CAPITAL BUDGETING

(PRINCIPLES & TECHNIQUES)

• Capital budgeting is the process of evaluating &
selecting long-term investments that are consistent
with the goal of shareholders’ wealth maximization.
• Types of investment decisions:
1. Expansion & Diversification
2. Replacement & Modernization
• Investment Evaluation Criteria:
1. Estimation of cash flows,
2. Estimation of required rate of return (the opportunity
cost of capital),
3. Application of a Decision Rule (Capital budgeting
techniques) for making the choice.
 Evaluation Criteria
• Discounted Cash • Non-Discounted
flow Techniques: Cash flow
1. Net Present Value Techniques:
(NPV) 1. Payback Period (PB)
2. Internal Rate of 2. Discounted Payback
Return (IRR) Period (DPB)
3. Profitability Index 3. Accounting Rate of
(PI) Return (ARR)
 NDCF Techniques
1. Pay Back period
• Payback(PB): Refers to the number of years
required to recover the initial outlay of the
investment.
• If the project generate constant annual cash
flows, then PB = (Initial investment ÷ Annual
cash inflow) = [Co ÷ C]
• In case of unequal cash inflows, the PB period
can be found out by adding up the cash inflows
until the total is equal to the initial cash outlay.
 Pay Back period………..
• Acceptance Rule : Accept if PB< Standard payback &
vice versa.

• Payback Period Reciprocal:

• An alternative way of expressing the payback period=
[(1 ÷ Payback Period) X 100]; if a project has a
payback of 2 ½ years, payback period reciprocal is
40%.

• The higher the payback period reciprocal ( and hence

the lower payback period) the more worthwhile the
project becomes.
 Pay Back period………..
• Merits:
1. Easy to compute and inexpensive to use;
2. Emphasizes liquidity;
3. Recognizes cash flows & a crude way to cope with risk.

• Demerits:
1. Ignores the time value of money (magnitude & timing of
cash inflows);
2. Ignores cash flows occurring after the PB period;
3. No objective way to determine the standard pay back.
 NDCF Techniques
2. Discounted Pay Back period
• The number of years required in
recovering the cash outlay on the present
value basis.
• Cash inflows are discounted with the
opportunity cost of capital of the said
project.
• Still fails to consider the cash flows
occurring (magnitude & timing) after the
payback period.
 NDCF Techniques
3. Accounting Rate of Return(ARR)
• ARR [ also known as ROI] method employs the
normal accounting technique to measure the
increase in profit expected to result from an
investment.

• An average rate of return found by dividing the

average net operating profit [EBIT(1 – T)] by the
average investment.

• Acceptance rule: Accept if ARR > minimum rate

& vice versa.
 Accounting Rate of Return…..
• Merits:
1. Uses accounting data with which executives are
familiar;
2. Easy to understand & compute;
3. Gives more weightage to future receipts.

• Demerits:
1. Ignores time value of money;
2. Does not use cash flows
3. No objective way to determine the minimum
acceptable rate of return.
 DCF Techniques
1. Net Present value (NPV)
• The difference between PV of cash inflows and
PV of cash outflows is equal to NPV; the firm’s
opportunity cost of capital being the discount rate.
n
Ct
• NPV = t 1 (1  k ) t
 Co

• Acceptance Rule:
• Accept if NPV > 0 (NPV is positive) & vice versa.
• Project may be accepted if NPV = 0.
 Net Present value (NPV)
• Merits: • Demerits:
1. Considers all cash 1. Requires estimates of
flows; cash flows which is a
2. Based on the concept of tedious task;
time value of money; 2. Requires computation of
3. Satisfies the value the opportunity cost of
additivity principle capital which poses
(i.e.NPVs of two or more practical difficulty;
projects can be added); 3. Sensitive to discount
4. Consistent with rates.
shareholders wealth
maximization principle.
NPV sensitive to discount rates
• Example:
• Two projects A & B – both costing Rs.50
each. Project A returns Rs.100 after 1 year
& Rs. 25 after 2 years. Project B returns
Rs.30 after 1 year and Rs.100 after 2
years. At discount rates of 5% & 10%,
what will be the NPV of the projects & their
ranking ?
 Solution
• Particulars NPV Rank NPV Rank
5% 10%
Project A 67.92 II 61.57 I
Project B 69.27 I 59.91 II
• Ranking reversed when discount rate changed from 5%
to 10%.

• Happened due to cash flow pattern – impact of

discounting becomes more severe for cash flows
occurring later in the life of the project.

• The higher is the discount rate, the severe would be the

discounting impact.
 DCF Techniques
2. Internal Rate of Return (IRR)
• The discount rate which equates the present value of an
investment’s cash inflows and outflows is its internal rate
of return; or
• The discount rate at which the NPV = 0.
n
Ct
• NPV =  (1  r ) t  C0  0
t 1

• For Uneven Cash flows = IRR calculated by Trail & Error

method.
• For Even Cash flows= NPV= (-) Initial Investment + Cash
flows (PVFAn opportunity cost)
 IRR for Uneven Cash flows
(Trail & Error Method)
• Steps:
1. Select any discount rate to compute the PV of cash
flows;
2. If the NPV is (+), try with a higher rate or vice versa;
3. Process repeated till NPV is zero (in reality, if we can
identify two NPVs at lower as well as higher rate, we
can use the method of interpolation to get the IRR).

