FINANCIAL MANAGEMENT

(FIN401)

Lecture 6:

Capital Budgting Techniques

Capital Budgeting
(Cont.)

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What is CAPITAL BUDGETING?
• It involves:
• GENERATING INVESTMENT PROPOSALS
• ESTIMATING AFTER-TAX INCREMENTAL CASH
FLOWS FOR THE PROPOSED PROJECT.

Capital Budgting Techniques

• EVALUATING PROJECT INCREMENTAL
CASH FLOWS (Inflows & Outflows) using
evaluation techniques like IRR & NPV methods.
• SELECTING PROJECTS BASED ON SOME RATE OF
RETURN CRITERION.
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• RE-EVALUATING IMPLEMENTED PROJECTS.
Evaluation techniques used in Capital
Budgeting include…
• Payback Period
• Discounted Payback Period

Capital Budgting Techniques

• Net Present Value (NPV)
• Internal Rate of Return (IRR)

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Payback period gives the number of years
required to recover a project’s cost…

• Project is acceptable if the payback period is lesser

than some pre-specified number of years.
• Simple payback ignores the time value of money.

Capital Budgting Techniques

Discounted payback considers the discounted cash
flows.
• Payback period can be used as a measure of
liquidity but doesn’t indicate anything about
profitability or value addition of the project.
• Payback method does not consider the cash flows
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beyond the payback period.
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Capital Budgting Techniques

NPV is the sum of the PVs of all cash inflows and outflows of a
project…

• If projects are independent, accept

if the project NPV is greater than 0.
• If projects are mutually exclusive,

Capital Budgting Techniques

accept projects with the highest
positive NPV, because that asset
adds the most value to
shareholders’ wealth.
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Understanding Net Present Value (NPV)
• A project requires investment of $ 100,000 and the project
gives a single cash flow of $ 120,000 after one year
• If required rate of return is 20% (WACC)
• The net present value of the project will be calculated as:
-100,000 +120,000
__________

Capital Budgting Techniques

Time 0 1 year later
PV -100,000 +120,000/(1.20)
PV -100,000 +100,000
NPV = Zero This means when NPV is Zero the project gives
required rate of return (in this case 20%).
If inflow is $130,000 after one year. PV of inflow = 130,000/1.20 = 108,333
and NPV = $ 8,333. INTERPRETATION OF $ 8,333: Over and above the required
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return of 20% this project adds $ 8,333 to the shareholders equity (wealth).
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Capital Budgting Techniques

Calculation of Net Present Value (NPV)
• Cash Outflow (Initial Outlay) Rs 60,000,000 Year =0
• Cash Inflows
• Year 1 Rs 15,000,000 Year 2 Rs 25,000,000
• Year 3 Rs 30,000,000 Year 4 Rs 30,000,000

Capital Budgting Techniques

• WACC = 20%
• Present Value of Inflows
• 15,000,000/1.2 + 25,000,000/(1.2)² + 30,000,000/(1.2)³
• + 30,000,000/(1.2)4 =Rs 61,675,000
• NPV = Rs 61,675,000 – Rs 60,000,000= Rs 1,675,000
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IRR is the discount rate that forces PV
of inflows equal to cost, and the NPV to
equal zero.
• If projects are independent, accept if the project
IRR > WACC (hurdle rate).
• If IRR > WACC, the project’s return exceeds its

Capital Budgting Techniques

costs and there is some return left over to boost
stockholders’ returns.
• Don’t use IRR for mutually exclusive projects or for
projects with non-conventional cash flows. May
result in wrong selection of projects.

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Profitability Index Method of
Evaluating Projects
• Profitability Index Method is also used for
Evaluating Projects.

Capital Budgting Techniques

However this method has been excluded
from your course.

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 Capital Budgting Techniques
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Solution using IRR method

Capital Budgting Techniques

Solve for i which is the internal rate of return.
Either use financial calculator or use trial &
error method to get approximate IRR (shown
in next slide). 13
 Capital Budgting Techniques
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 Capital Budgting Techniques
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IRR has some problems…

• Project can have Multiple IRRs or no IRR if the

cash flow pattern is non-conventional.

Capital Budgting Techniques

• IRR can give a different result compared to NPV
while evaluating mutually exclusive projects.

