wealth.
Uninformed Investors and
NPV
 If investors are not well informed about future
profitability of the company’s existing assets and
investment opportunities, the market value of the
stock may be different from its intrinsic value,
which is the value that would exist if all potential
investors had the same information that was
available to the person determining intrinsic value.
 In this case too NPV criterion can be applied, with
some modifications. For this purpose, we define
the intrinsic NPV of a proposed capital investment.
 Intrinsic Net Present Value
INPV = IE (n) S (0) IE (0)
S (n)

IE (n) = Intrinsic value of the equity with the proposed capital

investment.
IE (0) = Intrinsic value of the equity without the proposed capital
investment.
S (n) = number of the shares of stock if the new investment is
made.
S (o) = number of the shares of stock already outstanding.
Example
 A corporation generates cash flow of Rs 10 lakh a year
for the shareholders, after reinvesting a sufficient
portion of income to assure continuation at the
current level of profitability. The company has 1 Lakh
shares outstanding. Shareholders could earn 10%
elsewhere taking the same risk. The shareholders are
misinformed, so they expect cash flow of Rs 8 per
share.
The company has an opportunity to make a new
investment that would require Rs 20 lakh of additional
equity. The present value of the cash inflows to equity
would be Rs 24 lakh.
Strong Points of NPV:

 Conceptually Superior.
 Takes into consideration the entire period of the
project life and time value of money.
 Consistent with the basic valuation model.
 Favors early cash flows over later ones.

Weak Points of NPV:

a) Requires lot of estimates and forecasts eg: cost of
capital, future cash flows etc.
B) More difficult to apply.
 Internal Rate of Return Method
(IRR)
 This technique is also known as yield on investment,
marginal efficiency of capital, marginal productivity of
capital, rate of return & time-adjusted rate of return.
 In the case of the NPV, the discount rate is the required
rate of return and being a predetermined rate, usually
the cost of capital, its determinants are external to the
proposal under consideration. The IRR, on the other
hand is based on facts which are internal to proposal.
 The IRR is usually the rate of return that a project earns.
 It is defined as the discount rate which equates the
aggregate present value of the net cash inflows with the
aggregate present value of the net cash outflows.
 In other words, it is the rate which gives the project NPV
of 0.
 IRR Contd.

 The IRR is the rate of return earned on

money committed to a capital investment and
is analogous to interest rates generally
quoted in the financial market place.
 The internal rate of return, then, states the
profitability of an investment in terms they
are generally familiar to managers, whether
or not they are having a financial background.
The IRR of this project
NPV Profile: Boeing Super Jumbo

$35,000.00

$30,000.00

$25,000.00

$20,000.00

$15,000.00 NPV

$10,000.00 Internal Rate of Return

$5,000.00

$0.00

($5,000.00)
Discount Rate
IRR diagram concave from above and below

 For all investments with Ro = C less than

0, and all other cash flows are greater
than or equal to 0. Then the NPV function
is concave from above.For projects having
some cash flows greater than or equal to
0, this will not necessarily be true.
 Projects which are concave from below,
are neither purely investments nor purely
financing projects (loans to the enterprise)
but a mixture of two.
A Rule for IRR
Assume we have a project costing Rs 4000 that will last
only two years and provides cash flows of Rs 1000 in
year 1 and Rs 5000 in year 2
So IRR here is – 200% and 25%
 Which rate should we take as the IRR for this project?

The rule is : in the case of one positive or zero root

and one negative root, choose the negative root only
if the project cost it strictly greater than the
undiscounted sum of the cash flows in periods one
through N.
* A negative IRR < - 100% makes no economic sense
because it is not possible to lose more than all of
what is lost on a bad investment when all cash flows
attributable to the project are included.
Computation of IRR when cash inflows are in
the form of Annuities

 Determine the pay back period of the proposed investment

 In Table of an annuity look for the pay back period that is equal
to or closest to the life of the project
 In the year row, find two PV values or Discount Factor (DFr)
closest to PB period but one bigger and the other smaller than it.
 From the top row of the table, note interest rate ( r) corresponds
to these PV Values (DFr)
 Determine actual IRR by interpolation
IRR= r + PB-DFr
DFrl - DFrh
Problem
A project cost Rs 36000 and is expected
to generate cash inflows of Rs 11200
annually for 5 years. Calculate the IRR
of the project
Exercise

Consider an investment project costing Rs

5,000 that will last an estimated five years
and provides net after tax cash flows at the
end of each quarter of Rs 300 in all but in the
final quarter which with salvage amount to Rs
1000. If instead of quarterly, cash flows we
are having yearly cash flow ( at the end of
each year ). What will be the changes in IRR?
 Strong Point to IRR

 Conceptually superior to the payback and accounting methods.

