# CAP!TAL BUDCET!NC DEC!S!

ONS
Should we
build this
plant?
SEENA CHAKRABART!
CAP!TAL BUDCET!NC DEC!S!ONS
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
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.
TYPES OF !NvESTNENT DEC!S!ONS
One classification is as follows:
Replacement and modernisation
Yet another useful way to classify investments is as
follows:
Nutually exclusive investments
!ndependent investments
Contingent investments
AN EXANPLE OF NUTUALLY
EXCLUS!vE PRO]ECTS
BR!DCE vs. BOAT to get
products across a river.
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.
Nost common: Cost (negative CF), then string of
positive CFs,then cost to close project.
Example: Nuclear power plant, strip mine.
CAP!TAL BUDCET!NC DEC!S!ONS
These are generally:
Long·term decisions, involving large
expenditures.
Have long term consequences.
Difficult or expensive to reverse.
Capital Budgeting
Nethods
Discounting Criteria
NPv BCR !RR
N!RR
PBP ARR
DPBP
Non Discounting Criteria
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:
3 1 2
0
2 3
0
1
NPV
(1 ) (1 ) (1 ) (1 )
NPV
(1 )
3
3
3
9
9
9

=
¦
= + + + +
¦
+ + + +
¦
=
+
¯

NET PRESENT vALUE
Where,
C
t
= 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).
C
0
= !nitial investment
1 / (1 + k )
t
= known as discounting factor or Pv!F
i.e present value interest factor.
CALCULAT!NC NET PRESENT vALUE
Assume that Project X costs Rs 2,S00 now and is
expected to generate year·end cash inflows of Rs
300, Rs 800, Rs 700, Rs 600 and Rs S00 in years 1
through S. The opportunity cost of the capital may be
assumed to be 10 per cent.
2 3 4 5
1, 0.10 2, 0.10 3, 0.10
4, 0.10 5, 0.
Rs 900 Rs 800 Rs 700 Rs 600 Rs 500
NPV Rs 2,500
(1¹0.10) (1¹0.10) (1¹0.10) (1¹0.10) (1¹0.10)
NPV |Rs 900(PVF ) ¹ Rs 800(PVF ) ¹ Rs 700(PVF )
¹ Rs 600(PVF ) ¹ Rs 500(PVF
¦
= + + + +
¦
¦
=
10
)| Rs 2,500
NPV |Rs 900 0.909 ¹ Rs 800 0.826 ¹ Rs 700 0.751 ¹ Rs 600 0.683
¹ Rs 500 0.620| Rs 2,500
NPV Rs 2,725 Rs 2,500 ÷ ¹ Rs 225

= - - - -
-
=
ACCEPTANCE RULE OF NPv
Accept the project when NPv is positive
NPv > 0
Reject the project when NPv is negative
NPv < 0
Nay 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.
!t considers time value of money.
!t is a true measure of profitability as it uses the
present values of all cash flows (both outflows S
inflows) S 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
!t 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.
!t 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.
BENEF!T COST RAT!O
!t is calculated as:
Benefit·cost ratio = PvB / !
Where,
PvB = present value of benefits
! = !nitial investments
ACCEPTANCE RULE FOR BCR
BCR > 1 = Accept
BCR = 1 = !ndifferent
BCR < 1 = Reject
EvALUAT!ON OF BCR NETHOD
Since it considers the investment in the project, it is
considered to be preferable to NPv method.
!t does not provide for a means through which a
number of smaller projects can be combined to be
compared to a bigger project.
!nternal Rate of Return: !RR
0 1 2 3
CF
0
Cost
CF
1
CF
2
CF
3
Cash InfIow
!RR 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.
!NTERNAL RATE OF RETURN
NETHOD
The internal rate of return (!RR) 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 !RR is:
3 1 2
0
2 3
0
1
0
1
(1 ) (1 ) (1 ) (1 )
(1 )
0
(1 )
3
3
3
9
9
9
3
9
9
9

7 7 7 7

7

7
=
=
= + + + +
+ + + +
=
+
=
+
¯
¯

!NTERNAL RATE OF RETURN
NETHOD
Where,
C
t
= cash flow at the end of year t
n = Life of the project
r = discount rate
C
0
= !nitial investment
1 / (1 + r )
t
= known as discounting factor or Pv!F
i.e present value interest factor.
CALCULAT!ON OF !RR
evel or even Cash Flows:
Let us assume that an investment would cost Rs
20,000 and provide annual cash inflow of Rs S,430
for 6 years.
The !RR of the investment can be found out as
follows:
!RR = 16% approx.( Refer to PvAF table @ 3.68S for 6 yrs
6,
6,
6,
NPV Rs 20,000 ¹ Rs 5,430(PVAF ) ÷ 0
Rs 20,000 Rs 5,430(PVAF )
Rs 20,000
PVAF 3.683
Rs 5,430
7
7
7
=
=
= =
NPv Profile and !RR
A B C D E F G H
1 N P V P r o f i l e

2 C a s h F l o w
D i s c o u n t
r a t e A P J
3 - 2 0 0 0 0 0 ° 1 2 , 5 8 0
4 5 4 3 0 5 ° 7 , 5 6 1
5 5 4 3 0 1 0 ° 3 , 6 4 9
6 5 4 3 0 1 5 ° 5 5 0
7 5 4 3 0 1 6 ° 0
8 5 4 3 0 2 0 ° ( 1 , 9 4 2 )
9 5 4 3 0 2 5 ° ( 3 , 9 7 4 )
i g u r e 8 . 1 N P V P r o I i l e

