Capital Budgeting Decisions

Chapter Objectives
 Understand the nature and importance of investment decisions.
 Distinguish between discounted cash flow (DCF) and non-
discounted cash flow (non-DCF) techniques of
investment evaluation.
 Explain the methods of calculating net present value (NPV) and
internal rate of return (IRR).
 Show the implications of net present value (NPV) and internal rate
of return (IRR).
 Describe the non-DCF evaluation criteria: payback and accounting
rate of return and discuss the reasons for their popularity in
practice and their pitfalls.
 Illustrate the computation of the discounted payback.
 Describe the merits and demerits of the DCF and Non-DCF
investment criteria.
 Compare and contract NPV and IRR and emphasise the
superiority of NPV rule.
Financial Management, Ninth 2
Nature of Investment 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.

Financial Management, Ninth 3

Features of Investment Decisions
 The exchange of current funds for future
benefits.
 The funds are invested in long-term
assets.
 The future benefits will occur to the firm over
a series of years.

Financial Management, Ninth 4

Importance of Investment Decisions
 Growth
 Risk
 Funding
 Irreversibility
 Complexity

Financial Management, Ninth 5

Types of Investment Decisions
 One classification is as follows:
 Expansion of existing business
 Expansion of new business
 Replacement and modernisation
Yetanother useful way to classify
investments is as follows:
 Mutually exclusive investments
 Independent investments
 Contingent investments

Financial Management, Ninth 6

Investment Evaluation Criteria
 Three steps are involved in the evaluation of
an investment:
 Estimation of cash flows
 Estimation of the required rate of return (the
opportunity cost of capital)
 Application of a decision rule for making the
choice

Financial Management, Ninth 7

Investment Decision Rule
 It should maximise the shareholders’ wealth.
 It should consider all cash flows to determine the true profitability of
the project.
 It should provide for an objective and unambiguous way of
separating good projects from bad projects.
 It should help ranking of projects according to their true profitability.
 It should recognise the fact that bigger cash flows are preferable
to smaller ones and early cash flows are preferable to later ones.
 It should help to choose among mutually exclusive projects that
project which maximises the shareholders’ wealth.
 It should be a criterion which is applicable to any conceivable
investment project independent of others.

Financial Management, Ninth 8

Evaluation Criteria
 1. Discounted Cash Flow (DCF) Criteria
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Profitability Index (PI)
 2. Non-discounted Cash Flow Criteria
 Payback Period (PB)
 Discounted Payback Period (DPB)
 Accounting Rate of Return (ARR)

Financial Management, Ninth 9

Net Present Value Method
 Cash flows of the investment project should be
forecasted based on realistic assumptions.
 Appropriate discount rate should be identified to
discount the forecasted cash flows. The
appropriate discount rate is the project’s
opportunity cost of capital.
 Present value of cash flows should be
calculated using the opportunity cost of capital
as the discount rate.
 The project should be accepted if NPV is
positive (i.e., NPV > 0).
Financial Management, Ninth 10
Net Present Value Method
 Net present value should be found out by
subtracting present value of cash outflows
from present value of cash inflows. The
formula for the net present value can be
written as follows:
C1 C2 C3 Cn
 
NPV     (1  k) 3  …. (1  n   C0
 (1  k ) (1  
n  k)
k) 2 C
NPV 
t
 C0
(1 
 k ) t
t

1
Financial Management, Ninth 11
 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
NPV  5   Rs 2,500
(1+0.10) (1+0.10) (1+0.10)3 (1+0.10)4
2

500
NPV  [Rs 900(PVF(1+0.10)
1, 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
Financial Management, Ninth 12
NPV  Rs 2,725  Rs 2,500 = + Rs
 Acceptance Rule
The NPV represents the net benefit over and above the
compensation for time and risk. Hence the decision rule
associated with NPV is:
 Accept the project when NPV is positive
NPV > 0
 Reject the project when NPV is negative
NPV < 0
 May accept the project when NPV is zero
NPV = 0
 The NPV method can be used to select
between mutually exclusive projects; the one
with the higher NPV should be selected. 13
Evaluation of the NPV Method
 NPV is most acceptable investment rule for the
following reasons:
 Time value
 Measure of true profitability
 Value-additivity
NPV of Project A+B= NPV of Project A+ NPV of project B

