Capital Budgeting

Methods
Non-
Discounted
PB ARR
Discounted
Discounted
Payback

NPV PI IRR
Methods of Capital Budgeting
Discounted Payback
It is very similar to payback period
In this method the cash inflows are
adjusted with time value of money and
then the payback period is calculated.
Discounted Payback
A project requires investment of Rs.
5,00,000 and will generate cash flow
after taxes of Rs. 2,00,000 for first
three year and Rs. 3,00,000 for 4
th

and 5
th
year. The life of the project is 5
years. The cost of capital is assumed
to be 10%. Calculate the discounted
pay back period.
Discounted Payback Period
Year Annual
Cash
Flows
PV factor
@ 10%
PV of cash flow Cumulative PV
1 2,00,000 0.909 1,81,800 1,81,800
2 2,00,000 0.826 1,65,200 3,47,000
3 2,00,000 0.751 1,50,200 4,97,200
4 3,00,000 0.683 2,04,900 7,02,100
5 3,00,000 0.621 1,86,300 8,88,400
Pay back period = 3 years + 2,800/2,04,900
= 3.013 years
Discounted Payback Period
A company is contemplating to purchase a
machine. Two machines, A and B are
available, each costing Rs. 7,50,000.
Calculate the discounted payback period for
both the machines. The cost of capital is
12%. Which machine will be selected, if the
cut-off payback period is 3 years and 3
months? Cash flows (in Rs.) are expected as
follows:




Machine/Year 1 2 3 4 5
A 1,00,000 2,80,000 2,90,000 2,50,000 2,00,000
B 1,90,000 2,50,000 2,60,000 3,10,000 2,50,000
Accept/Reject Criteria:
Discounted Payback Period
The firm sets a standard or a target
discounted payback period. The
discounted payback period of the project
is compared with the target payback
period.
If the projects discounted PB > target PB,
then the project is rejected.
If the projects discounted PB < target PB,
then the project is accepted.
If the project's discounted PB = target PB
then one is indifferent to the project.
Evaluation of Discounted PB
Period
Advantages
Considers time
value of money
Easy and simple to
calculate
Focuses on fast
recovery of
investment
Disadvantages
Fails to consider the
cash-flow occuring
after the PB period
Inconsistent with
shareholders
wealth maximization
principle
Net Present Value (NPV)
The method recognizes the time value
of money
It considers all the cash flow occuring
over the life of the project
A positive NPV results in creation of
wealth for the shareholders
The discount rate used for the
computing NPV is the companys cost
of capital
Net Present Value (NPV)
It helps in determining as to the
project generate positive value or not.
If the NPV is positive it adds value to
the firm and is desirable

Net Present Value (NPV)

n
1 t
t
t
) k 1 (
CF
NPV
- C
o
S
n
+W
n

(1+k)
n

n
1 t
t
t
) k 1 (
CF
NPV
- C
o
NPV= PV of CF-C
0
Net Present Value
Year Annual Cash Flows PV factor @ 10% Present Value
1 2,00,000 0.909 1,81,800
2 2,00,000 0.826 1,65,200
3 2,00,000 0.751 1,50,200
4 3,00,000 0.683 2,04,900
5 3,00,000 0.621 1,86,300
8,88,400
NPV = 8,88,400 - 5,00,000
= 3,88,400
Net Present Value
A company is contemplating to purchase a
machine. Two machines, A and B are
available, each costing Rs. 7,50,000.
Calculate the Net Present Value for both the
machines. The cost of capital is 12%. Which
machine will be selected? Cash flows (in Rs.)
are expected as follows:




Machine/Year 1 2 3 4 5
A 1,00,000 2,80,000 2,90,000 2,50,000 2,00,000
B 1,90,000 2,50,000 2,60,000 3,10,000 2,50,000
Practice Question : NPV
Q

Year
1 2 3 4 5
Estimated CF before depreciation & Tax (Rs. in
Lakh)
4 6 8 8 10
Accept/Reject Criteria: Net
Present Value
If the projects NPV < 0, then the project is
rejected.
If the projects NPV > 0, then the project
is accepted.
If the project's NPV = 0 then one is
indifferent to the project.
Evaluation: Net Present Value
Advantages:-
Considers time value of money thus more
rational method
Considers all the cash flows occuring over the
life of the project
Consistent with shareholders wealth
maximization principle

Evaluation : NPV
Disadvantages:-
It relies on the expected cash flow which
are quite difficult to estimate
The discount rate used to discount the
cash flow is difficult to estimate and
moreover the discount rate may change
with time
Ranking of the project is given according
to the discount rate, if the discount rate
changes, then the ranking may change