 Does not ignore any periods in the project life nor any cash
flows.
 It takes into account the time value of funds .
 Consistent with basic valuation model.
 It yield a percentage that management can examine and make
judgments about when K is not known with confidence.
 It favors early cash flows ones later ones.
Weak points of IRR:

 Requires an estimate of the organizations cost of

capital
 Difficult to apply.
 Does not distinguish between projects of
different size and or different economic values.
 It often yields multiple, and thus ambiguous
results when there is more than one sign change
in the cash flows.
 It implicitly assumes that cash flow may be
reinvested at a return equal to the IRR.
Multiple IRR’s
 Descartes Rule: Maximum number of IRR’s
cannot exceed the number of changes of
signs in cash flows.
 The number of positive, real IRR’s cannot
exceed the number of changes in the signs of
cumulative cash flows.
 This cumulation process can be continued for
any number of stages, with the minimum
number of sign changes achieved at any
stage being the maximum possible number of
positive, real IRR’s.
Problem
Year 0 1 2 3 4

CASH FLOW -100 300 -800 1800 -1200

 Problem
YEAR 0 1 2

Project F -100 275 -180

Project G 100 -275 180

IRR = 7.4%, 67.6% and k = 15%

 Contd.

 The correctness of the net present value rule

in the case of multiple IRR’s can be
demonstrated with the help of current
consumption.
 Suppose an investor with a 15% opportunity
cost of funds is considering these two assets
and wants to consume as much as possible in
future period then:
F:
C (0) = W (0) - 100 + (275 – C (1))/1.15 –
(180 -C (2)) /1.15 ^2
 Reinvestment Rate Assumptions
for NPV & IRR
N N

X=  R / (1+d)
t
t =  R (1+d) t
-t ---------------------- (1)

t=0 t=0

Multiplying both sides of the equation by (1+d) N

N N

X (1+d)N =  R / (1+d)
t
t-N =  R (1+d)
t
N-t ---- (2)

t=0 t=0

 If in equation (2) d is the IRR, then X=0 and

X(1+d) N is zero.
 Therefore IRR could be as easily obtained from a future value
formulation as from the conventional present value
formulations & if X were not 0 then the effect of multiplying by
(1+d) N simply moves the reference point from t=0 to t=N.
 In equation 2 we obtain the same results as in equation 1
except for a constant of (1+d)N times the NPV by assuming the
cash flows are reinvestment at earning rate d, rather than
being discounted at that rate.
 The R0 which for most projects will be the cost or initial outlay
is invested for N periods at rate of compounded each period.

cont……
 For the initial outlay this may be interpreted
as the opportunity cost of committing funds to
this project in which rate d could be earned.
 Or in the case where d= K the opportunity
cost may arise from the decision to undertake
a project requiring funds to be raised where
as without the project no new funds would
need to be raised.
 The implication of future value formulation is
that the project return whether by IRR or by
NPV will depend on the rate at which cash
flows can be reinvested.
 Let us now consider the IRR and reinvestment rate in
another light.
 From the point of view of borrower of money cash
flows are identical as that of lender of money except
that the signs are reversed.
 The pre tax return to the lender cannot be less than
cost to the borrower even if the lender reinvest it or
not.
 The return is measured as a time adjusted
percentage of the principal amount outstanding and
is independent of what disposition is made of the
cash flows as they are received.
 Although the yield on the funds originally invested
may be increased by such uses, it cannot be reduced
by lack of such investment opportunities.
cont……
 Problem

t=0 t=1 t=2 t=3 t=4 t=5

-100000 33438 33438 33438 33438 33438

IRR IS 20%
 Problem

t=0 t=1 t=2 t=3 t=4 t=5

-100000 20000 20000 20000 20000 120000

IRR IS 20%
Problem (per period return on remaining principal on

the assumption of constant amortization)

t Principal % return
remaining
1 100000 13.438
2 80000 16.798
3 60000 22.397
4 40000 33.595
5 20000 67.190

IRR IS 20%
 The IRR is thus a minimum return on the
loan, and this minimum is independent of
investment opportunities.
 Percentage return on an investment does not
depend on the available reinvestment rate.
The actual gain to the lender may, of course,
be higher than this minimum amount if the
available reinvestment rate is greater than
zero, but that is condition external to the
investment.
 The IRR is concerned with the internal
characteristic only and therefore provides a
measure of the minimum return on the
investment.
 To conclude the conceptual difficulty
with the reinvestment rate assumption
arises from focusing on the superficial
aspects of the mathematics of IRR while
neglecting the economic interpretation
of the initial investment and the
subsequent cash flows.
Adjusted or Modified IRR

 The controversy over whether or not the IRR

should be used when there is doubt that the
projects cash flows can be reinvested at the
IRR lead to the development of adjusted IRR.
 The idea behind the adjusted IRR is to
assume that all cash flows after the initial
outlay or outlays are invested to earn some
other conservative reinvestment rate.
Modified Internal Rate of Return
 Managers wanting to use the internal
rate of return sometimes use a modified
internal rate of return to develop a
single internal-rate-of-return measure
when a project has multiple IRR’s:
 It involves two steps:
 Compute the terminal value of all

cash flows except the initial outlay.