 Shareholder value

 Value of the Firm= ∑ Present Value of projects + ∑ NPV of expected

future projects

Financial Management, Ninth 14

Evaluation of the NPV Method
 Limitations:
 Involved cash flow estimation
 Discount rate difficult to determine
 NPV is expressed in absolute terms hence does not
factor in the scale of investment
 Does not consider life of the project. Prefers long
term projects

Financial Management, Ninth 15

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. C0  C  C  C C
(1  r)3 … . (1 
1 2 3 n

(1  r) (1 
0
r)n 2 C r) n 
C  t

 t 1 (1 
n r)Ct
 (1 
t
 C0 
t 1 0
r)t Financial Management, Ninth 16
Calculation of IRR

•  Uneven 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.
Financial Management, Ninth 17
Calculation of IRR
 Level 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 )

PVAF6, r  Rs 20,000  3.683

Rs 5,430

Financial Management, Ninth 18

 NPV Profile and IRR
The slope of the NPV profile reflects how sensitive the project is to
discount rate changes.
A B C D E F G H
1 N P V P ro f ile
Dis co
2 C a sh F u n t N P
lo w r a te V
3 -2000 0 % 1 2 ,5 80 IR
0
4 5430 5 % 7 ,5 61
5 5 4 3 0 1 0 % 3 ,6 49
6 5430 15% 550
7 5430 16% 0
8 5 4 3 0 2 0 % ( 1 ,942) F ig u re8 .1 P r o f
9 5 4 3 0 2 5 % ( 3 ,974) NPV ile
Financial Management, Ninth 19
Acceptance Rule
 Accept the project when r > k.
 Reject the project when r < k.
 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.

Financial Management, Ninth 20

Evaluation of IRR Method
 IRR method has following merits:
 Time value
 Profitability measure
 Acceptance rule
 Shareholder value

 IRR method may suffer from:

 Multiple rates
 Mutually exclusive projects
 Value additivity
 IRR of Project A+B= IRR of Project A+ IRR of project B

Financial Management, Ninth 21

Profitability Index

•  Profitability index is the ratio of the

present value of cash inflows, at the
required rate of return, to the initial cash
outflow of the investment.

Financial Management, Ninth 22

 Profitability Index
 The initial cash outlay of a project is Rs 100,000
and it can generate cash inflow of Rs 40,000,
Rs 30,000, Rs 50,000 and Rs 20,000 in year 1
through 4. Assume a 10 per cent rate of
discount. The PV of cash inflows at 10 per cent
discount rate is:
PV  Rs 40,000(PVF1, 0.10 ) + Rs 30,000(PVF2, 0.10 ) + Rs 50,000(PVF3, 0.10 ) + Rs 20,000(PVF4, 0.10 )
= Rs 40,000  0.909 + Rs 30,000  0.826 + Rs 50,000  0.751 + Rs 20,000 
0.68 NPV  Rs 112,350  Rs 100,000 = Rs 12,350

Rs Rs 1,12,350
PI   1.1235.
1,00,000

Financial Management, Ninth 23

Acceptance Rule
 The following are the PI acceptance rules:
 Accept the project when PI is greater than one.
PI > 1
 Reject the project when PI is less than one.
PI < 1
 May accept the project when PI is equal to one.
PI = 1
 The project with positive NPV will have PI
greater than one. PI less than means that the
project’s NPV is negative.

Financial Management, Ninth 24

Evaluation of PI Method
 It recognises the time value of money.
 It is consistent with the shareholder value
maximisation principle. A project with PI greater than
one will have positive NPV and if accepted, it will
increase shareholders’ wealth.
 In the PI method, since the present value of cash
inflows is divided by the initial cash outflow, it is
a relative measure of a project’s profitability.
 Like NPV method, PI criterion also requires
calculation of cash flows and estimate of the discount
rate. In practice, estimation of cash flows and
discount rate pose problems.