Profitability Index (B/C Ratio)
Profitability Index (B/C Ratio)
It measures the present value of
returns per rupee invested
It is a ratio of present value of cash
inflows at the required rate of return,
to the initial cash outflow of the
investment.
Profitability Index (B/C Ratio)


PI = PV of cash inflows
Initial cash outflow

= PV(C
t
)
C
0

Profitability Index (B/C Ratio)
Year Cash flow 10%
0 5,00,000
1 2,00,000 0.909
2 2,00,000 0.826
3 2,00,000 0.751
4 3,00,000 0.683
5 3,00,000 0.621
Profitability Index (B/C Ratio)
A company is contemplating to purchase a
machine. Two machines, A and B are
available, each costing Rs. 7,50,000.
Calculate the Profitability index. The cost of
capital is 12%. Which machine will be
selected? Cash flows (in Rs.) are expected as
follows:




Machine/Year 1 2 3 4 5
A 1,00,000 2,80,000 2,90,000 2,50,000 2,00,000
B 1,90,000 2,50,000 2,60,000 3,10,000 2,50,000
Accept/Reject Criteria: PI (B/C
ratio)
If the projects PI < 1, then the project is
rejected.
If the projects PI > 1, then the project is
accepted.
If the project's PI = 1 then one is
indifferent to the project.

For any given project NPV and PI should
give the same accept-reject decision.
Evaluation: PI (B/C Ratio)
Advantages:-
Considers time value of money thus more
rational method
Considers all the cash flows occuring over the
life of the project
Consistent with shareholders wealth
maximization principle
Measure of relative profitability

Evaluation : PI (B/C ratio)
Disadvantages:-
It relies on the expected cash flow which
are quite difficult to estimate
The discount rate used to discount the
cash flow is difficult to estimate and
moreover the discount rate may change
with time
Ranking of the project is given according
to the discount rate, if the discount rate
changes, then the ranking may change


IRR(Internal
Rate of
Return)
Internal Rate of Return (IRR)
It is the internal rate of return that a given
investment generates over its useful life.
When evaluating an investment, it takes into
account both the magnitude and timings of
the expected cash flows in every time period
of the projects life.


IRR
It shows the discount rate below which
an investment results in a positive NPV
and should be selected and vice-versa
IRR computes the break even rate of
return.
IRR is not the return on the funds
initially invested in the project , unless
the cash inflow are reinvested
elsewhere to earn the same rate of
return as in the project.
Internal Rate of Return (IRR)
Internal rate of return is the discount
rate at which the Present value of
cash inflow is equal to the cost of the
project
It is the rate at which NPV is 0

n
1 t
t
t
0
) IRR 1 (
CF
C
Internal Rate of Return
Year Annual Cash Flows
1 2,00,000
2 2,00,000
3 2,00,000
4 3,00,000
5 3,00,000
Calculate IRR of the project which requires
investment of Rs. 5,00,000, if the cash flow are as
follows:-
Practice Question: IRR
A company is contemplating to purchase a
machine. Two machines, A and B are
available, each costing Rs. 7,50,000.
Calculate IRR Which machine will be
selected? The cost of capital for the firm is
15%. Cash flows (in Rs.) are expected as
follows:





Machine
/Year
1 2 3 4 5
A 1,00,000 2,80,000 2,90,000 2,50,000 2,00,000
B 1,90,000 2,50,000 2,60,000 3,10,000 2,50,000
Accept/Reject Criteria: IRR
If the projects IRR < k, then the project is
rejected.
If the projects IRR > k, then the project is
accepted.
If the project's IRR = k, then one is
indifferent to the project.
Evaluation of IRR
Advantages:-
Considers all the cash flows occuring over
the life of the project
Considers time value of money
It reveals the true profit potential of any
investment
It complies with the firms objective of
shareholders wealth maximization

Evaluation of IRR
Disadvantages:-
The IRR of two projects can not be added
to get the cumulative value of two projects
At times, IRR gives multiple results, hence
fails to act as selection criteria
Many a time, it gives contradictory results
with NPV method
Computation of IRR is also difficult
A project may have multiple IRR:-
If there are more than one change in sigh,
there are more than one IRR
Investment Decision Rule
Sound investment evaluation criterion
should have the following
characteristics:-
1. Consider all the cash flow
2. An objective and unambiguous way of
selection
3. Ranking of projects according to
profitability
4. Bigger cash flows are better than
smaller and earlier cash flows are better
than later
5. Should maximize the wealth of
shareholders

Conclusion
Pay back period, Net Present Value
and Internal Rate of Return are
popularly used method of capital
budgeting
Among all, NPV is preferred as it
considers the time value of money
and gives a single NPV as a result
Pay back period is simple and gives a
rough idea about the recovery of the
cost of the project