Professional Documents
Culture Documents
Should we
build this
plant?
By: Dr Pawan
Gupta
How do we decide
if a capital
investment
project should
be accepted or
rejected?
Indian School of Petroleum
Decision-making Criteria in
Capital Budgeting
■ The Ideal Evaluation Method should:
FVn = PV(1 + i) .
n
n
FVn 1
PV = = FVn
(1+ i)n 1+ i
3
1
PV = 100
1.10
= Rs 75.13.
Indian School of Petroleum
Payback Period
■ The number of years needed to
recover the initial cash outlay.
■ How long will it take for the project
to generate enough cash to pay for
itself?
0 1 2 3 4 5 6 7 8
0 1 2 3 4 5 6 7 8
0 1 2 3 4 5 6 7 8
0 1 2 3 4 5 6 7 8
This project is clearly unprofitable, but we
would accept it based on a 4-year payback
criterion! Indian School of Petroleum
Discounted Payback
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
Indian School of Petroleum
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
3 250Indian School of Petroleum
168.75
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
3 250Indian School of Petroleum
168.75 .52 years
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
The Discounted
0 -500 -500.00
Payback
1 250 219.30 1 year
is 2.52 years
280.70 280.70
2 250 192.38 2 years
88.32
3 250Indian School of Petroleum
168.75 .52 years
Other Methods
• Decision Rule:
0 1 2 3 4 5
Indian School of Petroleum
Profitability Index
Σ
ACFt
NPV = t - IO
(1 + k)
t=1
Σ
ACFt
NPV = t - IO
(1 + k)
t=1
Σ
ACFt
PI = IO
(1 + k) t
t=1
Indian School of Petroleum
Profitability Index
• Decision Rule:
Σ
ACFt
NPV = - IO
(1 + k) t
t=1
Σ
ACFt
NPV = - IO
(1 + k) t
t=1
n
ACFt
IRR:
Σ
t=1
(1 + IRR) t = IO
0 1 2 3 4 5
Indian School of Petroleum
83,000 83,000 83,000 83,000 116,000
(276,400)
0 1 2 3 4 5
■ This is what we are actually doing:
0 1 2 3 4 5
■ This is what we are actually doing: