Capital Budgeting

9 - 1
Copyright by R. S. Pradhan All rights reserved.

Should we
build this
plant?

WELCOME TO
CHAPTER 9: CAPITAL BUDGETING
9 - 2

Importance of capital budgeting
Financial decisions: Investment, financing &
dividend decisions.
Capital budgeting refers to investment
decisions.
Treasurers function.
Decisions involve substantial amount of money.
Decisions have implications for a longer period.
Loss of flexibility.
Shows direction in which firm goes.
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Categories of investment proposals or project
classifications
Replacement of obsolete assets: machine,
equipment, plant, production processes,
existing technology, etc.
Replacement for cost reduction: equipment is
serviceable but new one reduces the cost.
Expansion project: Expansion of existing
products/ markets.
Safety and/or environmental projects:
government compliance, insurance company
compliance, etc.
Research & development.
Others: Office building, parking lots etc.
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Ranking investment proposals
Capital budgeting approach stresses the
development of systematic procedures & rules for
evaluating investment proposals.
1. Payback period
(i) Ordinary payback period
(ii) Discounted payback period
2. Accounting rate of return (ARR)
3. Net present value (NPV)
4. Internal rate of return (IRR)
5. Modified internal rate of return (MIRR)
6. Profitability index (PI)
7. Replacement chain method
8. Equivalent annuity method (EAA)
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1.Payback period: Number of years required to
recover the initial capital outlay on a project.
Case 1: If cash flows are equal or even:
Original investment
Payback period = -----------------------------
Annual cash flow
Consider the following two projects:
Project X Project Y
Original Invest. -Rs.12,000 -Rs.12,000
Cash flows (Rs.)
Year 1 3,000 3,000
Year 2 3,000 3,500
Year 3 3,000 4,000
Year 4 3,000 4,500
Year 5 3,000 5,000
Payback period: Project X
= Rs.12,000/Rs.3000 = 4 years
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Case 2: If cash flows are unequal:
Find payback period for Project Y?

Cash flows Cum.CFs
Rupees Rupees
Original Investment -12,000 -12,000
Cash flows: Year 1 3,000 -9,000
Year 2 3,500 -5,500
Year 3 4,000 -1,500
Year 4 4,500 3,000
Year 5 5,000
Payback = 3+ (Rs.1500/Rs.4500) = 3.33 years
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Determine payback period for following
projects?

Year Project A B C D
0 (Rs.3,000) (Rs.3,000) (Rs.3,000) (Rs.3,000)
1 300 0 300 600
2 2,700 0 600 900
3 300 900 900 1,500
4 -300 2,100 1,200 1,500
5 -1,200 3,900 3,750 1,800

Which project?

Payback ? ? ? ?
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Year Project A B C D
0 (Rs.3,000) (Rs.3,000) (Rs.3,000) (Rs.3,000)
1 300 0 300 600
2 2,700 0 600 900
3 300 900 900 1,500
4 -300 2,100 1,200 1,500
5 -1,200 3,900 3,750 1,800
Payback 2 yrs. 4 yrs. 4 yrs. 3 yrs.
Merits
- Simple & easy to compute/understand.
- A widely used method.
- Provides an indication of a projects liquidity.
Demerits
- Not a measure of profitability.
- Fails to consider all the cash flows. Ignores
cash flows after the payback period.
- Fails to consider time value of money.
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Discounted Cash Payback
(Assume that cost of capital is 10%)
Year CFs, D, Rs. PVIF@ 10% PV Rs. Cum. CF 0 -3,000 Cum CFs, Rs.
0 -3000 1 (3,000.0) (3,000.0)
1 600 0.909 545.4 (2,454.6)
2 900 0.826 743.4 (1,711.2)
3 1,500 0.751 1,126.5 (584.7)
4 1,500 0.683 1,024.5 439.8
5 1,800 0.621 1,117.8 1,557.6
Discounted cash payback:
= 3 + (584.7 / 1,024.5) = 3.57 years.
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2. Accounting rate of return (ARR)
Payback period fails to indicate profitability of
the project.
ARR may be computed in different ways. One
of such methods may be indicated as under:
Average Net Income
ARR = ----------------------------
Investment outlay
Where:
Cash Flow = Net income + depreciation
Net income = Cash Flow Depreciation
Straight line depreciation
Life of the project = 5 years
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ARR for Project D
Year CFs Dep Net Inc.= CF- Dep.

