Hi!!!! I am Arjun.

I have just joined

a company as a management trainee
after my studies. My boss has
given me a decision problem which
looks to be straight forward but I
do not know really… how to go
about it. Can you help me, plz?

Here is the problem...

Decision Problem - the management is considering a
project whose cost is Rs. 100 crores and the estimated cash
inflows over its life of 5 years are as follows:
Year Cash Inflows (Rs. in Crores)
1 Rs. 15
2 Rs. 28
3 Rs. 40
4 Rs. 30
5 Rs. 50

Besides, I am told that the cost

of funds of the company is
estimated at 15%. Please show me
the way!!!!!!!
Can you help him?
But, before you agree to
help him, do you know
the nature of the
problem?
The problem is that of …

INVESTMENT DECISION

or

CAPITAL BUDGETING !!!

Dr. VIBHA JAIN
CAPITAL BUDGETING
DECISIONS

The capital budgeting decisions
are related to the allocation of
investible funds to different long-
term assets.


They denote a situation where
the lump-sum funds are invested
in the initial stages of a project
and the returns are expected
over a long period.
CAPITAL BUDGETING
DECISIONS Cont….

The capital budgeting decision
involves the entire process of
decision making relating to
acquisition of long-term assets
whose return are expected to
arise over a period beyond
one year.
BASIC NATURE OF CAPITAL
BUDGETING DECISION

Long - term decisions.

Involves one or few times
outflow of cash but promises a
future stream of cash inflows.

Involves huge amount of
investment.

Generally irreversible decision;
if tried then it is very costly to
undone it.
BASIC NATURE OF
CAPITAL BUDGETING
DECISION Cont…

Determines the assets side of a
firm’s balance sheet.

Determines the earning capacity of
a firm.

These decisions are highly risky.

These decisions are of strategic
importance.

These decisions are taken at
comparatively higher levels in the
management.
TYPES OF INVESTMENT
DECISIONS MADE BY A COMPANY

Project Selection


Decisions related to

Modernization, expansion and

renovation etc.


Purchase of Machines


Replacement of machines
Proper Evaluation of Capital
Budgeting Decisions requires…

One, proper estimation of cash
outlays; and

Second, proper estimation of
subsequent cash flows.

Third, proper choice of
selection criteria.

Therefore, we discuss them

one by one.
First, estimation of the initial
cash outlays…
Why cash flows and not
Profits

The accounting profits ignores the
concept of time value of money,
whereas the cash flow concept
takes into account the time value.

In capital budgeting a finance
manager is concerned with
measuring the economic value
created by a decision, rather than
book value.
Why cash flows and not
Profits Cont….
In cash flow analysis, the cost and
the benefits are measured in terms
of actual cash inflows and outflows
rather than an imaginary profit
figure.

The accounting profits are
influenced and affected by
adopting one or the other
accounting policy, however the
cash flow are the actual flows and
are not affected by any such
discretionary policy of the firm.
Estimation of relevant cash outlays
for a capital expenditure

The cost of a fixed assets
comprises
 its purchase price, including import
duties and other non-refundable
taxes;
 cost of bringing the asset to its
working condition;
 cost of site preparation;
 initial delivery and handling
charges;
Estimation of relevant cash outflow
for a capital expenditure
(continued)…

 installation cost;
 interest cost during construction
period; and
 professional fees of architects and
engineers.

Such a cost be reduced by the
inflows from the sale of the old
asset.
SOME GUIDING RULES TO DETERMINE
RELEVANT CASH FLOWS

Rule#1: All costs and revenue generated before/prior to the
investment appraisal decisions should be ignored. It basically
means that ignore SUNK COST.


Rule#2: Ignore all non-incremental cashflows. That is, exclude all
those cashflows that would be there whether there is project or not.


Rule#3: All allocated costs should be ignored.


Rule#4: Any increase in net working capital due to a project should be
taken as a part of Project Cost.
SOME GUIDING RULES TO DETERMINE
RELEVANT CASH FLOWS (continued…)

Rule#5: Cost to the project of resources that a firm is
already having in its stock. Three possible options:
 Historic Cost
 Current Replacement Cost
 Resale value or disposal value


Rule#6: The costs of those resources that are limited/scarce
but are in use in the firm for some other purpose should be
taken as their opportunity cost.

