Chapter 8

CAPITAL BUDGETING DECISIONS

What is
Capital Budgeting?
The process of identifying, analyzing, and
selecting investment projects whose
returns (cash flows) are expected to
extend beyond one year.
WHY CAPITAL BUDGETING?
Analysis of potential additions to fixed assets.
Long-term decisions; involve large expenditures.
Very important to firms future.

Nature of Investment
Decisions
The investment decisions of a firm are generally known
as the capital budgeting, or capital expenditure
decisions.

The firms investment decisions would generally include
expansion, acquisition, modernisation and
replacement of the long-term assets. Sale of a division or
business (divestment) is also as an investment decision.

Decisions like the change in the methods of sales
distribution, or an advertisement campaign or a
research and development programme have long-term
implications for the firms expenditures and benefits, and
therefore, they should also be evaluated as investment
decisions.
Features of Investment
Decisions
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.
Importance of Investment
Decisions
Growth

Risk

Funding

Irreversibility

Complexity
Types of Investment Decisions
One classification is as follows:
Expansion of existing business
Expansion of new business
Replacement and modernisation
Yet another useful way to classify investments is
as follows:
Mutually exclusive investments
Independent investments
Contingent 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 (the
opportunity cost of capital)
3. Application of a decision rule for making the
choice
Investment Decision Rule
It should maximise the shareholders wealth.
It should consider all cash flows to determine the true profitability
of the project.
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 recognise the fact that bigger cash flows are preferable
to smaller ones and early cash flows are preferable to later ones.
It should help to choose among mutually exclusive projects that
project which maximises the shareholders wealth.
It should be a criterion which is applicable to any conceivable
investment project independent of others.
Evaluation Criteria
1. Discounted Cash Flow (DCF) Criteria
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
2. Non-discounted Cash Flow Criteria
Payback Period (PB)
Discounted payback period (DPB)
Accounting Rate of Return (ARR)
Net Present Value Method
Cash flows of the investment project should be
forecasted based on realistic assumptions.
Appropriate discount rate should be identified to discount
the forecasted cash flows.
Present value of cash flows should be calculated using
the opportunity cost of capital as the discount rate.
Net present value should be found out by subtracting
present value of cash outflows from present value of
cash inflows. The project should be accepted if NPV is
positive (i.e., NPV > 0).

Net Present Value Method
The formula for the net present value can be written
as follows:

=

+
=

(
(

+
+ +
+
+
+
+
+
=
n
1 t
0
t
t
0
n
n
3
3
2
2 1
C
) k 1 (
C
NPV
C
) k 1 (
C
) k 1 (
C
) k 1 (
C
) k 1 (
C
NPV
Calculating Net Present Value
Assume that Project X costs Rs 2,500 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 the capital may be assumed to
be 10 per cent.
Why is NPV Important?
Positive net present value of an investment represents the
maximum amount a firm would be ready to pay for
purchasing the opportunity of making investment, or the
amount at which the firm would be willing to sell the right to
invest without being financially worse-off.

The net present value can also be interpreted to represent
the amount the firm could raise at the required rate of
return, in addition to the initial cash outlay, to distribute
immediately to its shareholders and by the end of the
projects life, to have paid off all the capital raised and
return on it.
Acceptance Rule
Accept the project when NPV is positive
NPV > 0
Reject the project when NPV is negative
NPV < 0
May accept the project when NPV is zero
NPV = 0

The NPV method can be used to select between mutually
exclusive projects; the one with the higher NPV should
be selected.
Our Case Study
We want to help Marge Simpson analyze the following
business opportunities by using the following cash flow
information. Assume Marge's cost of capital is 12%.



Time Falafel-Full How 'Bout A Pretzel?
0 (20,000) (20,000)
1 15,000 2,000
2 15,000 2,500
3 13,000 3,000
4 3,000 50,000
Net Present Value (NPV)
NPV = PV of inflows minus Cost = Net gain in
wealth.
Acceptance of a project with a NPV > 0 will add
value to the firm.
Decision Rule:
Accept if NPV >0,
Reject if NPV < 0
( )
NPV
CF
k t
n
t
t
=

+ =0 1
.
NPV: Sum of the PVs of inflows and outflows.
( )
.
1
0
1
CF
k
CF
NPV
t
t
n
t