0 Rs.-3,000 -
1 600 600 0
2 900 600 300
3 1,500 600 900
4 1,500 600 900
5 1,800 600 1,200
ARR is given by average net income divided by
investment.
(0+300+900+900+1200)/5
ARR for D = ----------------------------------- = 22%
3000
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ARR for all four projects are:
Projects A B C D
ARR -8% 26%. 25% 22%
Merits:
- Simple to understand and use.
- Can readily be calculated by using accounting
data.
- Uses all items of cash flows
Demerits:
- Does not consider time value of money.
- Use of profits rather than cash flows.
9 - 13
3. NPV Method
People began to search for better methods that
would recognize time value of money.
This recognition led to the development of
discounted cash flow (DCF) techniques. One such
method is NPV method.
n CF
t

NPV = --------------- I
o
t=1 (1+k)
t

CF = cash flows, I
o
= original investment
k = discounting factor, n = life of the project.
OR n CF
t

NPV= -------------
t=0 (1+k)
t

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Calculation of NPV for Project D. Assume that
cost of capital is 10%.
Year CFs (D) Rs. PVIF@ 10% PV Rs.
0 -3,000 1.000 -3,000.0
1 600 0.909 545.4
2 900 0.826 743.4
3 1,500 0.751 1,126.5
4 1,500 0.683 1,024.5
5 1,800 0.621 1,117.8
NPV: 1,557.6
NPV is positive, i.e., NPV > 0. Project is
acceptable.
Higher the NPV, the better it is.

NPV for all four projects?
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Mutually Exclusive Project

BRIDGE vs. BOAT to get
products across a river.
Projects A B C D
NPV 1,221.9 1,532.1 1,592.6 1,557.6

Types of project: Mutually exclusive &
independent projects.
If projects are independent, accept B,C & D.
If projects are mutually exclusive, accept C.
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4. Internal Rate of Return (IRR)
In NPV method, discount rate is given. How
realistic is cost of capital? COC is based on
number of assumptions. Hence we compute IRR.
IRR is the interest rate that equates the PV of
expected future cash flows to initial cost outlay.
n CF
t

NPV = ----------------- - I
o
= 0
t=1 (1+IRR)
t

n CF
t

NPV = ------------------ = 0
t=0 (1+IRR)
t

If IRR is greater than cost of capital, then the
projects rate of return is greater than cost of
capital. Accept project.
It means some return is left over to boost
stockholders returns.
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Decision rule: If IRR > k, accept project.
If IRR < k, reject project.
0 1 2 3
CF
0
CF
1
CF
2
CF
3
Cost Inflows
How to compute IRR? Follow trial & error
method if cash flows are not even.
k=?
9 - 18
Calculation of IRR for Project D
Try 31%:
Year CFs(D) Rs. PVIF@ 31% PV Rs.
0 -3,000 1.000 Rs.-3,000
1 600 0.763 457.8
2 900 0.583 524.7
3 1,500 0.445 667.5
4 1,500 0.340 510.0
5 1,800 0.259 466.2
NPV= -373.8
Try rate?
PVIFA
i
,
5yrs.
=Rs.3,000/(600+900+1500+1500+1800)/5
=2.381, i.e.31-32%.
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Try 25% Try 26%
Year CFs,Rs. PVIF PV Rs. PVIF PV Rs.
Proj.D @ 25% @26%
0 -3,000 1.000 Rs.-3,000 1.000 Rs.-3000
1 600 0.800 480 0.794 476.4
2 900 0.640 576 0.630 567.0
3 1,500 0.512 768 0.500 750.0
4 1,500 0.410 615 0.397 595.5
5 1,800 0.328 590.4 0.315 567.0
NPV : Rs.29.6 Rs.-44.1
NPV of LR
IRR= Lower Rate + ----------------------------------- (HRLR)
NPV of LR - NPV of HR
=25.4%
LR= Lower rate, HR=Higher rate.
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If cash flows are equal or even: IRR=?
PVIFA
i,n
= Investment outlay / PMT
Example: Investment outlay = Rs.52,125,
Payment or cash flow = Rs.12,000 per year,
Life of the project = 8 years
IRR = ?
PVIFA
i,8
= Rs.52,125/Rs.12,000 = 4.3438.
Using PVIFA Table, 8
th
year row shows that
4.3438 lies in 16% column.
Therefore, IRR is approximately 16 percent.
IRR for all four projects?
Projects A B C D
IRR -200% 20.9% 22.8% 25.4%
Decision rule: If IRR > k, accept project.
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Summary results
Project A B C D
Payback 2 yrs 4 yrs 4 yrs 3 yrs
ARR -8% 26% 25% 22%
NPV Rs.1222 Rs.1532 Rs.1592 Rs.1558
IRR -200% 20.9% 22.8% 25.4