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 For non-conventional projects, there are
maximum of as many potential IRRs as
there are sign changes…

Year 0 1 2
Cash flow (800) 5,000 -5,000

Capital Budgting Techniques

IRRs = 25% and 400%

Disc.Rate 0 10% 25% 100% 300% 400% 450%

NPV -800 -390 0 450 140 0 -60

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If discount rates of 25% & 400% are used

• YEAR 0 1 2
__________ ___________ ___________
Cash Flows ( 800 ) +5,000 -5,000

NPV with 25% rate = - 800 +5,000/(1+.25) -5,000/(1+.25)²

Capital Budgting Techniques

NPV = -800 +4,000 -3,200
NPV = Zero

NPV with 400% rate = - 800 + 5,000/(1+4) -5,000/(1+4)²

NPV = - 800 + 5,000/5 -5,000/(5)²
NPV = - 800 +1,000 - 200
NPV = Zero

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Why are there multiple IRRs in the previous example?
• At very low discount rates, the PV of CF2 (negative figure)
is large & negative, so NPV < 0.
• At very high discount rates, the PV of both CF1 and CF2
are low, so CF0 dominates and again NPV < 0.
• In between, the discount rate hits CF2 harder than CF1,
so NPV > 0.
• ---------------------------------------------------------------------

Capital Budgting Techniques

YEAR 0 1 2 .
Cash Flow -800 5,000 -5,000 NPV .
Disc rate (0%) -800 5,000 -5,000 = - 800
Disc rate (10%) -800 4,545 -4,135 = -390
Disc rate (25%) -800 4,000 -3,200 = 0
Disc rate (100%) -800 2,500 -1,250 = +450
Disc rate (300%) -800 1,250 - 310 = +140 19
Disc rate (400%) -800 1,000 - 200 = 0
For mutually exclusive projects,
ranking conflicts are possible using
NPV as well as IRR when…

• Projects have differing cash flow

patterns

Capital Budgting Techniques

• Project scales (sizes) are different

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Cash flows, NPV and IRR for two
projects with different cash flow
patterns…

Cash flows ($) NPV IRR

($) (%)

Capital Budgting Techniques

Year 0 1 2 3 4

Project A -200 80 80 80 80 53.6 21.9

Project B -200 0 0 0 400 73.2 18.9

NPV calculated at Cost of Capital of 10% (discount rate)

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Cash flows, NPV and IRR for two
projects with different sizes…

Cash flows ($) NPV IRR

($) (%)

Capital Budgting Techniques

Year 0 1 2 3 4

Project A -100 50 50 50 50 58.5 34.9

Project B -400 170 170 170 170 138.9 25.2

NPV calculated at COC of 10%

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Evaluation Results of Independent &
Mutually Exclusive Projects

Capital Budgting Techniques

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 Capital Budgting Techniques
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Ranking Problem Due to Scale of Investment Differences

Capital Budgting Techniques

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Why difference in scale of investment
may give conflicting results?

Capital Budgting Techniques

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REASONS FOR CONFLICTING
RESULTS
• The reasons for conflicting results
of NPV and IRR methods due
differences in cash flow patterns

Capital Budgting Techniques

and different lives of projects are
given in a separate word
document.
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When the choice is between two
mutually exclusive projects and there is
no restriction on available funds, NPV
criterion is strongly preferred…

• NPV shows the amount of gain, or wealth increase, as a

Capital Budgting Techniques

currency amount.

• The reinvestment assumption of NPV is more economically

realistic.

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Advantages & Disadvantages of Payback
Period Method

Capital Budgting Techniques

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Advantages & Disadvantages of Internal
Rate of Return (IRR)

Capital Budgting Techniques

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 Advantages of IRR contd.

Capital Budgting Techniques

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There are two ways of evaluating two
mutually exclusive projects with
unequal lives…
• Least common multiple of lives approach
(replacement chain method): involves
extending the time horizon of analysis so that

Capital Budgting Techniques

lives of two projects become equal.
• Equivalent annual annuity approach:
involves spreading NPV over the project’s
useful life through computing a series of equal
annual payments. 32
• The REPLACEMENT CHAIN APPROACH &
EQUIVALENT ANNUAL ANNUITY APPROACH
are explained in a separate word document.

Capital Budgting Techniques

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References
• Fundamentals of Corporate Finance. Stephen A. Ross,
Randolph W. Westerfield & Bradford D. Jordan, 8th edition.
Chapter 10.

• Fundamentals of Corporate Finance, Brealey Myers Marcus,

Stock Valuation Models

4th edition.

• Financial Management: Theory and Practice. Eugene F.

Brigham & Michael C. Ehrhardt, 11th edition.

• Corporate Finance. CFA-II Program Curriculum.

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