Rule#7: Remember that all the cash flows are to be
determined from the firm’s point of view and not from the
equity point of view.
Second, estimation of the
cash flows subsequently…
Estimation
Estimationof
ofrelevant
relevantcash
cashflows
flows
subsequently-some
subsequently
subsequently-some
subsequently guiding
guidingprinciples…
principles…


It requires determination of net cash flows
due to operation/use of the asset.

Ignore all financing cash flows and their
tax effects as capital budgeting decisions
are real decisions and hence, their analysis
should not be affected by the financing
decisions.

Cash flows should be determined as if
they are occurring to the firm and not to
shareholders.
Estimation of relevant cash
flows subsequently-some
subsequently
guiding principles… Cont…

Ignore all allocated expenses

Depreciation and all other non-cash
charges should be ignored.


Do not forget to take into account
the effect of an investment
decision on the remaining
business.
Estimation
Estimationof
ofrelevant
relevantcash
cashflows
flows
subsequently-some
subsequently
subsequently-some
subsequently guiding
guidingprinciples
principles
(continued)…
(continued)…


Take the net cash flows after tax
without recognizing the benefits of
tax on interest amount as the
discount rate used for discounting
future cash flows is determined
after tax.


Remember to incorporate the
opportunity cost of resources used
to generate cash flows and ignore
the sunk cost.
Classification of cash
flows

Original cash outflows
Installation Cost
Sunk Cost
Opportunity cost
Additional working capital

Requirement

Subsequent Inflows and outflows

Terminal cash inflows
Taxation and Cash Flows
All Financial Decisions are
subservient to Tax Laws. The cash
flows that are related to capital
decisions are the after tax cash
flows only. The after tax cash flows
resulting from a project are in fact
the relevant incremental cash
flows. These after tax cash flows
would not occur if the project is not
undertaken.
Treatment of Depreciation

Accounting Treatment- The
depreciation is provided for the
entire period for which the asset
has been used. At the time of
scraping the asset, the capital gain
or losses has to be adjusted in the
income of the year in which the
asset is discarded. Consequently
the capital gain or losses will have
its tax effect.
Treatment of Depreciation
Cont….

Depreciation is allowed on the
basis of block of assets under the
income tax Act,1961:
Block consisting of one asset-
1. In the terminal year, no
depreciation is allowed
2. The selling price/scrap value will
be compared with the WDV. The
difference between the two is
treated as short term capital gain
or loss and is treated as ordinary
income/loss.
Treatment of Depreciation
Cont….

Block consisting of more than one
asset—
1. When a new asset is purchased
and is added to the existing block
of asset, the cost of the new
asset is added to the opening
written down value of the block
and depreciation for that year is
provided on the total value.
2. At the time of acquisition of new
asset or even otherwise, any part
of the block
Treatment of Depreciation
Cont….
is sold or scrapped away then the
scrap value is deducted from the
opening written down value. The
depreciation is to be provided on
the net balance only.
2. There will not be any capital
gain/loss on the sale of asset
unless the entire block of asset is
scraped away.
Determination of relevant
cash inflows (Single
Proposal)

Cash Outflows
Cost of new project
+Installation Cost of Plant and
Equipment
+/- Working Capital Requirements
Cash Inflows
Cash Sales Revenues
Less cash operating cost
Cash inflows before Taxes (CFBT)
Less Depreciation
Taxable income
Determination of relevant
cash inflows (Single
Proposal) (continued)…
Taxable Income
Less Tax
Earning after taxes
Plus Depreciation
Cash inflows after Tax (CFAT)
Plus Salvage value (in Nth year)
Plus Recovery of Working Capital (in
nth year)
Determination of relevant
cash inflows (Replacement
Proposal)
Incremental Cash Outflows
Cost of the new Machine
+ Installation Cost
+/_ Working Capital
_ sale proceeds of existing Machine
Incremental Cash Inflows
Incremental Cash flows before Taxes
(CFBT)
Less TAXES
Incremental CFAT(a)
Determination of relevant
cash inflows (Replacement
Proposal) (continued)…
Incremental CFAT (a)
Add Depreciation (New- old)
Tax Saving on excess Depreciation (b)
Incremental CFAT (a+b)
+Working capital recovery in the terminal
(nth) Year
+Salvage Value in the terminal year
+ tax Advantage on short term capital loss
on sale of asset in the terminal year( if
the block of asset ceases to exist)
-Tax on short term capital gain
Third, proper selection
criteria …
 TECHNIQUES OF EVALUATING
CAPITAL BUDGETING
DECISIONS

Techniques of capital budgeting decisions are
tools/ benchmarks/methods/decision-criterion
that helps in making a final choice for an
investment project.