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NPV OR IRR? Answer: NPV. Why?
It takes into account all cash flows.
All cash flows are discounted at the appropriate
market-determined opportunity cost of capital.
NPV of a project is exactly the same as the
increase in shareholders wealth as can be seen
from below:
- pay off all interest payments to creditors.
- pay off all expected returns to shareholders.
- pay off the original investment.
A zero NPV is one, which earns a fair return to
compensate both debt holders & equity holders.
A positive NPV project earns more than the
required rate of return, & equity holders receive
all excess cash flows. Hence the NPV criterion is
so important in decision-making.
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NPV Profile
NPV & IRR methods assume that
discount rate or cost of capital is known
with certainty.
However, it is not so.
Construct NPV profiles:
Year 0 1 2 3
CF:L Rs. -100 10 60 80
CF:S Rs. -100 70 50 20
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Construct NPV Profiles
Find NPV
L
and NPV
S
at different discount
rates:

Find the crossover rate? The discount
rate where NPV
L
= NPV
S
?
k
0
5
10
15
20
NPV
L
50
33
19
7
(4)
NPV
S
40
29
20
12
5
9 - 25
-10
0
10
20
30
40
50
60
0 5 10 15 20 23.6
NPV (Rs.)
Discount Rate (%)
IRR
L
= 18.1%
IRR
S
= 23.6%
Crossover
Point = 8.7%
k
0
5
10
15
20
NPV
L
50
33
19
7
(4)
NPV
S
40
29
20
12
5
S
L
k > 8.7: NPV
S
> NPV
L
, IRR
S
> IRR
:
NO CONFLICT
k < 8.7: NPV
L
> NPV
S
, IRR
S
> IRR
L :
CONFLICT
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Can we calculate Crossover Rate?
1. Find cash flow differences between projects.
2. Discount these differences to compute IRR.
Crossover rate = 8.68%, rounded to 8.7%.
3. If profiles dont cross, one project dominates
the other.
Year CF:L CF:S Diff. 8%PVIF 9%PVIF
0 -100 -100 0 - -
1 10 70 -60 -55.554 -55.044
2 60 50 10 8.573 8.417
3 80 20 60 47.898 46.332
Total 0.917 -0.295
Crossover rate =8+[(0.917)/((0.917- (-0.295))]x(9-8)
=8.7%
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Why NPV profiles crossover? Two Reasons
1. Size (scale) differences. Size (Cost) of one
project is very big as compared to another.
2. Timing differences. Most cash flows of one
project occur in the early years while most cash
flows of the other project occur in the later years.
Though there is a conflict between NPV & IRR,
managers prefer IRR to NPV.
Because it is easier/ convenient to work with.
Simply by looking at positive NPV, it is difficult
to indicate how attractive is the project.
IRR is preferable but we may come across
multiple IRRs.
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Multiple IRRs
5,000 -5,000
0 1 2
k = 10%
-800
Enter CFs in CFLO, enter i = 10%.
NPV = -386.78
IRR = ERROR. Why?
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We got ERROR because there are two
IRRs. Here is a picture.
NPV Profile
450
-800
0
400 100
IRR
2
= 400%
IRR
1
= 25%
k
NPV
Multiple IRR arises
under non-normal cash
flows.
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Normal Cash Flow Project
Cost (negative CF) followed by a series of
positive cash inflows.
One change of sign.
Non-normal Cash Flow Project
Two or more changes of signs.
Most common:
Cost (negative CF), then a series of positive
CFs.

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Managers like rates - prefer IRR to NPV
comparisons. With IRR, multiple IRR is possible.
Can we give them a better IRR?
Yes, MIRR is the discount rate which causes
the PV of a projects terminal value (TV) to equal
the PV of costs.
TV is determined by compounding inflows at
WACC.
MIRR assumes that cash inflows are
reinvested at WACC.
9 - 32
MIRR = ?
10.0 80.0 60.0
0 1 2 3
k=10%
66.0
12.1
158.1
MIRR for Project L (k = 10%)
-100.0
10%
10%
TV inflows
-100.0
PV of costs
MIRR
L
= 16.5%
Rs.100=
Rs.158.1
(1+MIRR
L
)
3
9 - 33
To find MIRR: Time value money formula,
PV = FV / (1+r)
n
OR
100 = 158.1/ (1+MIRR)
3

(1+MIRR)
3
= 158.1/100 =1.581
FVIF
i,3
= 1.581 OR r = 16.5%.
Accept project if MIRR > k.
Profitability Index (Project D)
PV of benefits Rs. 4,558
PI = ---------------------- = ---------------- = 1.52.
PV of costs Rs. 3,000
The project is acceptable as PI > 1.
If NPV = 0, PI = 1.
Solve problems: Chapter 9
Self-Test Problems: SP1, 2, 5 & 7
Problems: P1, 2, 5, 6, 9 & 10. Thanking you.

Capital Budgeting

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Copyright by R. S. Pradhan All rights reserved.

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