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CAPITAL BUDGETING


DECISIONS
Introduction

• Net Present Value (NPV) Method

• Internal Rate of Return (IRR) Method

• Profitability Index

• Payback Method

• Accounting Rate of Return

• Discounted Payback Method

• Conventional and Non Conventional Cash Flow

• NPV Vs IRR

• Capital Rationing

• Excel Application
CAPITAL BUDGETING
DECISIONS
The investment decisions of a firm are generally known
as the Capital Budgeting or Capital Expenditure
decisions. A Capital Budgeting decision may be defined
as the firm’s decision to invest its current funds more
efficiently in the long term assets in anticipation of an
expected flow of benefits over a series of years to come.
The long term assets are those that affect the firm’s
operation beyond the one year period. The firm’s
investment decision would generally include expansion,
acquisition, modernization and replacement of long term
assets.
Examples :
Investment in Property, Plant and Equipment
Research and Development Projects
Large Advertising Campaigns
CAPITAL BUDGETING
DECISIONS
Investment Decisions require special
attention because of the following reason:
• Growth
• Risk
• Funding
• Irreversibility
• Complexity
CAPITAL BUDGETING
DECISIONS
The steps that are involved in the Capital Budgeting
decisions are as follows:
1. Cash Flow Estimation for different periods.

2. Estimating the required rate of return (The


Opportunity Cost of Capital).

3. Application of a decision rule for making a choice.


Evaluation Criteria
1. Discounted Cash Flow (DCF) Criteria
–   Net Present Value (NPV)
–   Internal Rate of Return (IRR)
–   Profitability Index (PI)

2. Non-discounted Cash Flow Criteria


–   Payback Period (PB)
–   Discounted Payback Period (DPB)
–   Accounting Rate of Return (ARR)
Net Present Value (NPV)
Method
Net present value should be found out by subtracting present value
of cash outflows from present value of cash inflows. The formula for
the net present value can be written as follows:

 C1 C2 C3  C
NPV =  + + 2 + + 3 −
L
n
C0
 (1 + k) (1+ k) + + (1 n
(1 k)  k)
n
Ct
NPV = ∑ − t C0
t =1 (1 + k)

Accept the Project when NPV is Positive NPV > 0


Reject the Project when NPV is Negative NPV < 0
May Accept the Project when NPV is Zero NPV = 0
NET PRESENT VALUE (NPV)
METHOD
Assume that Project X costs Rs 2,500 now and is
expected to generate year-end cash inflows of Rs 900,
Rs 800, Rs 700, Rs 600 and Rs 500 in years 1 through 5.
The opportunity cost of the capital may be assumed to be
10 per cent.

 Rs 900 Rs 800 Rs 700 Rs 600 Rs 500 


NPV =  + 2
+ 3
+ 4
+ 5  −Rs 2,500
 (1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10) 
NPV = [Rs 900(PVF1, 0.10 ) + Rs 800(PVF2, 0.10 ) + Rs 700(PVF 3, 0.10)
+ Rs 600(PVF4, 0.10 ) + Rs 500(PVF5, 0.10 )] − Rs 2,500
NPV = [Rs 900 × 0.909 + Rs 800 ×0.826 + Rs 700 ×0.751 + Rs 600 0.683
×
+ Rs 500 × 0.620] − Rs 2,500
NPV = Rs 2,725 − Rs 2,500 = + Rs 225
NET PRESENT VALUE
METHOD
A more precise definition of r is that r is the
opportunity cost of capital. If we are considering
the use of the NPV rule within the context of a
firm, we have to recognize that the firm has
several sources of capital, and the cost of each
of these should be taken into account when
evaluating the firm's overall cost of capital. .The
firm can raise funds via equity issues and debt
issues, and it is likely that the costs of these two
types of funds will differ.
NET PRESENT VALUE
METHOD
Merits Demerits

• Considers all cash flows • Cash Flow Estimation


• True measure of is a tedious task.
Profitability • Computation of
• Based on the concept of opportunity cost
Time Value of Money capital is difficult.
• Satisfy the value • Sensitive to discount
additivity principle
rates.
• Consistent with SWM
INTERNAL RATE OF
RETURN (IRR)
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
C
C =+ + + 1 C
+ 2rate which
C makes
L
C NPV = 3 n
0
(1 +
) r+
(1 )+
r (1 + 2 3 n
0. )r (1 ) r
n
Ct
C0 =∑
t=1 (1 +)r t

n
Ct

t=1 (1 +
)r t
−=
C0 0
NPV PROFILE AND IRR
A B C
1 N P V P r o file
D is c o u n t
2 C a s h F lo w r a te N P V
3 -2 0 0 0 0 0 % 1 2 ,5 8 0
4 5 4 3 0 5 % 7 ,5 6 1
5 5 4 3 0 1 0 % 3 ,6 4 9
6 5 4 3 0 1 5 % 5 5 0
7 5 4 3 0 1 6 % 0
8 5 4 3 0 2 0 % ( 1 ,9 4 2 )
INTERNAL RATE OF
RETURN (IRR)
Acceptance Rule:
Accept the project when r>k
Reject the Project when r<k
May accept the project when r=k

Where r is the internal rate of return and k is the


opportunity cost of capital.