+
=

=
Cost often is CF
0
and is negative.
Marges NPVs: k = 12%
Time Falafel-Full PV(CF) How 'Bout A Pretzel? PV(CF)
0 (20,000) (20,000) (20,000) (20,000)
1 15,000 13,393 2,000 1,786
2 15,000 11,958 2,500 1,993
3 13,000 9,253 3,000 2,135
4 3,000 1,907 50,000 31,776
NPV 16,510 17,690
Calculator Steps. Falafel-Full: CF0 = -20,000, C01 =
15,000, F01 = 2, C02 = 13,000, F02 = 1, C03 = 3,000.
NPV: I = 12, CPT NPV = 16,510
Pretzel: CF0 = -20,000, C01 = 2,000, C02 = 2,500,
C03 = 3,000, C04 = 50,000. NPV: I = 12, CPT NPV =
17,690
Marges NPV Decision
If projects are independent, Marge should select
both.
Both have positive NPV.
If the projects are mutually exclusive, select How
Bout A Pretzel?
Pretzel NPV > Falafel NPV.

Evaluation of the NPV Method
NPV is most acceptable investment rule for the
following reasons:
Time value
Measure of true profitability
Value-additivity
Shareholder value
Limitations:
Involved cash flow estimation
Discount rate difficult to determine
Mutually exclusive projects
Ranking of projects
INTERNAL RATE OF RETURN
METHOD
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.
Internal Rate of Return: IRR
0 1 2 3
CF
0
CF
1
CF
2
CF
3
Cost Inflows
IRR is the discount rate that forces
PV inflows = cost. This is the same
as forcing NPV = 0.
( ) t
n
t
t
CF
k
NPV
=

+
=
0 1
.
( ) t
n
t
t
CF
IRR =

+
=
0 1
0.
NPV: Enter k, solve for NPV.
IRR: Enter NPV = 0, solve for IRR.
CALCULATION OF IRR
Uneven Cash Flows: Calculating IRR by Trial and
Error
The approach is to select any discount rate to compute
the present value of cash inflows. If the calculated
present value of the expected cash inflow is lower than
the present value of cash outflows, a lower rate should
be tried. On the other hand, a higher value should be
tried if the present value of inflows is higher than the
present value of outflows. This process will be repeated
unless the net present value becomes zero.
Marges IRRs
Best to use calculator. Calculator Steps.
Falafel-Full: IRR = 54.7%
Pretzel: IRR = 33.3%
k = 12%. If independent projects: select both,
IRRs > 12%. Mutually exclusive: select Falafel;
higher IRR.
NPV Profiles
A graph which shows a projects NPV at different
interest rates (cost of capital).
Can illustrate ranking conflicts between NPV and
IRR.
Below is a table of NPVs for Marges projects.
k Falafel-Full How 'Bout A Pretzel?
0% 26,000 37,500
5% 21,589 27,899
10% 17,849 20,289
12% 16,510 17,690
15% 14,649 14,190
25% 9,485 5,216
35% 5,529 (874)
55% (68) (8,201)
Marges crossover rate
Time Falafel-Full How 'Bout A Pretzel? Fal - Pret
0 (20,000) (20,000) 0 CF0
1 15,000 2,000 13,000 C01
2 15,000 2,500 12,500 C02
3 13,000 3,000 10,000 C03
4 3,000 50,000 (47,000) C04
IRR = Crossover Rate = 14.1%
Marge's NPV Profiles
-20,000
-10,000
0
10,000
20,000
30,000
40,000
0% 10% 20% 30% 40% 50% 60%
Cost of Capital (k)
N
P
V
Falafel-Full
How 'Bout A
Pretzel?
IRR(P) IRR(F)
At a cost of capital less than 14.1%, Pretzel has higher
NPV but lower IRR = Ranking Conflict.
At cost of capital greater than 14.1%, Falafel has the
higher NPV and IRR.
Two reasons NPV profiles
cross:
1) Size (scale) differences. Smaller
project frees up funds at t = 0 for
investment. The higher the opp.
cost, the more valuable these funds,
so high k favors small projects.
2) Timing differences. Project with
faster payback provides more CF in
early years for reinvestment. If k is
high, early CF especially good, NPV
S

> NPV
L
.
Which project is best for Marge?
Think back to my indecent proposal.
Which of the following investment opportunities
would you prefer?
#1) Give me Rs1 now and Ill give you Rs2 at the
end of class.

#2) Give me Rs100 now and Ill give you Rs150
at the end of class.
CALCULATION OF IRR
Level Cash Flows
Let us assume that an investment would cost Rs 30,000
and provide annual cash inflow of Rs 6,483 for 6 years
The IRR of the investment can be found out as follows

674 . 4
6483 Rs
30,000 Rs
PVAF
) 6483(PVAF Rs 30,000 Rs
0 = ) F Rs6483(PVA + 30,000 Rs NPV
6,
6,
6,
= =
=
=
r
r
r
NPV Profile and IRR
NPV Profile
Acceptance Rule
Accept the project when r > k

Reject the project when r < k

May accept the project when r = k

In case of independent projects, IRR and NPV rules
will give the same results if the firm has no shortage
of funds.
Evaluation of IRR Method
IRR method has following merits:
Time value
Profitability measure
Acceptance rule
Shareholder value
IRR method may suffer from
Multiple rates
Mutually exclusive projects
Value additivity
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.
The formula for calculating benefit-cost ratio or
profitability index is as follows:
PROFITABILITY INDEX
The initial cash outlay of a project is Rs 100,000 and
it can generate cash inflow of Rs 40,000, Rs 30,000,
Rs 50,000 and Rs 20,000 in year 1 through 4.
Assume a 10 percent rate of discount. The PV of cash
inflows at 10 percent discount rate is:

Acceptance Rule
The following are the PI acceptance rules:
Accept the project when PI is greater than one. PI >
1
Reject the project when PI is less than one. PI < 1
May accept the project when PI is equal to one. PI =
1
The project with positive NPV will have PI greater
than one. PI less than means that the projects
NPV is negative.
Evaluation of PI Method
Time value:It recognises the time value of money.

Value maximization: It is consistent with the
shareholder value maximisation principle. A project with
PI greater than one will have positive NPV and if
accepted, it will increase shareholders wealth.

Relative profitability:In the PI method, since the
present value of cash inflows is divided by the initial
cash outflow, it is a relative measure of a projects
profitability.

Like NPV method, PI criterion also requires calculation
of cash flows and estimate of the discount rate. In
practice, estimation of cash flows and discount rate pose
problems.
PAYBACK
Payback is the number of years required to recover the
original cash outlay invested in a project.
If the project generates constant annual cash inflows,
the payback period can be computed by dividing cash
outlay by the annual cash inflow. That is:



C
C
Inflow Cash Annual
Investment Initial
= Payback
0
=
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 is:
years 4
12,000 Rs
50,000 Rs
PB = =
PAYBACK
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
Acceptance Rule
The project would be accepted if its payback
period is less than the maximum or standard
payback period set by management.
As a ranking method, it gives highest ranking to
the project, which has the shortest payback
period and lowest ranking to the project with
highest payback period.
Evaluation of Payback
Certain virtues:
Simplicity
Cost effective
Short-term effects
Risk shield
Liquidity
Serious limitations:
Cash flows after payback
Cash flows ignored
Cash flow patterns
Administrative difficulties
Inconsistent with shareholder value
Payback Reciprocal and the Rate
of Return
The reciprocal of payback will be a close
approximation of the internal rate of return if the
following two conditions are satisfied:
1. The life of the project is large or at least twice the
payback period.
2. The project generates equal annual cash inflows.
Marges Payback (Assume Marges
max is 2 years)
Time Falafel-Full Cumulative CF How 'Bout A Pretzel? Cumulative CF
0 (20,000) (20,000) (20,000) (20,000)
1 15,000 (5,000) 2,000 (18,000)
2 15,000 10,000 2,500 (15,500)
3 13,000 23,000 3,000 (12,500)
4 3,000 26,000 50,000 37,500
PB = Years Before Full Recovery of Initial Cost +
(Unrecovered CF0)/(Cash inflow during year)
Falafel PB = 1 + 5,000/15,000 = 1.33
Pretzel PB = 3 + 12,500/50,000 = 3.25
Marge should choose Falafel using Payback Period.
DISCOUNTED PAYBACK
PERIOD
The discounted payback period is the number of
periods taken in recovering the investment outlay on
the present value basis.
The discounted payback period still fails to consider
the cash flows occurring after the payback period.
Discounted Payback Illustrated
Marges Discounted Payback
Time Falafel-Full PV(CF) Cumulative PV(CF) How 'Bout A Pretzel? PV(CF) Cumulative PV(CF)
0 (20,000) (20,000) (20,000) (20,000) (20,000) (20,000)
1 15,000 13,393 (6,607) 2,000 1,786 (18,214)
2 15,000 11,958 5,351 2,500 1,993 (16,221)
3 13,000 9,253 14,604 3,000 2,135 (14,086)
4 3,000 1,907 16,510 50,000 31,776 17,690
PB = Years Before Full Discounted Recovery of Initial Cost
+ (Unrecovered Initial Cost)/(Disc. CF during year)
Falafel DPB = 1 + 6,607/11,958 = 1.55
Pretzel DPB = 3 + 14,086/31,776 = 3.44
Discounted Payback stills ignores cash flows beyond
the discounted payback period.
ACCOUNTING RATE OF RETURN
METHOD
The accounting rate of return is the ratio of the average
after-tax profit divided by the average investment. The
average investment would be equal to half of the original
investment if it were depreciated constantly.


