Capital Budgeting Decisions

• The investment decisions of a firm are generally

known as capital budgeting.

• A capital budgeting decisions may be defined as the

firm’s decisions to invest its current funds most
efficiently in the long term assets in anticipation of
an expected flow of benefits over a series of years.

• 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.
• The firm’s value will increase if investments are
profitable and add to the shareholder’s wealth.

• Thus, investment should be evaluated on the

basis of a criteria, which is compatible with the
objective of shareholders wealth maximization.

• An investment will add to the shareholder’s

wealth if its yields benefits in excess of cost of
capital.
 Steps to evaluate of an investment
1. Estimation of cash flows.
2. Estimation of the required rate of return (the
opportunity cost of capital).
3. Application of a decision rule for making the
choice.
 Investment decisions 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 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.
 Evaluation Criteria
– Payback Period (PB)
–   Discounted payback period (DPB)
– Net Present Value (NPV)
–   Internal Rate of Return (IRR)
–   Profitability Index (PI)
–   Accounting Rate of Return (ARR)
 PAYBACK Period
• Payback period is the number of years required
to recover the original cash outlay invested in a
project.
Initial Investment C0
Payback = 
Annual Cash Inflow C

• Example: Assume that a project requires an

outlay of Rs 50,000 and yields annual cash inflow
of Rs 12,500 for 7 years. The payback period for
the project is
Rs 50,000
PB   4 years
Rs 12,500
• 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
• Certain virtues:
– Simplicity
– Cost effective

• Serious vices:
Cash flows after payback
Time value of money

Discounted Payback Period:

 Net Present Value
• It is the difference between the sum of the present
value of future cash inflows & the initial investment.
• Decision rule:
• NPV > 0 : Accepted
• NPV < 0 : Rejected
• NPV = 0 : Indifferent
 Net Present Value
• The formula for the net present value can be
written as follows:

 C1 C2 C3 Cn 
NPV      n
 I0
 (1  k ) (1  k ) (1  k ) (1  k ) 
2 3

n
Ct
NPV    I0
t 1 (1  k )
t
 Example
• Assume there are two mutually exclusive projects with similar
initial investment of Rs.56,125 and expected life of 5years but
different expected cash flows. The cost of capital is 10%.
Year Project A Project B
0 56,125 56,125

1 14,000 22,000

2 16,000 20,000
3 18,000 18,000

4 20,000 16,000

5 25,000 17,000

Total 93,000 93,000

 Machine A
Year Cash Flow Present Value @ 10% PV of CF
0 56,125 1.000
1 14,000 0.909 12,726
2 16,000 0.826 13,216
3 18,000 0.751 13,518
4 20,000 0.683 14,660
5 25,000 0.621 15,525
Total 69,645
 Machine B
Year Cash Flow Present Value @ 10% PV of CF
0 56,125 1.000
1 22,000 0.909 19,998
2 20,000 0.826 16,520
3 18,000 0.751 13,518
4 16,000 0.683 10,928
5 17,000 0.621 10.557
Total 71,521
• NPV of Machine A = Rs.13,520 i.e. Rs.(69,645 – 56,125)
• NPV of Machine B = Rs.15,396 i.e. Rs.(71,521–56,125)
• Limitations:
– Mutually exclusive projects
Alternative projects with unequal lives or limited fund constraints
the NPV rule may give ambiguous results

– Ranking of projects: as per the NPV rule is not independent of

discount rates.
Two projects A & B both costing Rs.50. Calculate NPV at 5% and 10%
and rank the project.

Year Project A Project B

1 100 30
2 25 100
 Internal Rate of Return
• 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.
• Accept – Reject decision:
• The higher is better.
• Should more than cut-off rate / required rate
of return.
 Calculation of IRR
• When Cash Flows structure is annuity
• Step 1: Determine the payback period
• Step 2: Check PVIFA table
• Step 3: Find the two Pay back value, one is higher & one is lower
• Step 4: Determine IRR by interpolation
Example: Let us assume that an investment would cost Rs 20,000
and provide annual cash inflow of Rs 5,430 for 6 years.

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
Year Machine A Machine B
0 56,125 56,125
1 14,000 22,000
2 16,000 20,000
3 18,000 18,000
4 20,000 16,000
5 25,000 17,000
Total 93,000 93,000
 Machine A @18%
Year Cash Flow PV @18% PV of CF
0 56,125 1.000 - (56,125)
1 14,000 0.847 11,856
2 16,000 0.718 11,488
3 18,000 0.609 10,962
4 20,000 0.516 10,320
5 25,000 0.437 10,925
Net - (572)
 Machine A @17%
Year Cash Flow PV @17% PV of CF
0 56,125 1.000 - (56,125)
1 14,000 0.855 11,970
2 16,000 0.731 11,696
3 18,000 0.624 10,232
4 20,000 0.534 10,680
5 25,000 0.456 11,400
Net 853