Investment Appraisal:

Methods of Capital
Budgeting

Presented By: Shyam Kumar Mishra

Sonia Gupta
PGDM(IB)
2008-2010
 Investment Appraisal:
While operating Projects that cross National Boundaries
Firms must deal with a variety of issues which are:
Net operating Cash Flows(both Cash Inflows & Cash
Outflows and Factors influencing them)
 Fundamental Political and Economic conditions in the
Parent and Host countries such as differing Rates of Inflation,
Volatile Exchange Rate, different Tax Rates, restriction on
Cross Border Tax Financial Transaction etc.
Thus before deciding about making the decision to invest in a
country the firm has to undergo CAPITAL BUDGETING
Definition of Capital Budgeting:

Financial manager chooses investments with satisfactory

cash flows and rates of return. Therefore, deciding
whether an investment is worth undertaking and be
able to choose intelligently between two or more
alternatives to evaluate, compare, and select projects
needed is called capital budgeting.
 
Reason For Capital Budgeting:
In the form of either debt or equity, capital is a very
limited resource.
Faced with limited sources of capital, management
should carefully decide whether a particular project is
economically acceptable. In the case of more than one
project, management must identify the projects that
will contribute most to profits and, consequently, to the
value (or wealth) of the firm. This, in essence, is the
basis of capital budgeting.
Methods of Capital Budgeting:
I. Payback, discounted payback
II. NPV
III. IRR, MIRR
IV. Profitability Index
V. Accounting Rate of Return etc.
Payback:
The number of years required to recover a
project’s cost,

or how long does it take to get the

business’s money back?
Here payback period is the time when cumulative

cash inflows are equal to the outflows. i.e.,

Where (CF)t is Cumulative cash inflows in time period t

n is time period or No. Of years when Cumulative Cash Inflows = Cash
Outflows

The payback period is stated in terms of years.


Project L Project S
Cash Cash Remainin Cash Cash Remainin
Year Year
outflow Inflow g Balance outflow Inflow g Balance
0 -100 -100 -100 0 -100 -100 -100

1 10 -90 1 70 -30

2 60 -30 2 50 +20

3 80 +50 3 20

Payback=2+30/80=2+0.375=2.375 Payback= 1 +30/50=1+0.6=1.6

Therefore Project S is better since it has shorter Payback

Period.
Decision Rules for Pay Back criterion:

A. Capital Rationing Situation

• Select the projects which have payback periods lower than or

equivalent to the stipulated payback period.

• Arrange these selected projects in increasing order of their respective

payback periods.

• Select those projects from the top of the list till the capital Budget is
exhausted.
B. Mutually Exclusive Projects
In the case of two mutually exclusive projects, the one with a lower
payback period is accepted, when the respective payback periods are
less than or equivalent to the stipulated payback period.
Discounted Payback
Discounted Payback - is almost the same as payback,
but here we have to first discount our cash flows i.e.
we reduce the future payments by your cost of capital.

Where (CF)t is Cumulative cash inflows in time period t

cc is cost of capital
t is Time period of the investment when net discounted
cumulative cash inflows = cash outflows
 Discounted Payback
Project L at cc=10% Project S at cc = 10%
Remaining Remaining
Cash Cash Discounted Balance Cash Cash Discounted Balance
Year Year
outflow Inflow Cash outflow Inflow Cash
Inflow Inflow

0 -100 -100 0 -100 -100

1 10 9.09 - 1 70 63.64 -
90.91 36.36
2 60 49.59 - 2 50 41.32 4.96
41.32 3 20
3 80 60.11 18.79
Discounted Payback Period Discounted Payback Period
=2+(41.32/60.11)=2+0.687=2.688 yrs =1+ (36.36/41.32) =1+0.8799 =1.88
Therefore Project S is selected as it has smaller Discounted Payback Period.
NPV: Sum of the PVs of inflows and
outflows.
n
Formula of NPV: CFt
NPV   .
t  0 1  r 
t

Where CFt is Cumulative cash inflows in time period t

r is cost of capital
Therefore the above formula can be expanded as:
NPV = -CF0 + CF1/(1+r)1 +CF2/(1+r)2 + CF3/(1+r)3+
……………………………………CFn/(1+r)n
 NPV of proj L at r=10% NPV of proj S at r= 10%
Time CF0 CFt CFt Time CF0 CFt CFt
Period 1  r  t Period
1  r  t
0 -100 0 -100 0 -100 0 -100
1 10 9.09 1 70 63.64
2 60 49.59 2 50 41.32
3 80 60.11 3 20 15.03

Thus NPV of proj L= -100+ 9.09+ Thus NPV of proj S = -100 + 63.64 +
49.59 +60.11= 18.79 41.32 + 15.03 = 19.98

Therefore If both the proj are exclusive the proj S is selected as it has greater NPV
. If both the proj are independent then both the proj are selected since both has
+ve NPVs.
Decision Rule for NPV:
A. "Capital Rationing" situation
Select projects whose NPV is positive or equivalent to zero.
Arrange in the descending order of NPVs.
Select Projects starting from the list till the capital budget allows.

