CAPITAL BUDGETING

Capital budgeting decision

• A firm’s decision to invest its current funds most
efficiently in the long-term assets in anticipation of
an expected flow of benefits over a series of years
• Three features
• Exchange of current funds for future benefits
• Invested in long term assets
• The future benefit will occur in series of years
 Capital expenditure
• Fixed asset
• Expansion
• Acquisition
• Modernization
• Replacement
• Other long term investment
• New sales distribution
• Advertisement campaign
• R&D
 Importance of investment decision

• Growth
• Risk
• Funding
• Irreversibility
• Complexity
 Investment
• Cash flows not accounting profit
• Increase shareholder’s wealth by
increasing profitability
• Yield is greater than the opportunity
cost of capital
 Classification of investment
• Expansion of existing business
• Related or concentric diversification
• Expansion of new business
• Unrelated or conglomerate diversification
• Replacement and modernization
• Cost reduction investments
 Classification of investment
• Mutually exclusive investment
• Serve same purpose
• Compete with each other
• One is included other have to be excluded
• Independent investment
• Serves different purpose
• Do not compete with each other
• Depending on profitability, can undertake all the projects
• Contingent investment
• Dependent investment
• Choice of one, necessitates one or more other investment
 Investment Evaluation Criteria
• It should consider all cash flows to determine the true
profitability of the project
• It should provide an objective and unambiguous way separating
good projects from bad projects
• Help ranking of projects according to the profitability
• It should recognize the fact that bigger cash flows are preferable
than smaller ones and early cash flows are preferable than later
ones.
• It should choose among mutually exclusive projects that which
maximises the shareholders wealth
ESTIMATION OF CASH FLOWS
 Capital budgeting
Techniques

Discounted Cash Non -Discounted Cash

Flow (DCF) Flow (DCF)
Criteria Criteria

Net Present Value Payback Period

(NPV) (PB)

Internal rate of return Accounting

(IRR) Rate of return

Profitability Index
(PI)

Discounted Payback
period

Next
 Discounted Cash flow
• Any method of investment project
evaluation and selection that adjusts all cash
flows over the time for the time value of
money.

Back
 Net Present Value
• Classical economic method
• It is a DCF Technique
• Acceptance Rule
• Accept if NPV is positive NPV ≥ 0
• Reject if NPV is negative NPV<0
NPV- A true measure of investment
profitability
• Time value
• Measure of true profitability
• Value additivity
• NPV (A+B) = NPV (A) +NPV(B)
• Shareholders value
 NPV - Drawbacks
• Cash flow estimation
• Discount rate
• Mutually exclusive projects
• Ranking of projects
• PV declines as the discount rate increases
 Net Present Value

 NPV = the total PV of the annual net

cash flows - the initial outlay.

n
CFt
NPV    initial outlay
t 1 (1  k)
t
 NPV Example
• Suppose we are considering a capital
investment that costs 250,000 and
provides annual net cash flows of
100,000 for five years. The firm’s
required rate of return is 15%.
(250,000) 100,000 100,000 100,000 100,000 100,000

0 1 2 3 4 5
Mathematical Solution:
PV = PMT (PVIFA i, n )
PV = 100000 (PVIFA .15,5 ) = 335200
(use PVIFA table, or)
1
PV = PMT 1 - (1 + i)n
i

1
PV = 1000 1 - (1.15 )5 = 335216
.15
NPV = 335216-250000 =+ 85216

ACCEPT
Assume that project X costs Rs.2500
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
capital is 10%. Find the project using
NPV
Period Outflow Inflow PV Present
factor Value
(n, 10%)
0 -2500 1 -2500.00
1 900 0.909 818.10
2 800 0.826 660.80
3 700 0.751 525.70
4 600 0.683 409.80
5 500 0.620 310.00
NPV +224.40
 The cash flows of an investment
project :
Cash flows (Rs.)
C0 C1 C2
-5400 +3600 +14000

Calculate the NPV of project for discount rate 10%,

12%, , 14% and 15%,
Profitability Index (PI)
Benefit Cost (B/C) or Profitability Index
(Time adjusted method)


CFt
NPV = t - IO
(1 + k)
t=1
n


CFt
PI = IO
(1 + k) t
t=1
 Accept if PI >1
Reject if PI <1
May accept if PI =1
 The initial cash outlay of the
project is Rs.1,00,000 and it can
generate cash inflows of
Rs.40,000, Rs.30,000, Rs.50,000
and Rs.20000 in year 1 thro’ 4.
Assume 10% rate of discount.
Calculate NPV & PI
 4


