Capital Budgeting

Financial Management

by
Vipul Mehta
Unit III – Capital Budgeting
Capital Budgeting Decisions
 Also known as Investment Decisions
 Involves buying/selling of fixed assets, expansion plans etc
 Examples, truck manufacturer investing in a new plant,
airliner planning to buy a fleet of aircrafts, bank planning for
a computerization scheme, R&D programme by
pharmaceutical firm
 Basic characteristic: There is an initial outlay of funds in
expectation of a stream of benefits extending into future
Capital Budgeting Example
 You are the plant manager at Maruti Suzuki.You want to buy a new
machine for your plant which you believe will reduce the assembly time
for a car. The machine costs Rs 1,000,000. The machine is expected to
work for 5 years and generate the following stream of benefits as shown:

Year Cash Flow (INR)

0 (1,000,000)
1 200,000
2 200,000
3 300,000
4 300,000
5 350,000
Features of Capital Budgeting Decisions
1. Long-term consequences: Strategic in nature
2. Large initial outlay of funds followed by small periodic
inflows
3. Non-reversible: Decision once taken is expensive or
difficult to reverse
 Hence, we need utmost care and weigh all the aspects of
the project before making an investment decision
 Capital Budgeting Process

Evaluation of
Identification Selection using Performance
projects relevant Implementation
of investment a decision- Evaluation or
costs, cash flows, of the project
opportunities making rule follow-up audit
revenue
Types of Projects
1. Independent Projects
 Acceptance or rejection of one project is independent of the other
 For example, opening a new factory vis-à-vis buying a corporate
jet plane
Types of Projects
2. Mutually Exclusive Projects
 Acceptance of one automatically rejects the other projects
 For example, opening a new office in Delhi v. opening a new
factory in Mumbai
Types of Projects
3. Contingent Projects
 Acceptance of one project is dependent on the selection of another
 For example, a firm will buy new machinery only after opening
the factory
 Another classification

Investment
Projects

Revenue Cost
expansion Reduction

Expansion New Product M&A Replacement Modernization

How to analyse investment decisions?
 Expenditures and benefits of an investment should be
measured in cash
 In investment analysis, cash flow is more important than
accounting profit
 Note that investment decisions affect firm’s value
 A firm’s value will increase if investments add cash to the
firm, hence increase shareholders’ wealth
Capital Budgeting Case
 You are the plant manager at Maruti Suzuki.You want to buy a new
machine for your plant which you believe will reduce the assembly time
for a car. The machine costs Rs 1,000,000. The machine is expected to
work for 5 years and generate the following streams of income as
shown:
Year Cash Flow (INR)
0 (1,000,000)
1 200,000
2 200,000
3 300,000
4 300,000
5 350,000

 Should you buy the machine?

Decision Criteria
 So how do we find if we should buy or not?
 We use the Decision Criteria

Decision
Criteria

Non-
Discounting
discounting

Accounting Internal
Payback Net Present Profitability
Rate of Rate of
Period Value Index
Return Return
Good Decision Criteria
 So what is a good decision criteria?
 Account for Time Value of Money
 Adjust for risk
 Let’s consider them one by one
 Payback Period
 The amount of time required to recover the initial investment

200000 200000 300000 300000 350000

-1000000
 Payback period = 4 years
 Decision Criteria: Accept if payback is less than some preset limit
 Accept if you are recovering your money in a shorter time duration
Practice Payback
Year 0 1 2 3 4
A -200 40 20 10 130
B -200 100 100 -200 200
C -200 40 10 30 20
D -50 100 -200
E -100 30 40 50 60

 Payback:
 A: 4 years
 B: 2 or 4 years
 C: Never
 D: 0.5 years
 E: 2.6 years
Pros and Cons of Payback
Pros Cons
Provides an indication of a Ignores the time value of money
project’s risk and liquidity
Easy to calculate and understand Ignores CFs occurring after the
payback period
Accounting Rate of Return (ARR)
 The accounting rate of return (ARR) is the amount of profit,
or return, an individual can expect based on an investment
made.

Average Annual Profit

ARR =
Average Investment
Accounting Rate of Return
 You are the plant manager at Maruti Suzuki.You want to buy a new machine for
your plant which you believe will reduce the assembly time for a car. The
machine costs Rs 1,000,000. The depreciation of the machine is ₹200,000 per
year. The expected after-tax operating profit from the machine is as follows:

Year After-tax Operating Profit

(INR)
1 100,000
2 150,000
3 200,000
4 250,000
5 300,000

 Compute the ARR of the investment.