A Project costs Rs 16000 and is expected to generate


cash inflows of Rs 8000, Rs 7000 and Rs 6000 at the
end of each year for the next 3 years.

Find out the IRR by the Method of Interpolation.


INTERNAL RATE OF
RETURN (IRR)
MERITS DEMERITS

• It recognizes Time • Estimating cash flows is a


tedious task.
Value of Money.
• Does not hold value additive
• Considers all cash principle.
flows • Sometimes results in Multiple
IRRs.
• True measure of
• Relatively difficult to
profitability compute
• Consistent with SWM • At times fails to indicate the
Principle. correct choice between
mutually exclusive projects.
PROFITABILITY INDEX
Profitability Index is the ratio of the present value of cash inflows,
at the required rate of return, to the initial cash outflow the
investment. This is nothing but the benefit to cost ratio.

PI = PV of Cash inflows
Initial Cash Outlay

Acceptance Rule
Accept the Project when PI > 1
Reject the Project when PI < 1
May accept the project when PI = 1
PROFITABILITY INDEX
The initial cash outlay of a project is Rs 100,000
and it can generate cash inflow of Rs 40,000, Rs
30,000, Rs 50,000 and Rs 20,000 in year 1 through
4. Assume a 10 per cent rate of discount. The PV
of cash inflows at 10 per cent discount rate is:
PV = Rs 40,000(PVF1, 0.10 ) + Rs 30,000(PVF 2, 0.10 ) + Rs 50,000(PVF 3, 0.10 ) + Rs 20,000(PVF 4, 0.10 )
= Rs 40,000 × 0.909 + Rs 30,000 × 0.826 + Rs 50,000 × 0.751 + Rs 20,000 × 0.68
NPV = Rs 112,350 − Rs 100,000 = Rs 12,350
Rs 1,12,350
PI = = 1.1235 .
Rs 1,00,000
PROFITABILITY INDEX
MERITS DEMERITS
• Considers all cash • Estimating cash
flows flows a tedious
• Recognizes the Time task.
Value of Money • At times fails to
• Relative measure of indicate choice
profitability. between mutually
• Consistent with SWM exclusive projects.
PAYBACK METHOD
Payback is the number of years required to recover
the original cash outlay invested in a project.
If the project generates constant annual cash inflows,
the payback period can be computed by dividing cash
outlay by the annual cash inflow. That is:
Initial Investment C
Payback = = 0
Annual Cash Inflow C
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:
PB = 50000/12500 = 4 Years
PAYBACK METHOD
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

Accept the Project when PB < Standard Payback


Reject the Project when PB > Standard Payback
As a ranking method, it gives highest ranking to the project,
which has the shortest payback period and lowest ranking to the
project with highest payback period.
PAYBACK METHOD
MERITS DEMERITS
• Easy to understand • Ignores Time Value of
and compute and Money.
inexpensive to use. • Ignores cash flows
• Emphasizes liquidity occurring after the
• Easy and crude way to payback period.
cope with risk • Not consistent with
• Uses cash flow SWM.
information • Not a measure of
profitability.
DISCOUNTED PAYBACK
PERIOD
• The discounted payback period is the number of periods
taken in recovering the investment outlay on the present
value basis.
• The discounted payback period still fails to consider the cash
flows occurring after the payback period.

C0 C
ACCOUNTING RATE OF
RETURN
• The accounting rate of return is the ratio of the average after-tax profit divided
by the average investment. The average investment would be equal to half of
the original investment if it were depreciated constantly.

ARR = (Average Income)/(Average Investment)

• A variation of the ARR method is to divide average earnings after taxes by the
original cost of the project instead of the average cost.

• This method will accept all those projects whose ARR is higher than the
minimum rate established by the management and reject those projects which
have ARR less than the minimum rate.

