Capital Budgeting

Project Evaluation

❑ Net Present Value (NPV)

❑ Payback Period
❑ Internal Rate of Return
❑ Profitability Index
❑ Accounting Rate of Return
 Net Present Value (NPV)

❑ The difference between the present value of cash

inflows and the present value of cash outflows.

❑ NPV is used in capital budgeting to analyze the

profitability of an investment or project. 

❑ NPV analysis is sensitive to the reliability of future

cash inflows that an investment or project will yield.  
 Three Points about NPV

1. First, the NPV rule recognizes that a rupee today is

worth more than a rupee tomorrow, because the rupee
today can be invested to start earning interest
immediately Any investment rule which does not
recognize the time value of money cannot be sensible.

2. NPV depends solely on the forecasted cash flows from

the project and the opportunity cost of capital. Any
investment rule that is affected by the manager’s tastes,
the company’s choice of accounting method, the
profitability of the company’s existing business, or the
profitability of other independent projects will lead to
inferior decisions.
 Three Points about NPV

3. Because present values are all measured in today’s

rupees, you can add them up. Therefore, if you
have two projects A and B, the net present value of
the combined investment is
NPV(A + B) = NPV(A) + NPV(B)
NPV Depends on Cash Flow, Not on Book Returns

❑ Net present value depends only on the project’s

cash flows and the opportunity cost of capital.

❑ Financial managers sometimes use these numbers

to calculate a book (or accounting) rate of return on
a proposed investment. In other words, they look at
the prospective book income as a proportion of the
book value of the assets that the firm is proposing to
acquire:

❑ Book rate of return = Book income / Book Assets

NPV Depends on Cash Flow, Not on Book Returns

❑ Cash flows and book income are often very

different.
Making investment decisions with the NPV rule

❑ Only cash flow is relevant, not accounting earnings!!

❖ Accrual vs. Cash revenues and expenses
❖ Operating expenses and Capital expenditures
❖ Non cash charges e.g. depreciation and amortization

❑ Always estimate cash flows on an after – tax basis.

❑ Estimate cash flows on an incremental basis –

which includes only additional cash flows that follow
from project acceptance.
Making investment decisions with the NPV rule

❑ Include all incidental effects

❑ Do not forget working capital requirements

❑ Forget sunk costs

❑ Beware of accountant’s allocated overhead costs

❑ Treat inflation consistently

 Payback

❑ Some companies require that the initial outlay on

any project should be recoverable within a specified
period.

❑ The payback period of a project is found by counting

the number of years it takes before the cumulative
forecasted cash flow equals the initial investment.
Payback
 The Payback Rule
❑ The payback rule ignores all cash flows after the
cutoff date.

❑ The payback rule gives equal weight to all cash

flows before the cutoff date.

❑ To overcome the 2nd drawback, some companies use

discounted-payback rule. However, the
discounted-payback rule still takes no account of any
cash flows after the cutoff date.

❑ The simplicity of payback makes it an easy device

for describing investment projects.
 Internal Rate of Return (IRR)

❑ The discount rate often used in capital budgeting that

makes the net present value of all cash flows from a
particular project equal to zero.

❑ Generally speaking, the higher a project's internal rate

of return, the more desirable it is to undertake the
project.

❑ As such, IRR can be used to rank several prospective

projects a firm is considering.
 Internal Rate of Return (IRR)

❑ Assuming all other factors are equal among the

various projects, the project with the highest IRR
would probably be considered the best and
undertaken first.

❑ IRR is sometimes referred to as "economic rate of

return (ERR)”.

❑ In general, if IRR > Cost of Capital, the project must

be undertaken.
Calculating the IRR
Calculating the IRR

IRR = 28%
 Calculating the IRR
Hurdle Rate NPV Hurdle Rate NPV
1% 1901.38 21% 384.95
2% 1805.46 22% 326.79
3% 1712.13 23% 269.95
4% 1621.30 24% 214.36
5% 1532.88 25% 160.00
6% 1446.78 26% 106.83
7% 1362.91 27% 54.81
8% 1281.21 28% 3.91
9% 1201.58 29% -45.91
10% 1123.97 30% -94.67
11% 1048.29 31% -142.42
12% 974.49 32% -189.16
13% 902.50 33% -234.95
14% 832.26 34% -279.80
15% 763.71 35% -323.73
16% 696.79 36% -366.78
17% 631.46 37% -408.97
18% 567.65 38% -450.33
19% 505.33 39% -490.86
40% -530.61
20% 444.44
Calculating the IRR
 Pitfalls of IRR