Financial Management, Ninth 25

Payback
 Payback is the number of years required to recover the
original cash outlay invested in a project.
 If the project generates constant annual cash inflows,
the payback period can be computed by dividing cash
outlay by the annual cash inflow. That is:
Payback = Initial Investment
=
C0
 Assume that a project requires an outlay of Rs 50,000
Annual Cash Inflow C
and yields annual cash inflow of Rs 12,500 for 7 years.
The payback period for the project is:
Rs 50,000
PB = Rs 12,500 = 4 years
Financial Management, Ninth 26
Payback
 Unequal cash flows In case of unequal cash
inflows, the payback period can be found out by
adding up the cash inflows until the total is
equal to the initial cash outlay.
 Suppose that a project requires a cash outlay of
Rs 20,000, and generates cash inflows of
Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000
during the next 4 years. What is the project’s
payback?
3 years + 12 × (1,000/3,000) months
3 years + 4 months
Financial Management, Ninth 27
Acceptance Rule
 The project would be accepted if its payback
period is less than the maximum or standard
payback period set by management.
 As a ranking method, it gives highest ranking
to the project, which has the shortest payback
period and lowest ranking to the project with
highest payback period.

Financial Management, Ninth 28

Evaluation of Payback
 Certain virtues:
 Simplicity
 Cost effective
 Short-term effects
 Risk shield
 Liquidity
 Serious limitations:
 Cash flows after payback
 Cash flows ignored
 Cash flow patterns
 Administrative difficulties
 Inconsistent with shareholder value
Financial Management, Ninth 29
Payback Reciprocal and the Rate of
Return
 The reciprocal of payback will be a close
approximation of the internal rate of return if
the following two conditions are satisfied:
 The life of the project is large or at least twice the
payback period.
 The project generates equal annual cash inflows.

Financial Management, Ninth 30

Discounted Payback Period
 The discounted payback period is the number of
periods taken in recovering the investment outlay on the
present value basis.
 The discounted payback period still fails to consider the
cash flows occurring after the payback period.
3 DISCOUNTED PAYBACK ILLUSTRATED
Cash Flows
(Rs) Simple Discounted NPV at
C0 C1 C4 PB PB 10%
C2
C3
P -4,000 3,000 1,000 1,000 1,000 2 yrs – –
PV of cash flows -4,000 2,727 826 751 683 2.6 yrs 987
Q -4,000 0 4,000 1,000 2,000 2 yrs – –
PV of cash flows -4,000 0 3,304 751 1,366 2.9 yrs 1,421

Financial Management, Ninth 31

Accounting Rate of Return
Method
•  The accounting rate of return is the ratio
of the average after-tax profit divided by
the average investment. The average
investment would be equal to half of the
Average
original investment if itincome
were depreciated
ARR =
constantly. 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.
Financial Management, Ninth 32
Acceptance Rule
 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.

Financial Management, Ninth 33

Evaluation of ARR Method
 The ARR method may claim some merits
 Simplicity
 Accounting data

 Accounting profitability

 Serious shortcoming
 Cash flows ignored
 Time value ignored
 Arbitrary cut-off

Financial Management, Ninth 34

Conventional and Non-
conventional Cash Flows
 A conventional investment has cash flows the
pattern of an initial cash outlay followed by cash
inflows. Conventional projects have only one
change in the sign of cash flows; for example,
the initial outflow followed by inflows,
i.e., – + + +.
 A non-conventional investment, on the other
hand, has cash outflows mingled with cash
inflows throughout the life of the project. Non-
conventional investments have more than one
change in the signs of cash flows; for example,
– + + + – ++ – +. Financial Management, Ninth 35
NPV Versus IRR
 Conventional Independent Projects:
In case of conventional investments, which are
economically independent of each other, NPV
and IRR methods result in same accept-or-reject
decision if the firm is not constrained for funds
in accepting all profitable projects.

Financial Management, Ninth 36

 NPV Versus IRR
•Lending and borrowing-type projects:
Project with initial outflow followed by inflows is a lending type
project, and project with initial inflow followed by outflows is a
borrowing type project, Both are conventional projects.