They are only guides and means to final
decision-making.

All they do is help to communicate information
to the decision maker.
TECHNIQUES OF EVALUATING
CAPITAL BUDGETING
DECISIONS (continued)…

They can never replace
managerial judgements, but
they can help to make that
judgment more sound.

Two broad types of techniques
of evaluating capital budgeting
decisions:
 Traditional Techniques
 Modern Techniques
 TECHNIQUES OF EVALUATING
CAPITAL BUDGETING
DECISIONS (continued…)

Traditional Techniques
 Pay Back Period Method
 Rate of Return on Investment Method

Modern Techniques
 Net Present Value
 Internal Rate of Return
 Modified Internal Rate of Return
 Profitability Index
 Discounted Pay Back
Evaluation Techniques

Traditional Techniques:
Average Rate Of return: This method
is also called as accounting rate of
return method and is calculated on
accounting profits rather than cash
flows. There is no unanimity
regarding the definition but most
commonly acceptable is:
=Average Annual profits after
taxes/Average profits*100 Where:
Accounting Rate of return
Cont….
Average Investment=1/2(initial
investments-Salvage value)+
salvage value+ Net working capital
Annual average profits after taxes=
Total expected after tax
profits/Number of years
Accept–Reject decision: Projects
with higher ARR will be Preferred
to projects with lower ARR.
ARR- Shortcomings

It uses the accounting income
rather than cash flows.

It does not take into account the
time value of the money.

It does not differentiate between
the size of the investment required
for each project.

It does not take into consideration
the any benefits which can accru to
the firm from the sale of the
equipment which is replaced by the
new equipment.
Evaluation Techniques
Pay Back Method:
Annuity Cash Flows: PB= Initial
investment/ annual CFAT
Mixed Cash Flows: PB is calculated
by cumulating cash flows till the
cumulative cash flows equal the
initial investments.
Accept –Reject decision: Projects
with shorter pay back period will be
selected
Pay Back Method-
Shortcomings

It completely ignores all cash
inflows after the pay back period.

It does not distinquish the projects
in term of the timings or magnitude
of the cash flows as it does not
discounts the cash flows but rather
treat a rupee received in the
second or third year as valuable as
a rupee received in the first year.

It does not consider the entire life
of the project during which the
cash flows are generated.
ILLUSTRATION-1
The investment data for a new product are
as follows:
Capital outlay: Rs. 200,000
Depreciation : 25% p.a. on WDV basis
Forecasted annual income before charging
depreciation are as follows:
___________________________
Year 1 Rs. 100,000
2 100,000
3 80,000
4 80,000
5 40,000
____________________________
400,000
ILLUTRATION-1 contd.
On the basis of available data, set out
calculations, illustrating and comparing
the following methods of evaluating
capital budgeting decisions:
(a) PB method &
(b) Rate of Return on original investment.
Solution:
(a) PB period = Rs. I lakh, year 1 +

Rs. 1lakh, year 2 = 2 years
Solution to Illustration-1
Cont…….
(b) Rate of return on original investment
=Average income/Average
Investment*100 ={49,330(2,46,651/5
years)} /2,00,000*100 =24.7%

Year Earning before Depreci Net

depreciation ation Income
1 1,00,000 50,000 50,000
2 1,00,000 37,500 62,500
3 80,000 28,125 51,875
4 80,000 21,094 58,096
5 40,000 15,820 24,180
Discounted Cash flow
Techniques

These techniques take into account

the time value of the money while
evaluating the cost and benefits of
the project. The cash flows are to
be discounted at the minimum
required rate of return or cost of
capital. These techniques also
takes into account all the benefits
and costs occurring during the
entire life of the project.
Discounted Cash flow
Techniques

Net Present Value method:
NPV={CF1/(1+K)1+CF2/(1+K)2+
…….+CF1/(1+K)n}—{CFo}
Where CF =Cash Inflows
K =Cost of Capital
n =Life of the project
CFo=Cash Outflows
Accept –Reject decision: Projects
with highest positive NPV will be
selected and projects with negative
NPV will be rejected.
 NPV AND DISCOUNT RATE

Rs.12,000

Rs.10,000

Rs.8,000

Rs.6,000

Rs.4,000
NPV

Rs.2,000

Rs.0
0% 5% 10% 15% 20% 25% 30%

(Rs.2,000)
DISCOUNT RATE

(Rs.4,000)
WHAT SHOULD BE AN APPROPRIATE
DISCOUNT RATE …???

