WELCOME

TO OUR
PRESENTATION
 Presented
by
Group Unique
 Name ID

Shwyel Rana M220201095

Airin Hawlader M220201136

Shimul Hossain M220201092

Shajuti Saha M220201137

Abzal Mia M220201107

Shwyel Rana

ID: M220201095
 TOPIC
Introduction on Capital Budgeting
A Comprehensive Approach to Project Evaluation.
What is Capital Budgeting ?
 Capital budgeting is the process of planning, evaluating and selecting
long-term investment decisions that are in line with the goal of investors’
wealth maximization.

The Feature of Capital Budgeting

It is used to compare and evaluate alternative projects-
• financial and nonfinancial criteria
• short and long-term benefits
• fit with existing technology
• effect on marketing and cost management.
Type of Investment Decisions

One classification is as follows:

 Expansion of existing business
 Expansion of new business
 Replacement and modernization

Yet another useful way to classify investments is as follows:

 Maturity exclusive investments
 Independent investments
 Contingents investments
Investment Evaluation Criteria

Three steps are involved in the evaluation of an

investment :
1. Estimation of cash flows .
2. Estimation of the required rate of return.
3. Application of a decision rule for making the choice.
 Good Investment Decision
Nature:
 The exchange of current funds for future benefits
 The funds are invested in long-term assets
 The future benefits will occur to the firm over a series of years.
Criteria:
We need to ask ourselves the following questions when evaluating capital
budgeting decision rules:
 Does the decision rule adjust for the time value of
money?
 Does the decision rule adjust for risk?
 Does the decision rule provide information on
 Capital Budgeting Considerations

The capital budgeting decision, under any technique, depends in part on a variety
of considerations:


 The availability of funds
 The relationships among proposed projects
 The company’s basic decision-making approach
 The risk associated with a particular project
Airin Hawlader

ID: M220201136
 TOPIC
Phases of Capital Budgeting and
NPV
A Comprehensive Approach to Project Evaluation.
 Phases of Capital Budgeting
Capital budgeting is a multi-faceted activity. There are several sequential stages in the
process.
Planning

Analysis

Selection

Financing

Implementation

Review
 Project Appraisal Criteria
Project Appraisal Criteria

Discounted Cash Flow Criteria (DCF) Non- discounted Cash Flow Criteria

Net Present Internal Rate Profitability Payback Discounted Accounting

Value of Return Index (PI) Period Payback Rate of
(NPV) (IRR) (PB) Period Return
(ARR)
 Discounted Cash Flow Criteria
(DCF)
 It considers what money will be worth in the

future.

 Discounting – reduce value of future earnings to

reflect opportunity cost of an investment.

Net Present Value (NPV)
Net present value is equal to the present value of a project’s future cash flows, less the
project’s initial outlay.
General formula for NPV is as follows:
Acceptance Rules of NPV
NPV > 0 Accept (+)
NPV < 0 Reject (-)
NPV = 0 Indifferent ()

A positive NPV means that the project is expected to add value to the firm
and will therefore increase the wealth of the owners.
Calculation of NPV: An Example
Assuming, a new project A of which the following cash flows have been estimated:
Tk.
•Year 0: CF = -1,65,000
•Year 1: CF = 63,120
•Year 2: CF = 70,800
•Year 3: CF = 91,080
Required rate of return for assets=12%
Whether the investment should be accepted or not?
 Calculation of NPV
The calculation of the NPV of Project A will be:

NPV = Tk. -165,000 + 63,120/(1.12) + 70,800/(1.12) 2

+ 91,080/(1.12)3
= Tk. -1,65,000 + 56,357 + 56,441 + 64,829
= Tk. 12,627

So, the investment’s NPV is positive and therefore should be accepted

according to the acceptance rule of NPV.
Decision Criteria Test: NPV
 Does the NPV rule account for the time value of money?
 Does the NPV rule account for the risk of the cash flows?
 Does the NPV rule provide an indication about the increase in value?
 Should we consider the NPV rule for our primary decision rule?
 The answer to all of these questions is Yes.
 Here, the risk of the cash flows is accounted for through the choice of the
discount rate.
Advantages and disadvantages of
NPV
Advantages of NPV Disadvantages of NPV
 NPV method, is a direct  Complex to calculate
measure of the contribution.
 The final results depends
 Considers all the cash flows heavily on the rate of
 Considers the time value of discount
money  Ignoring qualitative factors
 Considers the risk of future  Inability to handle mutually
cash flows exclusive projects
 Provides better forecast
MD SHIMUL HOSSAIN

ID: M220201092
 TOPIC
IRR OF Capital Budgeting
A Comprehensive Approach to Project Evaluation.
 Internal Rate of Return (IRR)
Internal Rate of Return (IRR) is the discount rate that makes the Net
Present Value (NPV) of cash flows equal to zero. IRR is sometimes
referred to as "Economic Rate of Return (ERR)"

Objective of Internal Rate of Return (IRR)

 Evaluate Project Performance
 Rank Project Opportunities
 Account for Time Value of Money
 Enhance Financial Planning
 Support Decision-Making
 Formulation of IRR
IRR can be determined by solving the following equation
For r:

NPVLR
IRR= LR  ( HR  LR )
NPVLR  NPVHR
Where,

LR= Lower discount rate ( at which NPV positive)

HR= Higher discount rate ( at which NPV negative)
NPVLR = Net present value at lower discount rate
NPVHR = Net present value at Higher discount rate
 Acceptance Rules of
IRR
 All projects should be accepted whose IRR exceeds the
company’s cost of capital.