B. "No capital Rationing" Situation

Select every project whose NPV >= 0

C. Mutually Exclusive Projects

Select the one with a higher NPV.

IRR (Internal Rate of Return):IRR
is defined as the rate of discount at which the
present value of cash inflows and present value of
cash outflows are equal. Therefore it is that rate
of discount at which NPV becomes Zero.

IRR =

i.e. -CF0 (1+R)0+ CF1/(1+R)1 +CF2/(1+R)2 + CF3/(1+R)3+ ……………

CFn/(1+R)n = 0
Where CF0, CF1, CF2, CF3,………….CFn are the Cash Inflows at at years 0, 1,
2, 3……n respectively.
CF0 is actually Cash Outflow at the beginning of the project but since
it is taken a Cash Inflow therefore its sign is negative.
R is that rate of return which makes NPV=0
t is time period 0 to n
n is the total time period of the project.
 Project L:  CF0 =-100, CF1 = 70, CF2 =50, CF3 =
CF0 =-100, CF1 = 10, CF2 = 60, CF3 = 20
80  i.e. IRR = 100+ 70/(1+R )1 +50/(1+
 i.e. IRR = -100+ 10/(1+R )1 +60/(1+ R )2 + 20/( 1+R)3 = 0
R )2 + 80/( 1+R)3 = 0  Therefore R at which above equation
 Therefore R at which above equation satisfies = 23.56%.
satisfies = 18.13%.  Therefore IRR = 23.56% L
 Therefore IRRL = 18.13%

If both the projects are mutually exclusive then proj S is selected because
it has a higher IRR.
If S and L are independent, accept both. IRRs > r = 10%.

 Project S:
Decision rule for IRR:
 A. "Capital Rationing" Situation :Select those
projects whose IRR (R) = r, where r is the cost of
capital. Arrange all the projects in the descending
order of their Internal Rate of Return. Select
projects from the top till the capital budget allows.
B. "No Capital Rationing" Situation: Accept every
project whose IRR (R) = r, where r is the cost of
capital.
C. Mutually Exclusive Projects: Select the one with
higher IRR
Normal Cash Flow Project:

Cost (negative CF) followed by a series of

positive cash inflows.
One change of signs.

Nonnormal Cash Flow Project:

Two or more changes of signs which is
non predictable.
Most common: Cost (negative CF),
then string of positive CFs, then cost to
close the project.
Example: Nuclear power plant, strip mine.
Inflow (+) or Outflow (-) in Year

0 1 2 3 4 5 N NN
- + + + + + N
- + + + + - NN
- - - + + + N
+ + + - - - N
- + + - + - NN
NPV ($) r NPVL NPVS
60
0 50 40
50 5 33 29
NPV L=33 at r=5
10 19 20
40 Crossover 15 7 12
Point = 8.7% (4) 5
20
30 18.1 0 -
- 0
23.6
20
S
NPV S=29
10 at r=5 IRRS = 23.6%
L
0
0 5 10 15 20 23.6
Discount Rate (R%)
-10
IRRL = 18.1%
NPV and IRR always lead to the same
accept/reject decision for independent
projects:
NPV ($)

IRR > r r > IRR

and NPV > 0 and NPV < 0.
Accept. Reject.

r (%)
IRR
 Mutually Exclusive Projects

NPV r < 8.7: NPVL> NPVS , IRRS > IRRL

L
CONFLICT
r > 8.7: NPVS> NPVL , IRRS > IRRL
NO CONFLICT

S IRRS

r 8.7 r %
IRRL
Pavilion Project: NPV and IRR?