• This method would rank a project as number one if it has highest ARR and
lowest rank would be assigned to the project with lowest ARR.
CONVENTIONAL AND NON
CONVENTIONAL CASH

FLOWS
A conventional investment has cash flows the
pattern of an initial cash outlay followed by cash
inflows. Conventional projects have only one
change in the sign of cash flows; for example, the
initial outflow followed by inflows, i.e., – + + +.

• A non-conventional investment, on the other


hand, has cash outflows mingled with cash inflows
throughout the life of the project. Non-
conventional investments have more than one
change in the signs of cash flows; for example, –
+ + + – ++ – +.
NPV Vs IRR
Conventional Independent Projects:
In case of conventional investments, which are economically
independent of each other, NPV and IRR methods result in same accept-
or-reject decision if the firm is not constrained for funds in
accepting all profitable projects.

Lending and Borrowing type Projects:

Project with initial outflow followed by inflows is a lending type project,


and project with initial inflow followed by outflows is a lending type
project, Both are conventional projects.
C a sh F lo w s (R s)
P ro je c t C0 C1 IR R NPV at 10%
X -100 120 20% 9
Y 100 -120 20% -9
PROBLEM OF MULTIPLE
IRR’s
A project may have both
lending and borrowing
features together. IRR NPV (Rs )
250
method, when used to NPV Rs 63

evaluate such non- 0

conventional investment -250

can yield multiple internal


-500
rates of return because of
more than one change of -750
0 50 100 150 200 250
signs in cash flows. Dis c ount Rate (% )
RANKING OF MUTUALLY
EXCLUSIVE PROJECT
• Investment projects are said to be mutually
exclusive when only one investment could be
accepted and others would have to be excluded.
• Two independent projects may also be mutually
exclusive if a financial constraint is imposed.
• The NPV and IRR rules give conflicting ranking to
the projects under the following conditions:
– The cash flow pattern of the projects may differ. That is,
the cash flows of one project may increase over time,
while those of others may decrease or vice-versa.
– The cash outlays of the projects may differ.
– The projects may have different expected lives.
RANKINGS
Timing of Cash Flows

Cash Flows (Rs) NPV


Project C0 C1 C2 C3 at 9% IRR
M – 1,680 1,400 700 140 301 23%
N – 1,680 140 840 1,510 321 17%

Scale of Investment
Cash Flow (Rs) NPV
Project C0 C1 at 10% IRR
A -1,000 1,500 364 50%
B -100,000 120,000 9,080 20%
RANKINGS
Project Life Span

C a sh F lo w(R
s s)
P ro ject C0 C1 C2 C3 C4 C5 NP V a t 1 0 % IR R

X – 10 ,0 0 0 12 ,0 0 0 – – – – 908 20%
Y – 10 ,0 0 0 0 0 0 0 20 ,1 2 0 2, 49 5 15%
CAPITAL BUDGETING
Reinvestment Assumption
The IRR method is assumed to imply that the cash flows generated by the project can be
reinvested at its internal rate of return, whereas the NPV method is thought to assume that the
cash flows are reinvested at the opportunity cost of capital.

MIRR
The modified internal rate of return (MIRR) is the compound average annual rate
that is calculated with a reinvestment rate different than the project’s IRR. The
modified internal rate of return (MIRR) is the compound average annual rate that
is calculated with a reinvestment rate different than the project’s IRR.

Varying Opportunity Cost of Capital

• There is no problem in using NPV method when the opportunity cost of capital varies
over time.
• If the opportunity cost of capital varies over time, the use of the IRR rule creates
problems, as there is not a unique benchmark opportunity cost of capital to compare
with IRR.
CAPITAL RATIONING
The Capital Rationing situation refers to the choice of
investment proposals under financial constraints in
terms of a given size of capital expenditure budget. The
objective is to select the combination of projects would
be the maximization of the total NPV. The project
selection under capital rationing involves two stages.
1. Identification of the acceptable projects.
2. Selection of the combination of projects.

The acceptability of the project can be based either on


the PI or IRR. In case the project is to be accepted or
rejected in its entirety, then it is called Indivisible
Project and when a project is to be accepted in part
it is called Divisible Project.
CAPITAL BUDGETING
Capital Rationing basically limits the amount to be spent on capital expenditure decisions. The firms
generally impose such a limit primarily for two reasons.
1.There may be paucity of funds.
2.The managers may be conservative and may not like to invest more than a specified amount in
projects at any point of time, they may like to accept projects with greater amount of safety.

Capital Rationing……….

•Usually results in an investment policy that is less than optimal.

• Leads to the acceptance of several small investment projects ( promising higher return per rupee
investment) rather than a few large investment projects. It does have a bearing on the risk
complexion of the firm.

•Management should consider more than one period in the allocation of limited capital for investment
projects .

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