IRR> Cost of Capital Accept (+)

IRR< Cost of Capital Reject (-)

 For mutually exclusive projects, the projects with the

highest IRR should be chosen.
 FINDING IRR
(Trial & Error Method with Interpolation Formula)
Years Cash
 A project involves an initial outlay of Tk. Flows(Tk.)
240,000. The estimated net cash flows
1 140000
for the project are as given:
2 80000
 The company’s required rate of return is 13
percent. 3 60000

 Calculate the IRR for the project. Is the project 4 20000

feasible assuming all other factors are equal ?
5 20000
 Trial & Error Method
(By applying different discount rates)
At 13 % discount rate:

NPV = 140,000/(1.13)]+[80,000/(1.13) 2 ]+[60,000/(1.13) 3 ]

+[20,000/(1.13) 4 ]+[20,000/(1.13) 5 ] - 240,000
= 123,894 + 62,652 + 41,583 + 12,266 + 10,855 - 240,000
= 251,250 - 240,000
= Tk. 11,250

At 17 % discount rate:

NPV = [140,000/(1.17)]+[80,000/(1.17) 2 ]+[60,000/(1.17) 3 ]+[20,000/(1.17) 4]+[20,000/(1.17) 5

] - 240,000
= 119,658 + 58,441 + 37,463 + 10,673 + 9,122 - 240,000
= 235,357 - 240,000
= Tk. - 4643
 INTERPOLATION FORMULA :
By using 13% rate we have a positive figure that is greater than zero whereas
by using 17% rate we have a negative figure that is lesser than zero. NPV
appears to be zero between 13% and 17%, so IRR is somewhere in that range.
By using INTERPOLATION Formula, we can find that the IRR is about
15.79 %

IRR = Lower discount Rate + Difference between the two discount rates x (NPV
at lower discounted rate / absolute difference between the NPVs of the two
discount rates)
=15 + ( 17 – 15 ) x ( 3,059 / (3,059 – ( - 4643 )) =15 + 2 x ( 3,059 / 7,702 )
=15 + 2 x 0.3972
=15.79 %
 Now Applying 15.79%,
We have NPV nearer to Zero :

NPV =[140,000/(1.1579)]+[80,000/(1.1579) 2 ]
+[60,000/(1.1579)3]+[20,000/(1.1579) 4]+[20,000/(1.1579) 5 ] -240,000

= 120,909 + 59,669 + 38,649 + 11,126 + 9,609 -240,000

= Tk. 00
 Project Feasibility :

The project is feasible as its Internal Rate of Return (IRR) is greater than the
company’s required rate of return, assuming all other factors are equal*.

*( If there are two mutually exclusive projects and both have IRR greater
than the company’s required rate of return then the project with higher NPV
will be preferred. In other words, other capital budgeting techniques will be
employed. )
 Calculation of NPV & IRR: Level Cash Flows
Assuming a project’s initial outlay= Tk. 1,00,000, estimated life=10 years, annual cash inflow= Tk. 23,000,
& cost of capital= 12%.

 -Tk. 1,00,000+ Tk. 23,000(PVFA10, 0.12 )

NPV=
= -Tk. 1,00,000+ Tk. 23,000 X 5.65= Tk. 29,950
To calculate IRR, first we need to calculate the PV factor.
PV factor= Tk. 1,00,000/ Tk. 23,000 = 4.348
which stands somewhere between 18% & 20% in the 10- year line of the PV table. Using the
interpolation as follows:
PV Factor
18% 4.494 4.494
IRR 4.348
20% 4.192
Difference 0.301 0.146
Therefore, IRR= 18% + 0.146/ 0.301 (20%- 18%)= 18.97%= 19% (approx.)
Since, the project’s NPV is positive & IRR> cost of capital(12%), the project should be accepted
according to both of these techniques.
IRR and Mutually Exclusive
Projects
 Mutually exclusive projects
• If we choose one, we cannot choose the other.
• Example: We can choose to get admitted in either A&IS or Finance
Department, but not both.

