You are on page 1of 27




Capital budgeting addresses the issue of strategic longterm investment decisions.
Capital budgeting can be defined as the process of analyzing, evaluating, and deciding whether resources should be allocated to a project or not. Process of capital budgeting ensure optimal allocation of resources and helps management work towards the goal of shareholder wealth maximization.


Involve massive investment of resources Are not easily reversible Have long-term implications for the firm

Involve uncertainty and risk for the firm


Payback Period Approach Discounted Payback Period Approach Net Present Value Approach Internal Rate of Return Profitability Index


A technique that helps us in selecting projects that are consistent with the principle of shareholder wealth maximization. A technique is considered consistent with wealth maximization if It is based on cash flows Considers all the cash flows Considers time value of money Is unbiased in selecting projects


The amount of time needed to recover the initial investment The number of years it takes including a fraction of the year to recover initial investment is called payback period To compute payback period, keep adding the cash flows till the sum equals initial investment Simplicity is the main benefit, but suffers from drawbacks Technique is not consistent with wealth maximization Why?


Similar to payback period approach with one difference that it considers time value of money The amount of time needed to recover initial investment given the present value of cash inflows Keep adding the discounted cash flows till the sum equals initial investment All other drawbacks of the payback period remains in this approach Not consistent with wealth maximization


NPV is DCF technique that explicitly recognises the time value of money. NPV may be described as the summation of Present Values of Cash inflows in each year minus the summation of the present values of the net cash outflows in each year.

Accept a project if NPV 0



WHERE: Ct= Cash Flows K= Opportunity cost of capital C0= initial cost of inv. t= expected life of investment

Question: Assume a project x costs 2500 now and is expected to generate a year end cash inflow of Rs 900,800,700,600,500 in the years 1 to 5 and opportunity cost of capital is assumed to be 10%.

NPV for project x is calculated as:

year 1 2 3 4 5 Cash inflow 900 800 700 600 500 PVF(O.1O) 0.909 0.826 0.751 0.683 0.620 PRESENT VALUE 818.1 660.8 525.7 409.8 310 2724.4

NPV= 2724.4 2500=(+VE) 224.4


Merits: 1. Tells whether the investment will increase the firms value. 2. Consider all the cash flows. 3. Consider the time value of money. 4. Considers the risk of future cash flows (through the cost of capital. Demerits: 1. It involves the calculation of the required rate of return to discount cash flows. 2. Expressed in terms of Rs not as a percentage.


IRR method is another DCF technique which takes into account the magnitude and timing of cash flows.
The rate at which the net present value of cash flows of a project is zero, I.e., the rate at which the present value of cash inflows equals initial investment Accept a project if IRR Cost of Capital

Question: Let us assume an investment that would cost 20000 and provide annual cash flow of 5430 for 3 years. and the opportunity cost of capital is 10%. what will be the IRR?

STEP1:CALCULATION OF NPV: NPV=-20000+5430(PVFA 6,0.10) =-20000+5430*4.355=3648 STEP 2: CALCULATION OF IRR: NPV= -20000+5430(PVFA 6,0.10)=0 20000=5430(PVFA 6,0.10) hence,(PVFA 6,0.10)= 20000/5430=3.683 STEP 3 : LOOK UP FOR THE VALUE OF PVFA IN TABLE. THE VALUE IS APPROXIMATELY 16%. thus , 16% is the project IRR that equates the present value of initial cash outlay (20000) with a constant annual cash inflow (5430 per year) for 6 years.


Merits: 1. It considers the time value of money 2. It takes into a/c total cash inflows and outflows 3. It is easier to understand for lay people as they may have difficulties in understanding NPV 4. It also is consistent with shareholders objective Demerits: 1. First it involves tedious calculations. 2. Next it produces multiple rates which is confusing. 3. Thirdly in evaluating mutually exclusive proposals the project with the highest IRR would be picked up to the exclusion of all others.But practically it may not be so..

NPV versus IRR :

Usually, NPV and IRR are consistent with each other. If IRR says accept the project, NPV will also say accept the project IRR can be in conflict with NPV if Investing or Financing Decisions Projects are mutually exclusive Projects differ in scale of investment Cash flow patterns of projects is different If cash flows alternate in signproblem of multiple IRR If IRR and NPV conflict, use NPV approach

Key differences between the most popular method the NPV (Ne Present Value) Method and IRR (Internal Rate of Return) Method include:
NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return firm expects the capital project to return; Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not;

The IRR Method cannot be used to evaluate projects where there are changing cash flows (e.g an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm);

However, the IRR Method does have one significant advantage -- managers tend to better understand the concept of returns stated in percentages and find it easy to compare to the required cost of capital; and, finally,

While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows, is preferable to a larger project that will generate more cash. Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation.