• Interpolation Formula = Lower Discount Rate +

Difference between two Discount rates (NPV at Lower
discount rate ÷ Absolute difference between two
NPVs)
 IRR for Even Cash flows
NPV= (-) Co + CI (PVFAn opportunity cost)

Q. An investment would cost Rs.20,000 & provide an annual cash flow

of Rs.5430 p.a. for 6 years. If the opportunity cost of capital is 10%,
identify project’s NPV & IRR.

A. NPV = -Rs.20,000 + Rs.5430(PVAF6,0.10)

= - 20,000 + (5430 X 4.355) = Rs.3,648.

For IRR; NPV = -20,000 + 5430(PVAF6,r) = 0;

or, 20,000 = 5430 (PVAF6,r)
or, (PVAF6,r) = (20,000 ÷ 5430) = 3.683
Rate which provides PVAF of 3.683 for 6 years is project’s IRR =
(Approximately 16%).
 Internal Rate of Return (IRR)……
NPV Profile & IRR
• NPV of a project declines as the discount rate
increases & for discount rates higher than the
project’s IRR, NPV will be negative.
• If all NPVs and discount rates are plotted in a
graph, we get NPV profile and the discount rate
at which the NPV is zero can be identified as
IRR, or
• The point where its NPV profile crosses the
horizontal axis indicates a project’s Internal Rate
of Return.
 NPV Profile & IRR
(Example)
Cash flow Discount NPV
rate
-20000 0% 12,580

5430 5% 7,561

5430 10% 3,649

5430 15% 550

5430 16% 0

5430 20% (1942)

5430 25% (3974)

 Internal Rate of Return (IRR)……
• Acceptance Rule: Accept the project when r > k, and
reject when r < k; may accept the project when r = k.
• Merits: Same as of NPV criterion.
• Demerits:
1. Requires estimates of cash flows which is a tedious
task;
2. Does not hold the value additivity principle (i.e. IRRs of
two or more projects do not add);
3. At times fails to indicate correct choice between
mutually exclusive projects;
4. At times yields multiple rates;
5. Difficult to compute.
 DCF Techniques
3. Profitability Index (PI)
• The ratio of present value of cash flows to the initial outlay is
Profitability Index or Benefit Cost Ratio.

• PI = (PV of annual cash flows) ÷ (Initial Investment)

• Acceptance Rule:Accept the project when PI > 1.

• Example: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 per cent rate of discount. Calculate the PV
of cash inflows at 10 % discount rate & the PI.
• Rs.12,350; & the PI = (Rs.12,350 ÷ Rs.1,00,000) = 1.235
 Profitability Index (PI)…….
• Merits: 1) Considers all cash flows & recognizes
the time value of money.
• 2) A relative measure of profitability used at the
time of capital rationing.
• Demerits: 1) At times fails to indicate correct
choice between mutually exclusive projects;
• 2) 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.
Conventional and 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 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 Versus 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 Versus 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 borrowing type project.
Both are conventional projects.
Cash Flows (Rs)
Project C0 C1 IRR NPV at 10%
X -100 120 20% 9
Y 100 -120 20% -9
 Problem of Multiple IRRs
• A project may have both NPV (Rs)
250
lending and borrowing NPV Rs 63
features together. IRR 0
method, when used to
evaluate such non- -250
conventional investment
can yield multiple internal -500
rates of return because of
more than one change of -750
signs in cash flows. 0 50 100 150 200 250
Discount Rate (%)
 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
• Refers to a situation where cash flows of one
project increases overtime & those of another
decreases.

Cash Flows (Rs) NPV

Project C0 C1 C2 C3 at 9% IRR
M – 1,680 1,400 700 140 301 23%
N – 1,680 140 840 1,510 321 17%
 Scale of Investment
• When costs of projects differ:

Cash Flow (Rs) NPV

Project C0 C1 at 10% IRR
A -1,000 1,500 364 50%
B -100,000 120,000 9,080 20%
 Project Life Span
• Difference in the life span of two mutually
exclusive projects can give rise to the conflict
between NPV & IRR rules.

Cash Flows (Rs)

Project C0 C1 C2 C3 C4 C5 NPV at 10% IRR

X – 10,000 12,000 – – – – 908 20%

Y – 10,000 0 0 0 0 20,120 2,495 15%
 Reinvestment Assumption
(Reason - why NPV & IRR differs)
• 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.
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. Follow
NPV method:
Project C Project D
PV of cash inflows 100,000 50,000
Initial cash outflow 50,000 20,000
NPV 50,000 30,000
PI 2.00 2.50