ARR – Decision Criteria
 Decision Rule
 Accept if ARR is more than a pre-specified rate
 Pros
 Uses accounting statements hence easier to calculate
 Cons
 Uses income rather than cash flows
 Ignores time value of money
Net Present Value (NPV)
 As the name suggests, it has something to do with Present
Value!
 NPV is the difference between market value of a project and
its cost
 NPV tells us how much value is created from undertaking an
investment
NPV =  CF i i − CF 0
n
 Mathematically,
i =1 (1+i)
 Let’s see what it means by looking at our case
 NPV
200000 200000 300000 300000 350000

-1000000

Let's say your cost of raising funds is 8%

Year 0, CF = -1000000
Year 1, CF = 200000
Year 2, CF = 200000
Year 3, CF = 300000
Year 4, CF = 300000
Year 5, CF = 350000
 200000 200000 300000 300000 350000
NPV = + 2
+ 3
+ 4
+ 5
− 1000000
1.08 (1.08) (1.08) (1.08) (1.08)
NPV = Rs 53,515.7
 So what does it mean?
 A +ive NPV represents that we are getting Rs 53,515.7 over
and above our initial investment of Rs 1,000,000
 We are getting our initial money back and also some positive
cash on top of it
 Hence +ve NPV is favorable
NPV Decision Criteria
 Decision Rule:
 Accept a project when NPV is positive
 Reject a project when NPV is negative
 If there are more than one projects to compare, which one will we
go for?
Project C0 C1 NPV (r=12%)
1 -10,000 20,000
2 -50,000 75,000

 So which one will you go for?

We will choose the one with the
highest NPV
NPV Interpretation
 NPV Advantages:
 Considers TVM
 Gives the absolute number value of cash returns on top of the
invested capital
 NPV Disadvantages:
 Need cost of capital of the project/firm for evaluation
Internal Rate of Return (IRR)
 IRR of a project is defined as the discount rate at which NPV
equal to zero
 Simply put, at IRR the present value of future cash flows is
equal to initial investment
n
CF
CF 0 =  t

(1+ r )
t
t =1

 Where,
r is the Internal Rate of Return of the project
  Let’s go back to our case
200000 200000 300000 300000 350000

-1000000
200000 200000 300000 300000 350000
1000000 = + + + +
(1 + r ) (1 + r ) 2
(1 + r ) 3
(1 + r ) 4
(1 + r ) 5

 And now we solve for r

 But how?
 Using Excel!
  Let’s go back to our case
200000 200000 300000 300000 350000

-1000000
200000 200000 300000 300000 350000
1000000 = + + + +
(1 + r ) (1 + r ) 2
(1 + r ) 3
(1 + r ) 4
(1 + r ) 5

 We observe that project IRR = 9.81%

IRR – Decision Criteria
 Compare IRR with the cost of raising funds
 In our case, cost of capital is 8%
 IRR is 9.81%
 This is favorable
Relation between NPV & IRR
 IRR is the discount rate at which NPV = 0
 What happens when discount rate is less than IRR?
 NPV is Positive!
 What happens when discount rate is more than IRR?
 NPV is Negative!
 Can we draw a graph?
 Yes
NPV Profile
NPV

0
9.81

 NPV > 0 when Discount Rate < IRR

 NPV = 0 when Discount Rate = IRR
 NPV < 0 when Discount Rate > IRR
IRR –Solve this!
 Compute the IRR of the two projects:
Project C0 C1 NPV (r=12%)
1 -10,000 20,000
2 -50,000 75,000

 Decision Criteria
 Out of two projects, choose the project whose IRR is more!
But wait. Isn’t there a clash?
IRR and NPV may lead to different results!

In such cases what do you do?

 So what do we do when there’s a clash?

Generally, go with NPV!

Problems with IRR
1. When the project cash flows are not conventional (meaning
not all cash flows positive or negative), it is difficult to
define IRR
Consider this:
Project Co C1 C2
A -160 1000 -1000

IRR will be calculated as:

1000 1000
− 160 + − =0
(1 + r ) (1 + r ) 2

Upon solving this equation, we find that r = 25% and 400%

So which is the correct IRR?
Ans: None
Problems with IRR
2. For certain projects, there can be no IRR
Consider this:
Project Co C1 C2
A +150 -450 +375

450 375
+ 150 − + =0
(1 + r ) (1 + r ) 2

In this case, no value of r satisfied this equation, hence there is

no IRR
 Whenever in doubt, go with NPV
Advantages of IRR
 Closely related to NPV
 Accounts for TVM
 Easy to understand and interpret
Profitability Index
 Measures the benefit per unit cost, based on the time
value of money
PV of cash inflows
PI =
PV of cash outflows

 A profitability index of 1.1 implies that for every Re. 1

of investment, we create an additional Re. 0.10 in value
 This measure can be very useful in situations where we
have limited capital
 Decision criteria:
 Accept the project if PI > 1
 Reject the project is PI < 1
 Indifferent if PI = 1
Motorola Phones
 You are working as the manager at Motorola smart phones
company. In order to expand the production due to increased
demand, you want to set up a new plant in China. The initial
investment of the plant is $12m and you expect cash flows to
be $2m, $2.5m, $3m, $3.5m, $4m and $4.5m for years one
to six.You plan to shut down the plant after six years with
and expect to get nothing out of it at the time of shut down.
a. Compute the Payback Period of the project.
b. Compute the NPV and PI of the project if the required rate
of return is 11%.