Capital Budgeting Decisions

or
Investment Decisions

 The investment decisions of a firm are generally

known as capital budgeting.
A capital budgeting decisions may be defined
as the firms decisions 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.
The firms investment decisions would generally
include expansion, acquisition,
modernisation and replacement of the longterm assets. Sale of a division or business
(divestment) is also as an investment
decision.

Steps in Capital Budgeting

Process

Step
Step
Step
Step
Step

I: Proposal Generation
II: Review & Analysis
III: Decision Making
IV: Implementation
V: Follow-up

Investment Decision or Project Evaluation

A project is characterized by a set of

periodic benefits and costs involved.
Project evaluation is estimating the
worth of the project when compared
with alternate investment opportunity.
In order to take informed decisions, the
benefits and costs should be measured
in the same denomination.
Worth of a project is simply the net
benefit through the project.

 The firms value will increase if

investments are profitable and add to
the shareholders wealth.
Thus, investment should be evaluated
on the basis of a criteria, which is
compatible with the objective of
shareholders wealth maximization.
An investment will add to the
shareholders wealth if its yields
benefits in excess of cost of capital.

Steps to evaluate of an investment

1. Estimation of cash flows.
2. Estimation of the required rate of return
(the opportunity cost of capital).
3. Application of a decision rule for
making the choice.

Investment decisions rule

It should provide for an objective and

unambiguous way of separating good
projects from bad projects.
It should help ranking of projects
according to their true profitability.
It should help to choose among
mutually exclusive projects that project
which maximises the shareholders
wealth.

Evaluation Criteria
Payback Period (PB)
Discounted payback period (DPB)
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
Accounting Rate of Return (ARR)

PAYBACK Period
Payback period is the number of
years required to recover the original
cash outlay invested in a project.
C0
Initial Investment
Payback =

Annual Cash Inflow

C

Example: Assume that a project

requires an outlay of Rs 50,000 and
yields annual cash inflow of Rs 12,500
for 7 years. The payback period for the
project isPB Rs 50,000 4 years
Rs 12,500

 Unequal cash flows: In case of unequal cash

inflows, the payback period can be found out by
adding up the cash inflows until the total is equal
to the initial cash outlay.
Suppose that a project requires a cash outlay of
Rs.20,000, and generates cash inflows of
Rs.8,000; Rs.7,000; Rs.4,000; and Rs.3,000
during the next 4 years. What is the projects
payback?
3 years + 12 (1,000/3,000) months
3 years + 4 months

 Certain virtues:
Simplicity
Cost effective

Serious vices:

Cash flows after payback

Time value of money

Discounted Payback Period:

Net Present Value

It is the difference between the sum of
the present value of future net cash
inflows & the initial investment.
Decision rule:
NPV > 0 : Accepted
NPV < 0 : Rejected
NPV = 0 : Indifferent

Net Present Value

The formula for the net present value
can be written as follows:

C1
C2
C3
Cn
NPV

I0
2
3
n
(1 k )
(1 k ) (1 k ) (1 k )
n
Ct
NPV
I0
t
t 1 (1 k )

Example
Assume there are two mutually exclusive projects
with similar initial investment of Rs.56,125 and
expected life of 5years but different expected cash
flows. The cost of capital is 10%.
Year

Project
A

Project
B

-56,125

-56,125

14,000

22,000

16,000

20,000

18,000

18,000

20,000

16,000

25,000

17,000

Total

93,000

93,000

Machine A
Year Cash Flow Present Value @ 10% PV of CF
0
1
2
3
4
5

-56,125
14,000
16,000
18,000
20,000
25,000
Total

1.000
0.909
0.826
0.751
0.683
0.621

12,726
13,216
13,518
14,660
15,525
69,645

Machine B
Year
0
1
2
3
4
5

Cash Flow
-56,125
22,000
20,000
18,000
16,000
17,000
Total

Present Value @ 10%

1.000
0.909
0.826
0.751
0.683
0.621

PV of CF
19,998
16,520
13,518
10,928
10.557
71,521

 NPV of Machine A = Rs.13,520 i.e. Rs.(69,645

56,125)
NPV of Machine B = Rs.15,396 i.e. Rs.(71,521
56,125)

Limitations:
Ranking of projects: as per the NPV rule is not
independent of discount rates.
Yea Project
B
Two projects
A & B Project
both costing
Rs.50. Calculate NPV
r
A
at 5% and 10% and rank the project.
1

100

30

25

100

NPV Limitations Cont

The NPV is expressed in absolute
terms & hence does not factor the
scale of investment.
NPV rule is biased in favor of the long
term project.

Internal Rate of Return

The internal rate of return (IRR) is the
rate that equates the investment
outlay with the present value of cash
inflow received after one period. This
also implies that the rate of return is
the discount rate which makes NPV =
0.

 Accept Reject decision:

The higher is better.
Should more than cut-off rate /
required rate of return.