CFt
NPV = (1 + 0.10) t - IO
t=1

NPV = 112350 – 100000 = Rs. 12350

112350
PI   1.1235
100000
 EVALUATION OF PI
• Time value
• Shareholders’ Value maximisation
• Relative profitability
 Payback
• The payback period of a project is the number
of years it takes before the cumulative
forecasted cash flow equals the initial outlay.
• The payback rule says only accept projects
that “payback” in the desired time frame.
• This method is very flawed, primarily
because it ignores later year cash flows and
the the present value of future cash flows.
 PAY BACK PERIOD
Equal cash flows

initial investment C0
Payback  
annual cash inflows C
 Assume the project requires an
outlay of Rs.50,000 and yields
annual cash inflows of Rs.12,500 for
7 years. Find the payback.

initial investment C 0 50000

Payback     4 years
annual cash inflows C 12500
 Payback period
uneven cash flows
unrecovered cost at the start of the year(t)
payback  year before full recovery (t - 1) 
cash flow during the year(t)

unrecovered cost at the start of the year(t) 

inital outlay - cumulative amount at the year (t - 1)
PAY BACK PERIOD
Unequal cash flows
initial investment Rs.1000
Year cash inflows

1 500
2 400
3 300
4 100
 cash Cumulative
Year inflows cash flows

1 500 500

2 400 900

3 300 1200

4 100 1300

(1000 - 900) 100

payback  2   2  2  (0.33 x12)
300 300
 2years 4 months
 DISCOUNTED PAYBACK
PERIOD
• Find the present value for the cash flows
• Find the no.of years it takes to get back the
initial investment using the present value of
the cash flows.
IT WILL BE GREATER THAN THE
NORMAL PAYBACK PERIOD
 Discounted at 10%

Cumulative
cash PV Factor @ Discounted Discounted
Year inflows 10% cash flows Cash Flows

1 500 0.909 455 455

2 400 0.826 331 786

3 300 0.751 225 1011

4 100 0.683 68 1079

(1000 - 786) 214

payback  2   2  2  (0.95 x12)
225 225
 2years 11 months
 Acceptance Rule
• Highest ranking to the shortest
Payback period
• Lowest ranking to the longest
Payback period
EVALUATION OF PAYBACK
• Virtues
• Simplicity
• Cost effective
• Short term effect
• Risk shield
• Liquidity
• Demerits
• Cash flow after payback period – ignored
• Administrative difficulties
• Inconsistent with the shareholders value
 INTERNAL RATE OF RETURN
(IRR)
• Discounted cash flow technique
• Magnitude and timing of cash flows
Also known as
• Yield on investment,
• Marginal efficiency of capital,
• Rate of return over cost
• Time adjusted rate of internal return
Formula
C1  C 0
r
C0

C1
r 1
C0

C1
C0 
(1  r)
 IRR Equation
C1 C2 C3 Cn
C0     ..... 
(1  r) (1  r) (1  r)
2 3
(1  r) n

n
Ct
C0  
t 1 (1  r)
t

n
Ct

t 1 (1  r)
t
 C0  0
 Annuities
• Determine the pay back period
• Look the value of PB in the Present value
annuity table closest to the life of the project
• In the year row find two PV or Discounting
factor (DFr) one bigger and other smaller than
that (ie PB value)
• From the top row of the table find the interest
rate
• Determine the IRR
 IRR- Annuities
 PB  DFr 
IRR  r   
 DFrL  DFrH 
PB = Pay back period
DFr= Discount factor for the interest rate r
DFrL= Discount factor for the Lower interest rate r
DFrH= Discount factor for the Higher interest rate r
r = either of two interest rate
 OR
 PVco  PVCFAT 
IRR  r    x Δ r
 PV 

PVC0 = Present value of the cash outlay

PVCFAT = PV of cash inflows (DFr x Annuity)
ΔP= difference in calculated PV values of the inflows
Δr = Difference in interest rate
r = either of two interest rate
 Acceptance Rule
If r > k = Accept
If r < k = Reject
If r = k = May accept or reject
if
IRR = cost of capital : no change in the
shareholders wealth
IRR> cost of capital : increases the
shareholders wealth
 A project cost Rs.36,000 and is
expected to generate cash inflows of
Rs.11200 annually for 5 years.
years
Calculate the IRR of the project
initial investment C 0 36000
Payback     3.214
annual cash inflows C 11200

Find the discount factor which is close to 3.214 in PV

annuity table for 5 years (one greater and one below)
3.274 = 16% and 3.199 =17%
  PB  DFr 
IRR  r   
 DFrL  DFrH 

 3.274  3.214 
IRR  16     16.8%
 3.274  3.199 

 3.214  3.199 
IRR  17     16.8%
 3.274  3.199 
  PVco  PVCFAT 
IRR  r    x Δ r
 PV 

PVCFAT(16%) = 11200 x 3.274 = Rs.36,668.80

PVCFAT(17%) = 11200 x 3.199 = Rs.35828.80

 36668.80  36000 
IRR  16    x (17 - 16)  16.8%
 (36668.80  35828.80) 
 36000  35828.80 
IRR  17    x (17 - 16)  16.8%
 (36668.80  35828.80) 
Equipment cost Rs.75,000 and net
cash flow of Rs.20,000 per year for
six years. Calculate the IRR.