An appropriate discount rate should take into account

the following:
 Various sources of finance
 expectations of return of the funds - suppliers
 After - tax cost of each source of finance
WHAT SHOULD BE AN
APPROPRIATE DISCOUNT
RATE …???
 Risk associate with the
project under consideration
 capital structure of the firm
 average cost of capital and
not the marginal cost of
capital
 the nature of discount rate
and the nature of the cash
flows should be same.
NPV--- Advantages

It explicitly recognises the
time value of money


It also considers the total
benefits arising out of the
proposal over its life time

Changing discount rate can be
built into the NPV calculations
by altering the denominator.
NPV- Advantages Cont-
This feature is very important as
longer the time span, the lower
the value of money & higher
the discount rate.

This method is particularly
useful for the selection of
mutually exclusive projects.

The method is instrumental in
achieving the objective of
financial management i.e.
wealth maximisation.
NPV- Shortcomings

It is difficult to calculate as
compared to Pay-Back
method and Accounting Rate
of Return method.

The calculation of required
rate of return to discount the
cash flows poses a problem as
the discount rate is based on
the Cost of Capital, which is
complicated to calculate.
NPV- Shortcomings

It is an absolute measure as it
does not take into account the
initial capital outlay.

It does not give satisfactory
results in case of projects
having different effective lives.
Discounted Cash flow
Techniques

Internal Rate Of Return:
It is the discount rate at which the
present value of all the cash
inflows are equal to the present
value of all outflows. In other
words, it is the rate at which the
NPV is zero.r
Accept –Reject decision: Projects
with highest IRR will be selected.
Accept if r>k
Reject if r<k
Indifference r=k
Steps for the calculation of
IRR

Determine the average cash
inflows in the case of different cash
inflows.

Determine the fake pay back
period on the basis of average
cash flows.

In present value annuity table , in
the year row, find two PV values
closest to PB period but one
bigger and another smaller than it
and note corresponding interest
rates.
Steps for the calculation of
IRR Cont…

Determine the actual IRR by
interpolation formula:
IRR=r+ (DFrl-PB)/(DFrl-DFrh)
Where:
PB=Pay Back Period
r=Lower of the two interest rate.
DFrl= Discount factor for the lower
interest rate.
DFrh= Discount factor for the higher
interest rate.
 Ilustration-2(Differential
cash flows)

Vinayak Ltd Investments X (70,000) Y (70,000)
whose cost of
capital is 10% is Cash inflows 10,000 50,000
considering two year 1
mutually Year 2 20,000 40,000
exclusive projects
X and Y, the Year 3 30,000 20,000
details of which
are:
Year 4 45,000 10,000

Year 5 60,000 10,000

Total 1,65,000 1,30,000

 Ilustration-2 Contd….

Determination of NPV:
Year CFAT PV Total PV
Factor
X Y (at 0.10) X Y
1 10000 50000 0.909 9090 45450
2 20000 40000 0.826 16520 33040
3 30000 20000 0.751 22530 15020
4 45000 10000 0.683 30735 6830
5 60000 10000 0.621 37260 6210
Total 116135 106550
 Ilustration-2 Contd….
Year CFAT PV Total PV
Fact
or
X Y 10% X Y
Less:Cash 70000 70000
Outflow
NPV 46135 36550

PI=Gross PV of CFAT/ 1.659 1.522

PV of cash outlays
Ilustration-2 Contd….