1. Pitfall 1 – Lending or Borrowing

 Pitfalls of IRR

2. Pitfall 2 – Multiple Rates of Return

 Pitfalls of IRR

2. Pitfall 2 – Multiple Rates of Return

 Pitfalls of IRR

2. Pitfall 2 – Multiple Rates of Return

Some projects do not have IRR!!!
 Pitfalls of IRR

3. Pitfall 3 – Mutually Exclusive Projects

 Pitfalls of IRR

3. Pitfall 3 – Mutually Exclusive Projects

 Pitfalls of IRR

3. Pitfall 3 – Mutually Exclusive Projects

 Pitfalls of IRR

4. Pitfall 4 –What Happens When We Can’t Finesse

the Term Structure of Interest Rates?
Choosing Capital Investments when resources are
limited – Capital Rationing

❑ All three projects are attractive, but suppose that the

firm is limited to spending Rs. 10 million!!!
Choosing Capital Investments when resources are
limited – Capital Rationing

❑ When funds are limited, we need to concentrate on

getting the biggest bang for our buck.

❑ In other words, we must pick the projects that offer

the highest present value of Net Future Cash Flows
per rupee of initial outlay.

❑ This ratio is known as the profitability index.

Choosing Capital Investments when resources are
limited – Capital Rationing

❑ Profitability Index = PV of Net Future Cash Flows /

Initial Investment

Project Investment PV of Net Future Profitability

(Rs. Millions) Cash Flows Index
(Rs. Millions)
A 10 21 2.1
B 5 16 3.2
C 5 12 2.4
Choosing Capital Investments when resources are
limited – Capital Rationing

❑ In general:
❖ If PI > 1, then accept the project
❖ If PI < 1, then reject the project

❑ In case of initial Capital Rationing only, choose

those projects with highest PIs, which satisfy
the given constraints.
Choosing Capital Investments when resources are
limited – Capital Rationing

❑ Unfortunately, there are some limitations to this

simple ranking method. One of the most serious is
that it breaks down whenever more than one
resource is rationed).

❑ For example, suppose that the firm can raise only

Rs. 10 million for investment in each of years 0 and
1, and that the menu of possible projects is
expanded to include an investment next year in
project D.
Choosing Capital Investments when resources are
limited – Capital Rationing
Uses of Capital Rationing Models

❑ Soft Rationing

❑ Hard Rationing
 A project is not a Black Box
❑ Sensitivity Analysis – examine the NPV of a
project at various levels of dependant variable, e.g.
sales and find out how the result changes

❑ Scenario Analysis – probabilities assigned to each

scenario, which can be used to arrive at the
expected value of the project

❑ Break – even analysis

❑ Simulation
Risks involved in evaluating a project
❑ Stand alone Risk – the risk of the asset when it is
held in isolation

❑ Corporate, or within-firm, risk – it is measured by

the impact an asset is expected to have on the
operations of the firm - that is, how an asset will
affect the firm’s total risk if it is purchased and
added to existing assets.

❑ Beta, or market, risk - which is the portion of an

asset’s risk that cannot be eliminated through
diversification - that is, how an asset will affect the
firm’s market risk, or beta, if it is purchased and
added to existing assets.
 Stand-alone Risk
❑ Measuring risk relative to return

❑ Usage of sensitivity analysis / scenario analysis /

Monte Carlo simulation

❑ Calculation of co-efficient of variation (CV) through

scenario analysis, which is used as an indicator of
the stand-alone risk.
 Corporate or within firm Risk
❑ Determine how a capital budgeting project is related
to the existing assets of the firm.

❑ If the firm wants to diversify its risk, it will try to

invest in projects that are negatively related (or have
little relationship) to the existing assets.

❑ If a firm can reduce its overall risk, then it generally

becomes more stable and its required rate of return
decreases.
 Beta or Market Risk
❑ Any asset has a beta, or some way to measure its
systematic risk.

❑ If we can determine the beta of an asset, then we

can use the capital asset pricing model, CAPM, to
compute its required rate of return.

❑ The concept of beta can also be used to determine

the impact of adding a project to existing assets.
Remember that the beta of a portfolio is the
weighted average of the betas of the individual
investments.
 Beta or Market Risk
❑ The beta for a firm can be thought of as the
weighted average of the betas of the individual
assets it possesses.

❑ For example, if the firm’s beta equals 1.5, then the

weighted average of the betas of all the assets in
the firm is 1.5. Suppose the firm adds a new project.
If the new project has a beta equal to 3.0 and it will
constitute 20% of the firm’s operations once it is
added, then the beta of the firm after the project is
added, new, will be:
βnew = (0.20 x βproject) + (0.80 x βold) = (0.20 x 3.0) + (0.80
x 1.5) = 1.8
THANK YOU