0 1 2
r = 10%

-800 5,000 -5,000

NPV = -386.78
 NPV NPV Profile

IRR2 = 400%
450
0 r
100 400
IRR1 = 25%
-800
Modified Internal Rate of Return - MIRR -
Is basically the same as the IRR, except it assumes that the revenue (cash
flows) from the project are reinvested back into the company, and are
compounded by the company's cost of capital, but are not directly invested
back into the project from which they came.
The MIRR is similar to the IRR, but is theoretically superior in
that it overcomes two weaknesses of the IRR. The MIRR
correctly assumes reinvestment at the project’s cost of capital
and avoids the problem of multiple IRRs. However, please
note that the MIRR is not used as widely as the IRR in practice.
MIRR (=R at which)= TV/(1+R)n – CF0 =0
Where TV (Terminal Value of cash Inflows) = CF 1 (1+r)n-1 +
CF2(1+r)n-2 + CF3(1+r)n-3 + ………………. CFn
CF1, CF2….. are Cash Inflows at time period 1 year, 2 years…
etc.
N is total time of project
MIRR (=R at which)= TV/(1+R)n – CF0 =0

Where TV (Terminal Value of cash Inflows) = CF1 (1+r)n-1 + CF2(1+r)n-2

+ CF3(1+r)n-3 + ………………. CFn
CF1, CF2….. are Cash Inflows at time period 1 year, 2 years…etc.
N is total time of project
 

Considering Proj L:
CF0 =-100 , CF1= 10, CF2= 60, CF3= 80
MIRR= TV/(1+ R)n+CF0= 0
i.e. [10(1+r)2 + 60(1+r)1+ 80(1+r)0]/(1+R)3-100= 0
i.e. [10(1.1)2 + 60(1.1)1+ 80]/(1+R)3-100= 0
i.e. [12.10 + 66+ 80]/(1+R)3-100= 0
i.e. [158.10]/ (1+R)3 = 100
i.e. 58.10= (1+R)3
i.e. R=16.9 % which satisfy the above equation
Therefore MIRR= 16.9%
 
MIRR is better than IRR because:

1. MIRR correctly assumes reinvestment at project’s

cost of capital.
2. MIRR avoids the problem of multiple IRRs.

 
Decision Rule for MIRR:

 A. "Capital Rationing" Situation :Select those projects whose

MIRR (R) = r, where r is the cost of capital. Arrange all the projects
in the descending order of their Internal Rate of Return. Select
projects from the top till the capital budget allows.

B. "No Capital Rationing" Situation: Accept every project whose

MIRR (R) = r, where r is the cost of capital.

C. Mutually Exclusive Projects: Select the one with higher MIRR

 
PI(Profitability Index);
Profitability
 ratio is otherwise referred to as Benefit/Cost ratio. This is an extension of the
Net Present Value Method.


definition of PI: Profitability index (PI) is the ratio of present value of Cash
Inflows to the present value of Cash outflows. The present values of cash flows are obtained
at a discount rate equivalent to the cost of capital.
i.e. PI= ( Present value of Cash Inflows)/ (Present value of Cash outflow)
i.e. PI = PVCF/ Initial Investment
i.e. PI= Present Value of Total BENEFIT/Present Value of Total Cost
i.e. PI = [ CF1/(1+r)1 + CF2/(1+r)2 + CF3/(1+r)3+…………CFn(1+r)n]/ CF0
Where CF1, CF2……….are Cash Inflows after 1 year, 2years respectively.
CF0 is Present value of Cash Outflow or Initial Investment
i.e. PI = NPV+1

Therefore Selection Criteria for PI is:

PI>1 i.e. NPV>0 : ACCEPT THE PROJECT
PI<1 i.e. NPV<0 : REJECT THE PROJECT
PI=1 i.e. NPV=0 : INDIFFERENT 

 
Accounting rate of return is the rate
arrived at by expressing the average annual net
profit (after tax) as given in the income statement
as a percentage of the total investment or average
investment. The accounting rate of return is
based on accounting profits. Accounting profits
are different from the cash flows from a project
and hence, in many instances, accounting rate of
return might not be used as a project evaluation
decision. Accounting rate of return does find a
place in business decision making when the
returns expected are accounting profits and
not merely the cash flows.
AROR = Net Profit after Tax/Average Investment
 Decision Rules for AROR:
A. Capital Rationing Situation :

• Select the projects whose rates of return are higher than the cut-off rate

• Arrange them in the declining order of their rate of return and Select
projects starting from the top of the list till the capital available is
exhausted.
B. No Capital Rationing Situation and Independent Projects:

Select all projects whose rate of return are higher than the cut-off rate.
C. Mutually Exclusive Projects :

Select the one that offers highest rate of return.

Accounting Rate Of Return – Advantages :

• It Is Easy To Calculate.

• The Percentage Return Is More Familiar To The Executives.

Accounting Rate Of Return – Disadvantages

• The definition of cash inflows is erroneous; it takes into account profit

after tax only. It, therefore, fails to present the true return.

• Definition of investment is ambiguous and fluctuating. The decision

could be biased towards a specific project, could use average investment
to double the rate of return and thereby multiply the chances of its
acceptances.