Determination of IRR:
Fake Pay Back Value=Initial cash
outlay/average cash inflows
Project X=70,000/33,000=2.121
Project Y=70,000/26,000=2.692
PV factor closest to 2.121 against
5 years is 2.143 at 37% for
project X and to 2.692 is 2.689
at 25% for project Y.
Ilustration-2 Contd….
since in project X the cash flows in
the initial years are much smaller
than the average cash inflows,
the IRR is likely to be much smaller
than 37%. Lets try 27% and 28%.
since in project Y the cash flows in
the initial years are Considerably
higher than the average cash
inflows, the IRR is likely to be
much higher than 25%. Lets try for
36% and 37%.
 Ilustration-2 Project X IRR
Year CFAT PV factor Total PV
0.27 0.28 0.27 0.28
1 10,000 0.787 0.781 7870 7810
2 20,000 0.620 0.610 12400 12200
3 30,000 0.488 0.477 14640 14310
4 45,000 0.384 0.373 17280 16785
5 60,000 0.303 0.291 18180 17460
Total 70370 68565

IRR=.27+370/1805= 27.204%
 Ilustration-2 Project Y IRR
Year CFAT PV factor Total PV
0.37 0.38 0.37 0.38
1 50,000 0.730 0.725 36500 36250
2 40,000 0.533 0.525 21320 21000
3 20,000 0.389 0.381 7780 7620
4 10,000 0.284 0.276 2840 2760
5 10,000 0.207 0.200 2070 2070
Total 70510 69700

IRR=.37+510/810= 37.62%
Illustration -3(Annuity cash
flows)
A machine costing Rs.110 lakhs has
a life of 10 years, at the end of
which its scrap value is likely to be
Rs.10 lakhs. The firms cut of rate
is 12%. The machine is expected
to yield an annual profit after tax of
rs. 10 lakhs, depreciation is to be
provided on straight line basis.
Should the machine be installed.
Use NPV method as the decision
criteria.
Illustration -3(Annuity cash
flows)-Solution NPV
Profit after tax Rs. 10,00,000
Add Dep( 1,00,00,000/10 10,00,000
CFAT 20,00,000
PV Factor (12%,10 yrs.) *5.650
Total PV 1,13,00,000
Scrap value in 10th year 10,00,000
PV Factor * 0.322
Additional PV Value 3,22,000
Total PV 1,16,22,000
Project Cost 1,10,00,000
NPV 6,22,000
Illustration – 4 (Annuity
cash flows)- IRR

R Company is planning to purchase

a machine worth Rs.50,000 and has
no salvage value after the life of the
machine(5 Yrs). EAT are Rs. 5,000
each year for 5 years. After tax
required rate of return is 12%.
Determine Internal rate of return and
Pay Back period.
Illustration -4(Annuity cash
flows)-Solution IRR

Earning After Taxes Rs. 5,000

Add Depreciation 10,000
CFAT 15,000
PB Period(50,000/15,000) 3.333
The PV Factor closest to 3.333 as
per table A-4 are 3.373(0.15)and
3.274(0.16) against 5 years.
IRR=0.15+0.040/0.099= 15.4%
Discounted Cash flow
Techniques-IRR Merits

It takes into account the
time value of money

It is a profit making concept
and hence helps in
selecting those projects
which gives more return
than the cost.

It considers all the cash
flows.
Discounted Cash flow
Techniques-IRR Merits

It is based on cash flows
rather than accounting profits.

The salvage value , working
capital released and used are
also considered.

The value is free from units
and scale and hence better
measure for comparision.
Discounted Cash flow
Techniques-IRR Demerits

It involves the tedious calculations.

It produces multiple rates which
can be confusing.

In evaluating the mutually
exclusive proposals, the project
with the highest IRR will be
accepted but it may not turn out to
be consistent with the objective of
the firm i.e maximisation of the
shareholders wealth.
Discounted Cash flow
Techniques-IRR Demerits
Cont…
Under this method it is assumed
that all intermediate cash flows
are reinvested at the IRR. Eg.
The cash flows of project A
can be reinvested at 17.6%
whereas that of B at 20.9%. It
is rather ridiculous to think
that the same firm has the
ability to reinvest the cash
flows at different rates.
Discounted Cash flow
Techniques Cont…