Ì R
R
CALCULAT!ON OF !RR
neven or non-normal Cash Flows: Calculating
!RR by Trial and Error
The approach is to select any discount rate to
compute the present value of cash inflows. !f 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.
CALCULAT!ON OF !RR
A project costs Rs.16000 and is expected to generate
cash inflows of Rs. 8000, Rs.7000 S Rs.6000 at the
end of each year for next 3 years.
ACCEPTANCE RULE FOR !RR
Accept the project when r (!RR) > k (WACC).
Reject the project when r (!RR) < k (WACC).
Nay accept the project when r = k.
!n case of independent projects, !RR and NPv rules
will give the same results if the firm has no shortage
of funds.
!n case of projects with equal !RR S different NPv,
select project with higher NPv as it is consistent with
firm's wealth maximisation objective.
!t considers time value of money.
!t is a true measure of profitability as it uses the
present values of all cash flows(both outflows S
inflows) rather than any other arbitrary
assumption or subjective consideration.
!n case of conventional independent projects NPv
S !RR methods gives the same decision.
Whenever a project with higher !RR than WACC is
undertaken, it results in the increase in the
shareholder's return. Hence, the value of the firm
also increases.
PROBLENS W!TH !RR
Lending S 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 !RR does not
differentiate between lending and borrowing projects,
a higher !RR may not always be a desirable thing.
Nultiple !RR: !n case of projects with non·normal or
unconventional cash flows more than one !RR are
Nutually Exclusive projects: !n case of mutually
exclusive projects the results of NPv S !RR methods
may conflict each other. This is because the !RR
method does consider the scale of investment.
PROBLENS W!TH !RR
Different short term S 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.
LEND!NC S BROW!NC PRO]ECTS
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 C
o
C
1
!RR NPv at 10%
X ·100 110 10% 0
Y 100 ·110 10% 0
LEND!NC SBORROW!NC PRO]ECTS
Cash Flows (Rs.)
Project C
o
C
1
!RR NPv at S%
X ·100 110 10% 4.72
Y 100 ·110 10% ·4.72
Cash Flows (Rs.)
Project C
o
C
1
!RR NPv at
1S%
X ·100 110 10% ·4.3
Y 100 ·110 10% 4.3
PROBLEN OF NULT!PLE !RRS
A project may have both lending and borrowing
features together. !RR 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.
Case of Ranking Nutually Exclusive Projects
!nvestment 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 !RR 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.
RANK!NC NUTUALLY EXCLUS!vE PRO]ECTS
(Timing of Cash Flows)
Cash Flows (Rs) APJ
Project Cô C1 C2 C3 at 9" IRR
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 -388
1000
800
600
400
200
0
·200
·400
S% 10% 1S% 20% 2S% 30%
NPv
Discount Rate
NPv !NR 276/·
___ Project N
···· Project N
RANK!NC NUTUALLY EXCLUS!vE PRO]ECTS
(Timing of Cash Flows)
discount is k/as Fisher's
intersection.
RANK!NC NUTUALLY EXCLUS!vE PRO]ECTS
(Scale of !nvestment)

Cash Flow (Rs) APJ

Project Cô C1 at 1ô" IRR
-1,000 1,500 364 50°
-100,000 120,000 9,080 20°

RANK!NC NUTUALLY EXCLUS!vE PRO]ECTS
(Project Life Span)
Cash Flows Rs
Project C
ô
C
1
C
2
C
3
C
4
C
5
APJ at 1ô" IRR
10,000 12,000 908 20°
10,000 0 0 0 0 20,120 2,495 15°
Nodified !nternal Rate of Return
(N!RR)
The modified internal rate of return (N!RR) is
the compound average annual rate that is calculated
with a reinvestment rate different than the project's
!RR.
Both NPv S !RR 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)
S internal rate of return (i.e r) respectively in each of
the above two methods.
But, in N!RR the cashflows are assumed to be
reinvested at cost of capital ( k) instead of internal
rate of return ( r )as in !RR method.
PAY BACK PER!OD
!t is the number of years required to recover a
project's cost, or how long does it take to get the
10 80 60
0 1 2 3
-100
=
CF
CumuIative -100 -90 50
Payback 2 + 30/80 = 2.375 years
0
100
2.4
PAY BACK PER!OD
-30
\$trengths of Payback:
1. Provides an indication of a project's risk and
Iiquidity.
2. Easy to caIcuIate and understand.
Weaknesses of Payback:
1. Ignores the time vaIue of money.
2. Ignores CFs occurring after the payback period.
3. It is a measure of capitaI recovery & not
profitabiIity.
PAY BACK PER!OD
D!SCOUNTED PAYBACK PER!OD
(DPBP)
10 80 60
0 1 2 3
CF
t
CumuIative
-100
-90.91 -41.32 18.79
Discounted
payback
2 + 41.32/60.11 = 2.7 yrs
Discounted Payback: Uses discounted
rather than raw CFs.
PVCF
t
-100
-100
9.09 49.59 60.11
=
ACCOUNT!NC 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
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.
ACCOUNT!NC RATE OF RETURN
The ARR method has certain advantages as:
!t is very simple to understand.
Dependency on accounting data which is readily
available.
Shows the profitability of the project.
ACCOUNT!NC RATE OF RETURN
!t is based on accounting profit rather than cash
flows.
Time value of money is ignored.
!t 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 S preference
shareholders.

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