A variation of the ARR method is to divide average
earnings after taxes by the original cost of the project
instead of the average cost.
or
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
Acceptance Rule
This method will accept all those projects whose
ARR is higher than the minimum rate established
by the management and reject those projects
which have ARR less than the minimum rate.

This method would rank a project as number one
if it has highest ARR and lowest rank would be
assigned to the project with lowest ARR.
Evaluation of ARR Method
The ARR method may claim some merits
Simplicity
Accounting data
Accounting profitability
Serious shortcomings
Cash flows ignored
Time value ignored
Arbitrary cut-off
Conventional & Non-Conventional
Cash Flows
A conventional investment has cash flows the pattern of
an initial cash outlay followed by cash inflows.
Conventional projects have only one change in the sign
of cash flows; for example, the initial outflow followed by
inflows, i.e., + + +.

A non-conventional investment, on the other hand, has
cash outflows mingled with cash inflows throughout the
life of the project. Non-conventional investments have
more than one change in the signs of cash flows; for
example, + + + ++ +.
NPV vs. IRR
Conventional Independent Projects:
In case of conventional investments, which are
economically independent of each other, NPV and
IRR methods result in same accept-or-reject decision
if the firm is not constrained for funds in accepting all
profitable projects.
NPV vs. IRR
Lending and borrowing-type projects:
Project with initial outflow followed by inflows is a
lending type project, and project with initial inflow
followed by outflows is a lending type project, Both are
conventional projects.
Problem of Multiple IRRs
A project may have both
lending and borrowing
features together. IRR
method, when used to
evaluate such non-
conventional investment
can yield multiple internal
rates of return because of
more than one change of
signs in cash flows.
Case of Ranking Mutually
Exclusive Projects
Investment projects are said to be mutually exclusive
when only one investment could be accepted and
others would have to be excluded.
Two independent projects may also be mutually
exclusive if a financial constraint is imposed.
The NPV and IRR rules give conflicting ranking to the
projects under the following conditions:
The cash flow pattern of the projects may differ. That is, the cash
flows of one project may increase over time, while those of
others may decrease or vice-versa.
The cash outlays of the projects may differ.
The projects may have different expected lives.
Timing of cash flows
The most commonly found condition for the conflict between the
NPV and IRR methods is the difference in the timing of cash
flows.
Cont
NPV Profiles of Projects M and N NPV versus IRR
The NPV profiles of two projects intersect at 10 per cent discount
rate. This is called Fishers intersection.
Incremental approach
It is argued that the IRR method can still be used to
choose between mutually exclusive projects if we
adapt it to calculate rate of return on the incremental
cash flows.

The incremental approach is a satisfactory way of
salvaging the IRR rule. But the series of incremental
cash flows may result in negative and positive cash
flows. This would result in multiple rates of return and
ultimately the NPV method will have to be used.
Scale of investment
Project life span
REINVESTMENT ASSUMPTION
The IRR method is assumed to imply that the cash
flows generated by the project can be reinvested at
its internal rate of return, whereas the NPV method
is thought to assume that the cash flows are
reinvested at the opportunity cost of capital.

MODIFIED INTERNAL RATE OF
RETURN (MIRR)
The modified internal rate of return (MIRR) is the
compound average annual rate that is calculated
with a reinvestment rate different than the projects
IRR.
VARYING OPPORTUNITY COST
OF CAPITAL
There is no problem in using NPV method when
the opportunity cost of capital varies over time.
If the opportunity cost of capital varies over time,
the use of the IRR rule creates problems, as
there is not a unique benchmark opportunity cost
of capital to compare with IRR.
NPV VERSUS PI
A conflict may arise between the two methods if a
choice between mutually exclusive projects has to
be made. NPV method should be followed.