Profitability Index: A major
drawback of NPV method is that ,
being an absolute measure, it is
not reliable method to evaluate the
projects having different initial
outlays. PI method provides the
solution to this problem as it is a
relative measure.
PI=Present value of inflows/
present value of outflows
This method is also called as B/C
(benefit cost) ratio.
Discounted Cash flow
Techniques (continued)…
When PI is greater than, equal to or
less than 1, the NPV is greater
than, equal to or less than zero
respectively. In other words NPV
will be positive when PI is greater
than 1. Thus NPV and PI give the
same results regarding the
investment proposals.
Accept –Reject decision: Projects
with highest PI will be selected.
Accept if PI>1, Reject if
PI<1, Indifference PI=1
NPV & IRR Giving
Concurrent Decisions
NPV and IRR will give the concurrent
results in terms of acceptance or
rejection of investment proposal in
respect of conventional and
independent proposal.
Conventional investment- In
which the initial investment is
followed by a series of inflows.
Independent proposal- It refers
to investments , the acceptance of
which does not precludes the
acceptance of others.
NPV & IRR Giving
Contradictory Decisions
The different ranking given by
NPV and IRR under mutually
exclusive proposals can be
because of these reasons:

Size Disparity problem

Time Disparity Problem

Unequal expected Life
NPV & IRR Giving
Contradictory Decisions

Size Disparity Problem:
This arises when the initial outflow in
mutually exclusive projects under
consideration are considerably
different. For Example:
A and B are two mutually projects
involving different outlays. Find out
NPV and IRR of two different
Projects. Suggest which one do
you recommend and why?
 Illus-5 NPV & IRR Giving
Contradictory Decisions
Particulars Project A Project B ProjectB-A

Cash outflow (5000) (7500) (2500)

Cash inflows 6250 9150 2900

at the end of
year one
IRR % 25 22 16

K 10 10 10

NPV 681.25 817.35

NPV & IRR Giving
Contradictory Decisions
The conflict between NPV and IRR in
the example can be resolved by
modifying the IRR so that it is
based on incremental analysis. If
the IRR of the incremental project
is more than the cost of capital, the
bigger outlay project should be
accepted. This is called as
modified IRR. This method gives
the same result as that of NPV
method which is compatible with
the objective of maximisation of
shareholders wealth..
Illus-6 NPV & IRR Giving
Contradictory Decisions
Time Disparity Year Proj. A Proj.B
Problem: 0 105000 105000
The mutually
exclusive projects 1 60,000 15000
gives conflicting 2 45,000 30000
results under the 3 30,000 45000
NPV and IRR
methods with 4 15,000 75000
different patterns
of cash flows i.e IRR 20 16
there is a time
disparity in the K 0,08 0.08
cash inflows
NPV 23,970 25,455
E.g: Illustration 1
NPV & IRR Giving
Contradictory Decisions
Time Disparity Problem: The answer
to the different ranking lies in the
implied assumption of reinvestment
rate. All the mutually exclusive
proposals intermediate cash inflows
are reinvested at the same discount
rate in NPV method, while in IRR
method at proposal’s IRR which is
different for different proposals.
Illus-7 NPV & IRR Giving
Contradictory Decisions

Projects with Period Proj A Proj B
unequal lives:
Another situation in 0 (20000 (20,00
which NPV and ) 0)
IRR methods At the 1st yr 5th yr
would give a end of 24,000 40,200
conflicting ranking
to mutually IRR 20% 15%
exclusive projects
is when the NPV 1816 4900
projects have
different expected
lives. Eg.
NPV & IRR Giving
Contradictory Decisions
The conflict due to unequal lives can
be resolved by adopting either of
two approaches:
Common time horizon Approach:
The assumption is the replacement
of investment of shorter duration
four times so as to make the life
of two projects equal. The
application encounters
operational difficulty in terms of
the assumption of the same
technology, price of the capital
asset, and operational cost and
revenues.
NPV & IRR Giving
Contradictory Decisions

Equivalent annual value/cost :
Equivalent annual NPV (EANPV) is
determined by dividing the NPV of
the cash inflows of the project by
the annuity factor corresponding to
the life of the project at the given
cost of the capital.
The decision criteria:
Revenue expanding project:
Maximisation of EANPV
Cost reduction project:
Minimisation of equivalent annual
cost (EAC)
 NPV vs IRR
NPV IRR

It is calculated under the 
It is calculated under the
assumption that assumption that
reinvestment rate is reinvestment rate is IRR
discount rate. itself..

NPV is unique and crisply 
IRR is not unique and
defined. crisply defined.

NPV considers the size of 
IRR ignores the size of the
the project. project.
 NPV vs IRR Cont…

Useful when projects are 
IRR is intuitively
mutually exclusive. appealing.