Cash Flows (Rs)

Project C0 C1 IRR NPV at 10%

X -4000 6000 50% 145

Y 4000 -7000 75% -2364

Financial Management, Ninth 37

 NPV Versus IRR
•Lending and borrowing-type projects:
•Non conventional Cash Flows:
Cash Flows (Rs)
Project C0 C1 C2
X -1,60,000 1,00,000 -10,00,000

The IRR equation for this cash flow stream is:

C1 C2
C0  
(1  r) (1 
r) 2
1,60,000  1,00,000 -10,00,000 0
(1  r) (1  r) 2

Financial Management, Ninth 38

Problem of Multiple IRRs
A project may have
both lending and
borrowing features NPV (Rs)
250
NPV Rs

together. IRR method, 0

63

when used to evaluate -

250

such non- -
500
conventional -
750 0
investment can yield
5 100 150 20 25
0 0 0
Discount Rate

multiple internal rates

(%)

of return because of
more than one change
of signs in cash flows.
Financial Management, Ninth 39
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.
 Scale of Investments. The cash outlays of the projects

may differ.
 The projects may have different expected lives.

Financial Management, Ninth 40

Timing of Cash Flows /Cash Flow Pattern

Cash Flows (Rs) NPV

Project C0 C1 C3 at 9% IRR
C2
M – 1,680 1,400 700 140 301 23%
N – 1,680 140 840 1,510 321 17%

Project N with its higher NPV, contributes more to the value of the firm.
But from IRR point of view project M looks more attractive.
Hence,
The IRR rule can be misleading when a choice has to be made between
mutually exclusive projects which have different patterns of cash flow over
time.

Financial Management, Ninth 41

 Scale of Investment

Cash Flow (Rs) NPV

Project C0 at 10% IRR

C1
A -1,000 1,500 364 50%
B -100,000 120,000 9,080 20%
Both the projects are good but project B with its higher NPV, contributes more to the
value of the firm. But from IRR point of view Project A looks better than B.
Hence,
The IRR rule seems unsuitable for ranking projects of different scale.

Financial Management, Ninth 42

 Project Life Span

Cash Flows
Project (Rs) NPV at 10% IRR
C0 C1 C2 C3 C4 C5
X – 10,000 12,000 – – – – 908 20%
Y – 10,000 0 0 0 0 20,120 2,495 15%

The conflict may be resolved by adopting a modified procedure.

(i) Common Time Horizon approach
(ii) Equivalent annual value/cost approach( EANPV) - It evaluates unequal
lived projects that converts the net present value of unequal-lived
mutually exclusive projects into an equivalent (in NPV terms) annual
amount.

Financial Management, Ninth 43

 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%

The conflict may be resolved by adopting a modified procedure.

(i) Equivalent annual value/cost approach( EANPV) - It evaluates unequal
lived projects that converts the net present value of unequal-lived
mutually exclusive projects into an equivalent (in NPV terms) annual
amount.
NPV of the project
EANPV =
PV of annuity corresponding to life of the project at given
cost of capital
Financial Management, Ninth 44
Reinvestment Assumption

•  The IRR method is assumed to imply that

the cash flows generated by the project can
be reinvested at its internal rate of return,
whereas the NPV method is thought to
assume that the cash flows are reinvested
at the opportunity cost of capital.

Financial Management, Ninth 45

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.
The modified internal rate of return (MIRR)
overcomes the shortcomings of regular IRR.

Financial Management, Ninth 46

Modified Internal Rate of Return
(MIRR)

Financial Management, Ninth 47

Modified Internal Rate of Return
(MIRR)
PV = FVn
(1+k)n

PV = TVn
(1+MIRR)n

Financial Management, Ninth 48

Varying Opportunity Cost of Capital
 There is no problem in using NPV method
when the opportunity cost of capital
varies over time.
 If the opportunity cost of capital varies over
time, the use of the IRR rule creates
problems, as there is not a unique benchmark
opportunity cost of capital to compare with
IRR.

Financial Management, Ninth 49

NPV Versus PI
 A conflict may arise between the two methods
if a choice between mutually exclusive projects
has to be made. Follow NPV method:

Project C Project D
PV of cash inflows 100,000 50,000
Initial cash outflow 50,000 20,000
NPV 50,000 30,000
PI 2.00 2.50

Financial Management, Ninth 50