Ans : IRR = 15.34%

 IRR (uneven cash flows)
• Calculate the average annual cash flows to get annuity
• Determine fake pay back period dividing initial outlays
with the average CFAT
• Look for the factor table same manner as annuities. The
result will be fake IRR
• Adjust subjectively the IRR obtained in step 3 by
comparing the pattern of average annual cash flows
stream happen to be higher in initial years of the project
life than the average stream adjust the percentage
upwards
• Since greater recovery of funds in the initial years will
give higher rate of return
• Adjust subjectively the IRR obtained in step 3 by
comparing the pattern of average annual cash flows
stream happen to be lower in initial years of the
project life than the average stream adjust the
percentage downwards
• If the average cash flow pattern seems close to
actual pattern no adjustment need not be done
• Find out the Present value Re. factor taking IRR as
the discounted rate
• Calculate PV using the discount rate
• If the PV of CFAT is equal to the initial
outlay that is NPV is Zero it is the IRR other
wise repeat previous step
• Stop once two consecutive discount rate that
cause the NPV to positive and Negative
respectively is calculated
• Whichever of these two rate causes the NPV
closest to zero is the IRR %
 EVALUATION OF IRR
• Merits
• Time value
• Profitability measure
• Acceptance rule
• Shareholders value
• Demerits
• Multiple rates
• Mutually exclusive projects
• Value additive
 CALCULATE IRR
Initial investment Rs.56125
Year Annual CFAT (Rs.)
A B
1 14000 22000
2 16000 20000
3 18000 18000
4 20000 16000
5 25000 17000
 SOLUTION
• The sum of cash inflows for project A is Rs.93000

93000
Fake annuity   18600
5
56125
Fake payback   3.017
18600

Find PV discount factor from annuity table for life 5 years value close to 3.017
2.991 for 20%
• Since actual earlier cash flows for machine A is smaller than
18600 reduce by some percentage say 2 then IRR = 18%
• Calculate PV for the cash flows @18%
Year CFAT PV factor Total PV
(Rs.)
1 14000 0.847 11858
2 16000 0.718 11488
3 18000 0.609 10962
4 20000 0.516 10320
5 25000 0.437 10925

55553
Initial investment 56125
NPV -572
• Since NPV is negative lower by some percentage
(say 1%). IRR be 17%
Year CFAT PV factor Total
PV
(Rs.)
1 14000 0.855 11970
2 16000 0.731 11696
3 18000 0.624 11232
4 20000 0.534 10680
5 25000 0.456 11400

56978
Initial investment 56125
NPV 853
• Since 17% and 18% are the two consecutive
discount rates that give one positive and one
negative NPV, we use interpolation method to find
the IRR
 PVco  PVCFAT 
IRR  r   x Δ r
 PV 

 56978  56125 
IRR  17    x 1  17.6%
 56978  55553 
 ACCOUNTING RATE OF RETURN
(ARR)
• Return on investment

Average Pr ofit
ARR 
AverageInvestments
 EVALUATION OF ARR
• Simplicity
• Accounting data
• Accounting profitability
• Demerits
• Cash flows are ignored
• Time value ignored
• Arbitrary cut-off
 A project will cost Rs.40000. Its
stream EBDIT during first five years
is expected to be Rs. 10000,
Rs.12000, Rs.14000, Rs.16000 and
Rs.20000.assume a 50% tax rate and
depreciation on straight line basis.
Calculate ARR
 1 2 3 4 5 average
EBDIT 10000 12000 14000 16000 20000 14400
Depn. 8000 8000 8000 8000 8000 8000
EBIT 2000 4000 6000 8000 12000 6400
Tax 50% 1000 2000 3000 4000 6000 3200
EAT 1000 2000 3000 4000 6000 3200
book value 1 2 3 4 5 average
beginning 40000 32000 24000 16000 8000 24000
depn 8000 8000 8000 8000 8000 8000
end 32000 24000 16000 8000 0 16000
average 36000 28000 20000 12000 4000 20000

Average Profit 3200

ARR   x100  16%
Average Investments 20000
 Acceptance Rule (ARR)
• Accept : ARR > standard rate of return
• Reject : ARR < Standard rate of return
• May Accept or Reject :
ARR = Standard rate of return
 WHICH IS BEST???

• Independent Project
• Either IRR or NPV can be
used
 Capital Rationing
• A situation refers to the choice of
investment proposals under financial
constraints.