NPV gives the one value. 
IRR gives multiple rates of
return or it is indeterminate

NPV follows ADDITIVE in the case of non
PROPERTY. conventional cash flows.

NPV is an absolute in

IRR does not follow
nature. ADDITIVE PROPERTY.

IRR is dimensionless in
nature.
Illustration-8 Indeterminate
IRR

Project A has got the following
pattern of cash flows, determine
IRR and NPV:
Co =Rs.1 lakh
CFAT1 =RS.2 Lakhs
CO2 =Rs.2 Lakhs
Cash inflows= cash outflows
2/(1+r)1={2/(1+r)2}+1 which leads to
r2=-1
Indeterminate IRR Cont..
(NPV)
Year Cash flows PV factor Total
(Lacs) (.10) Present
Value(Lacs)
0 (1) 1.000 1.000

1 +2 0.909 1.818

2 (2) 0.826 (1.652)

Total (0.834)
Illustration-9 Multiple IRR
A project has the initial cost of Rs
20,000, net cash flow in the 1st
year Rs 90,000 and in the second
year Rs (80,000). Find IRR.
The required equation is: Rs20,000
={90,000/(1+r)}-{80,000/(1+r)2)}
Let (1+r)=x and divide Eq.by 10,000
2=(9/x)-(8/x2) By solving this
equation, r=21.9% and 228%.
Which rate should be used for
decision making purpose?
Some interesting Cases
about IRR…
 PROJECT - A
Rs.3,500

Rs.3,000

Rs.2,500

Rs.2,000

Rs.1,500
NPV

Rs.1,000

Rs.500

Rs.0
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
(Rs.500)
DISCOUNT RATE

(Rs.1,000)
 PROJECT - B
Rs.1,000

Rs.500

Rs.0
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
(Rs.500)

(Rs.1,000)
NPV

(Rs.1,500)

(Rs.2,000)

(Rs.2,500)

(Rs.3,000)
DISCOUNT RATE

(Rs.3,500)
 PROJECT - C
Rs.50

Rs.0
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

(Rs.50)

(Rs.100)

(Rs.150)
NPV

(Rs.200)

(Rs.250)

(Rs.300)
DISCOUNT RATE

(Rs.350)
 NPV vs PI

It is a 
It is a relative
absolute method.
method. 
The project is

The project is acceptable if
acceptable if PI is greater
NPV is than one & it
positive and will be more
rejected if it than one only
is negative. if NPV is +ve
& vice versa.
 NPV vs PI
But in evaluating mutually
exclusive investment projects,
the two methods can give the
conflicting results. In that case
the best project is considered to
be that project which adds the
most to the wealth of the
shareholder. The NPV method
by definition select that project
and hence considered to be
superior.
Project selection under
Capital Rationing
It refers to the selection of
investment projects under
financial constraints in terms of
capital expenditure budget with
the objective to maximise total
NPV. It involves two stages:

Identification of acceptable
projects based on NPV/IRR/PI.

Selection of the combination of
projects based on whether the
projects are either indivisible
/divisible
Inflation and Capital
budgeting
The cash flow pattern will not reflect
the real purchasing power if
inflation rate has not been taken in
the calculation of cash flows. So
the present value of the cash flows
should be calculated at nominal
discount rate or inflation
adjusted discount rate =
(1+ inflation rate)*(1+Real discount
rate)-1 and
NPV={cash inflows/(1+rate of
inflation)}/(1+real rate of discount)-
cash outflows
Inflation and Capital
budgeting-illustration 10
A firm has a proposal involving the
cash outlay of Rs 1,00,000 with a
life of one year after which it
expects a cash inflow of Rs115000
Ko=10%. So NPV=4545. But if the
inflation rate during the same
period is 8%,resulting in the
decrease in the purchasing power
of money i.e115000/1.08=1,06,481
Now this is to be discounted at Ko i.e
10% giving NPV as -3,199.
Inflation and Capital
budgeting-illustration 10
Since CFAT of 1,15,000 is a
inflated sum, it is to be deflated
at the rate of inflation of 8% to
determine the real cash flows
which will be lower than nominal
cash flows. This is to be
discounted at Ko to find out the
present value of inflows, which
is coming out to be negative.
Hence the project should be
rejected.