 Calculate the MIRR that sets the
terminal value equal to the initial
outlay.
 One of the purpose of calculating a MIRR
is to give the analysts an unambiguous
accept-reject signal when multiple IRR are
possible.
 Another advantage of the MIRR is that it
uses the most conservative estimate of the
IRR by using the company’s cost of capital
as the assumed reinvestment rate and
financing rate.
 There is no adjustment for project size
and project life
 The method does not work well for
investments that have outlay spread over
several years.
NPV, IRR and the Reinvestment Rate
Assumption
The NPV rule assumes that intermediate cash flows on
the project get reinvested at the hurdle rate (which is
based upon what projects of comparable risk should
earn).
 The IRR rule assumes that intermediate cash flows on
the project get reinvested at the IRR. Implicit is the
assumption that the firm has an infinite stream of
projects yielding similar IRRs.
 Conclusion: When the IRR is high (the project is creating
significant surplus value) and the project life is long, the
IRR will overstate the true return on the project.
 Solution to Reinvestment Rate
Problem
Cash Flow $ 300 $ 400 $ 500 $ 600

Investment 1000
$600
$500(1.15)
$575
$400(1.15)2 $529
$300(1.15)3 $456

Terminal Value = $2160

Internal Rate of Return = 24.89%

Modified Internal Rate of Return = 21.23%
Relationship of NPV & IRR
N

0=  R (1+r)
t
-t -------------------------- (1)

t=0
N

NPV =  R (1+k)
t
-t -------------------------- (2)

t=0
Subtract (1) from (2)
N

NPV =  Rt [ (1+k)-t – (1+r) –t ]

t=0
For NPV to be positive it is necessary only for the relation r > k to be
true. This shows the equivalence of the NPV and IRR criteria for
project that have Rt > 0 for t>0 in terms of accept reject decision.
The NPV & IRR suggests..
 The IRR and the NPV will yield similar results most
of the time, though there are differences between
the two approaches that may cause project rankings
to vary depending upon the approach used.
 The information needed to use IRR in investment
analysis is the same as the information need to use
NPV. But, If the hurdle rate is changing over time,
IRR becomes more complicated to use. It has to be
compared to the geometric average of the hurdle
rates over time.
Case 1: IRR versus NPV
 Consider a project with the following cash
flows:
Year Cash Flow
0 -1000
1 800
2 1000
3 1300
4 -2200
What do we do now?
 This project has two internal rates of return. The
first is 6.60%, whereas the second is 36.55%.
 Why are there two internal rates of return on

this project?
 If your cost of capital is 12.32%, would you

accept or reject this project?

 I would reject the project

 I would accept this project

Explain.
Profitability Index (PI)

 The profitability index (PI) is the value

increase per rupee invested.
 If an initial investment Io will generate cash
flows in future years with cash flow in year t
designated CFt, the profitability index is:
 CF 
PI   
n

/I
t

 (1  k )
o

t 1 t

 If the NPV is positive, the profitability index

will be greater than 1.00 and vica versa
 Year 0 1 2 3 4
Cash Flow -1,000 500 -2,000 2,000 2,000

There is a definition problem with the profitability

Index (PI) when Investment are spread over several
years rather than being made as a lump sum
 The question of whether to subtract the

present value of a future outlay from the

numerator or add it to the denominator.
 To compare projects using this method, a

standard rule for dealing such situation is

necessary. The modified profitability index
provides one such rule
 Modified Profitability Index (MPI):
Net Present Value
MPI  1 
Initial Outlay  PV of future commitments

Year 0 1 2 3 4
Cash Flow -1,000 500 -2,000 2,000 2,000
-1,818
-1,318

-1,198
INITIAL COMMITMENT 2,198

670
MPI  1
2,198
 If the only question is whether the benefit
exceed the cost, the 2 profitability indexes
give the same signal. Both will be greater
than 1.0 when the NPV is positive.
 If PI is used to discuss the degree of
attractiveness, then the two measures are
substantially different.
 Contd.

 To measure relative attractiveness of

investments, PI is a poor tool, because:
 Even if we use MPI the rules are arbitrary so

there is no clear relationship between the PI

and wealth creation.
 PI ignores the project size.

 But PI, is sometimes used as a measure of the

margin of error, which gives an indication of
how much benefits can fall below expectations
before the project begins to destroy wealth
 Present Value Payback Period
 This method is used today primarily as
supplementary information.

* Example (Cash flow in 0 period is Rs 2,000 & k=10%

Year Cash Benefit PV Factor Present Value CPV
1 1,000 0.9091 909.10 909.10
2 1,000 0.8264 826.40 1,735.50
3 1,000 0.7513 751.30 2,486.80

264.5
PV PBP  2   2.35 years
751.30