Calculation of IRR

When Cash Flows structure is annuity

Step 1: Determine the payback period
Step 2: Check PVIFA table
Step 3: Find the two Pay back value, one is higher &
one is lower
Step 4: Determine IRR by interpolation
Example: Let us assume that an investment would cost
Rs 20,000 and provide annual cash inflow of Rs 5,430
for 6 years.
NPV Rs 20,000 + Rs 5,430(PVAF ) = 0
6,r

Rs 20,000 Rs 5,430(PVAF6,r )
PVAF6,r

Rs 20,000

3.683
Rs 5,430

Year

Machine A

Machine B

-56,125

-56,125

14,000

22,000

16,000

20,000

18,000

18,000

20,000

16,000

5
Total

25,000
93,000

17,000
93,000

Selecting a Guidance Rate

Computation: For the mixed
stream of cash flow structure:
Step 1: Calculate the average annual
cash inflows
Step 2: Determine the fake payback
period
Step 3: Look at the PVIFA table
Step 4: Find the guidance rate.

Machine A @19%
Year Cash Flow

PV @19%

PV of CF

-56,125

1.000

- (56,125)

14,000

0.840

11,760

16,000

0.706

11,296

18,000

0.593

10,674

20,000

0.499

9,980

25,000

0.419

10,475

Net

- (1940)

Machine A @17%
Year

Cash Flow

PV @17%

PV of CF

-56,125

1.000

- (56,125)

14,000

0.855

11,970

16,000

0.731

11,696

18,000

0.624

10,232

20,000

0.534

10,680

25,000

0.456

11,400

Net

853

Machine B @19%
Year

Cash Flow

PV @19%

PV of CF

-56,125

1.000

- (56,125)

22,000

0.84

18,480

20,000

0.706

14,120

18,000

0.593

10,674

16,000

0.499

7,984

17,000

0.419

7,123

Net

2256

Machine B @21%
Year

Cash Flow

PV @21%

PV of CF

-56,125

1.000

- (56,125)

22,000

0.826

18,172

20,000

0.683

13,660

18,000

0.564

10,152

16,000

0.466

7,456

17,000

0.385

6,545

Net

-140

 IRR by interpolation
Machine A: 17.6%
Machine B: 20.9%
NPV of Machine A = Rs.13,520
NPV of Machine B = Rs.15,396

IRR method may suffer from

Multiple rates

Multiple IRRs Non-conventional Cash Flows

Conventional projects/ cash flows

initially have single cash outflows
followed by several net cash inflows
over the life of the projects.
There are some projects that may have
more than one net cash outflow during
the life of the project.
Example:
Year

0
1
-504 2862

2
3
4
5700
6070
2000

 Modified IRR is the solution to the

non-conventional cash flows.

NPV Vs. IRR

C0

C1

C2

C3

C4

IRR

NPV@1
0%

-1,10,000

31,000

40,000

50,000

70,000

23%

36,613

-1,10,000

71,000

40,000

40,000

20,000

26%

31,314

Conflict arises when

(i)Cost of one project differs from another
(ii)When timing of cash flow differs.

Profitability Index
Profitability index is the ratio of the
present value of cash inflows, at the
required rate of return, to the initial
cash outflow of the investment.
PI = (Sum of PV of cash inflows) / Initial
Outflow
Accept reject decision:
BCR/ PI > 1 accepted
BCR/ PI < 1 rejected

Accounting Rate of Return

The accounting rate of return is the ratio of
the average after-tax profit divided by the
average investment.
Higher is better.
Example:
A project will cost Rs.40,000. Its stream of
earnings before depreciation, interest and
taxes (EBDIT) during first year through five
years is expected to be Rs.10,000,
Rs.12,000, Rs.14,000, Rs.16,000 and
Rs.20,000. Assume a 50 per cent tax rate
and depreciation on straight-line basis.

Calculation of Accounting Rate

of Return
Period

Earnings before Interest

Depn. And Tax

10,00
0

12,00
0

14,00 16,00
0
0

20,000

Depreciation

8,000

8,000

8,000 8,000

8,000

Earning before Interest

and Tax

2,000

4,000

6,000 8,000

12,000

Less: Tax @ 50%

1,000

2,000

3,000 4,000

6,000

Earning after Interest and

Tax

1,000

2,000

3,000 4,000

6,000

Average After Tax profit = 16,000/5 =

3,200
Average Investment = (40,000 + 0)/2 =
20,000
ARR = 3,200/20,000 = 16%

Comparing Mutually Exclusive Projects

with Unequal lives
Year
0
1
2
3
4
5
6

Project
A
70,000
28,000
33,000
38,000

Project
B
85,000
35,000
30,000
25,000
20,000
15,000
10,000

NPV of Project A @ 10% = 81,248 70,000 =

11,248
NPV of Project B @ 10% = 1,03,985 85,000 =
18,985

Annualized NPV or Equivalent

Annuity Approach
ANPV =
Select the project with highest ANPV
ANPVA = = = 4,523
ANPVB= = = 4,359

The Practice of Capital Budgeting

Survey by Graham & Harvey 2001 [Survey of
392 CEOs]
% Always or
Almost
Always
Internal Rate of
Return

75.6%

Net Present Value

74.9%

Pay-back Period

56.7%

Discounted Payback
Period

29.5%

Accounting Rate of
Return

30.3%

Profitability Index

11.9%