 Intuitively, we would use the following decision rules:

 NPV – project with the higher NPV should be chosen.
 IRR – project with the higher IRR should be chosen.
Example With Mutually
Exclusive Projects
Period Project A Project B

The required return for both

0 -500 -400
projects is 10%.
1 325 325

2 325 200 Which project should we

accept and why?
IRR 19.43% 22.17%

NPV 64.05 60.74

 NPV Profiles
160.00
140.00 IRR for A = 19.43%
120.00
100.00 IRR for B = 22.17%
80.00
NPV

60.00 Crossover Point = 11.8% A

B
40.00
20.00
0.00
(20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3
(40.00)
Discount Rate

If the required return is less than the crossover point of 11.8%, then we should choose A, and B
will be chosen in the opposite case. Here, A fulfills the condition and also has higher NPV. So, to
maximize wealth and to avoid unreliability of IRR we’ll go for the project with larger NPV,
which is project A.
 IRR: Benefits and Drawbacks
Benefits Drawbacks
 Recognizes time value of money.  Difficult to compute, as a project
may have multiple rates rather than a
unique rate of return.
 Allows the risk associated with an  Fails to recognize the varying size of
investment project to be assessed. investment in competing projects and
their respective profitability's.
 Helps measure the worth of an  It may also fail to indicate a correct
investment. choice between mutually exclusive
projects under certain situations.
 Allows the firm to assess whether an
investment in the machine, etc.
would yield a better return based on
internal standards of return.
 Allows comparison of projects with
different initial outlays.
Shajuti Saha

ID: M220201137
 TOPIC
Understanding Profitability Index &
Payback Period
A Comprehensive Approach to Project Evaluation.
Introduction to Profitability Index (PI)

 Definition: PI is the ratio of discounted cash inflows, at the

required rate of return, to the initial investment. Also called the
benefit-cost ratio.
 Purpose: It is used as a mean of ranking projects in descending's
order of attractiveness when resources are limited.

 Formula: PI = =
=
 Acceptance Rules of PI
PI> 1.0 Accept (profitable)
PI< 1.0 Reject (Not profitable)
PI= 1.0 Indifferent

Example:
Project A: PI = 1,77,627 / 1,65,000 = 0.077.
Decision: Since this project generates Tk. 0.077 for each Taka
invested and its PI< 1, the project should
be rejected.
 PI: Benefits and Drawbacks
Benefits Drawbacks
It can discriminate better between large It provides no means for aggregating
and small investments and hence is several smaller projects into a package
preferable to the NPV criterion. that can be compared with a large
project.
When the capital budget is limited in When cash outflows occur beyond the
the current period, PI may rank current period, the PI criterion is
projects correctly in the order of unsuitable as a selection criterion.
decreasingly efficient use of capital.

Recognizes time value of money and

easy to compute as well.
 NPV vs. PI
o The NPV and PI yield same accept or reject rules, because PI
can be greater than one only when the project’s NPV is positive.
o In case of marginal projects, NPV will be zero and PI will be
equal to one.
o The NPV method should be preferred, except under capital
rationing, because the NPV reflects the net increase in the firm’s
wealth.
o But a conflict may arise between the methods if a choice
between mutually exclusive projects has to be made. In this case
between projects with same NPV, the one with lower initial cost
or higher PI will be selected.
 Payback Period Overview
 Definition: The time required to recover the original investment.
 Purpose: Measures how long it takes for a project to break even.
 Formula for Uniform Cash Flows:

Payback Period =
Payback Period: Decision Rules
Acceptance Criteria:
 A project would be accepted if its payback period is less than the
maximum or standard payback period set by management.
Shortest payback period gives highest ranking to a project, where
lowest ranking is given to a project with highest payback period.
 Between two mutually exclusive projects, the project with shorter
payback period will be selected.
Generally, a payback period of 3 years or less is preferred.
According to some advisors, project with payback period of less
than a year should be considered essential.
Example of Payback period:
Initial Outlay: Tk. 50,000; Annual Inflow: Tk. 12,500.
Payback Period = =4 years.
Decision: Reject (if standard < 4 years).

Comparison: PI vs. Payback Period

Profitability Index:
 Incorporates the time value of money.
 Focuses on profitability per unit of investment.
Payback Period:
 Measures time to recover investment.
 Doesn't account for profitability or value creation.
 Payback Period
Benefits Drawbacks
Easy to understand. Ignores the time value of money.

Adjusts for uncertainty of later cash flows. Requires an arbitrary cutoff point.

Biased towards liquidity. Ignores cash flows beyond the cutoff date.

Payback reciprocal is a good approximation Biased against long-term projects, such as

of the rate of return under certain research and development, and new
conditions. projects.
 Discounted Payback Period
 Computes the present value of each cash flow and then
determine how long it takes to pay back on a discounted basis.

 Compares to a specified required period.

 Acceptance Rule – The project should be accepted if it pays

back on a discounted basis within the specified time.
 Calculation of Discounted Payback
Period: An Example
Assuming that, we will accept project A if it pays back on a discounted basis
in 2 years. Shall we accept or reject the project?
First, we will Compute the PV for each cash flow and determine the payback
period using discounted cash flows:

Year 1: 165,000 – 63,120/1.121 = 108,643

Year 2: 108,643 – 70,800/1.122 = 52,202
Year 3: 52,202 – 91,080/1.123 = -12,627

So, the project pays back in year 3

Since, it doesn’t pay back on a discounted basis within the required 2-year
period, we should reject the project.
Conclusion
 Both metrics are important in decision-making but serve
different purposes.
 Profitability Index: Better for evaluating long-term
profitability and ranking projects.
 Payback Period: Useful for understanding breakeven time.
THE END
Thank You