Yet another time adjusted Capital budgeting technique is the PI or the Benefit Cost Ratio (B/C) method . It is similar to NPV approach. It measures the PV of returns per rupee invested, while the NPV is based on the PV of future cash inflows and PV of future cash outflows. A major shortcoming of the NPV method is that being an absolute measure it is not a reliable method to evaluate projects requiring different initial investments. The PI method provides a solution to this kind of a problem .PI=(PV of Cash Inflow /PV of Cash Outflow) Numerator measures benefit and denominator Costs. Therefore B/C method. Accept Reject Rule : PI>1accept otherwise reject

Question: Assume a project x costs 2500 now and is expected to generate a year end cash inflow of Rs 900,800,700,600,500 in the years 1 to 5 and opportunity cost of capital is assumed to be 10%.

NPV for project x is calculated as:

year 1 2 3 4 5 Cash inflow 900 800 700 600 500 PVF(O.1O) 0.909 0.826 0.751 0.683 0.620 PRESENT VALUE 818.1 660.8 525.7 409.8 310 2724.4

NPV= 2724.4 2500=(+VE) 224.4 PI=2724/2500=1.09

Evaluation of PI method
Time value : it recognizes the time value of money concept. Value maximisation : it is consistent with the shareholder value maximisation principle .A project with PI greater than1 will have positive NPV and if accepted , it will increase the shareholders wealth. Relative profitability: in the PI method , since the present value of cash inflows is divided by the initial cash outflows, it is a relative measure f a projects profitability.

The NPV and the IRR are both time-weighted, cash flow based measures of return for an investment and yield the same conclusion accept or reject- for an independent, stand-alone investment. When comparing or ranking multiple projects, though, the two approaches can yield different rankings, either because of differences in scale or because of differences in the reinvestment rate assumption.

NPV versus IRR

PROJECT C PV of cash inflows PV of cash outflow NPV PI 1,00,000 50,000 50,000 100000/50000 =2.00 PROJECT D 50,000 20,000 30,000 50,000/20,000 =2.50 INCREMENTAL FLOW 50,000 30,000 20,000 50,000/30,000 =1.67

Capital rationing
Capital Rationing: Refers to the choice of investment proposals under financial constraints in terms of a given size of capital expenditure budget . The objective to select the combination of projects would be the maximisation of total NPV . Project selection under capital rationing involves 2stages: (1) Identification of the acceptable projects (2) Selection of the combination of projects . The acceptability of projects can be based either on PI or IRR. The method of selecting investment projects under capital rationing situation will depend upon whether the projects are indivisible or divisible . In case the project is to be accepted or rejected in its entirety ,it is called an indivisible project ; a divisible project on the other hand can be accepted/rejected in part.

Reasons for Capital Rationing Constraints

1. Project discovery: the implicit assumption that firms know when they have good projects on hand underestimates the uncertainty and the errors associated with project analysis. In very few cases can firms say with complete certainty that a prospective project will be a good one.
2. Credibility: financial markets tend to be sceptical about announcements made by firms, especially when such announcements contain good news about future projects because it is easy for any firm to announce that its future projects are good, regardless of whether this is true or not, financial markets often require more substantial proof of the viability of projects.

3.Market efficiency: if the securities issued by a firm are underpriced by markets, firms may be reluctant to issue stocks and bonds at these low prices to finance even good projects. In particular, the gains from investing in a project for existing stockholders may be overwhelmed by the loss from having to sell securities at or below their estimated true value.
4.Flotation costs: these are costs associated with raising funds in financial markets, and they can be substantial. If these costs are larger than the NPV of the projects considered, it would not make sense to raise these funds and finance the projects.

Exercises on capital rationing


Although our decision should be based on NPV, but each technique contributes in its own way. Payback period is a rough measure of riskiness. The longer the payback period, more risky a project is.

IRR is a measure of safety margin in a project. Higher IRR means more safety margin in the projects estimated cash flows PI is a measure of cost-benefit analysis. How much NPV for every dollar of initial investment