A bus manufacturer is thinking investment in a new project; an air flight company is

planning to purchase a new fleet of jet aircrafts, a big commercial bank is thinking of an
ambitious computing programme, a pharmaceutical company is assessing a major Research
& Development programme. In all these situations, there is a need of decision making
pertained to capital expenditure. Essentially each of these situations presents a series of
scheme for investing resources that can be analysed and assessed reasonably in independent
form. Capital expenditure has basic characteristics that, it involves outflow of funds in
expectations of a stream of benefits, which are getting extended for future. In terms of
finalising these capital expenditures and understanding the project viability, let us have a
complete grasping of capital budgeting and find out, what are the tools used in capital
budgeting for project appraisal.
Capital budgeting is a process where we undergo different steps and they we finalize
with the position. The entire process of capital budgeting may be categorized as below in
different phases:
(i)

Identification of opportunities of potential investment which will be always

(ii)

seeks for better investment propositions.

Proposed investment assembling in line with the capital expenditure

(iii)

requirements.
Decision making for going ahead with the project or getting dropped from the

(iv)

project.
Capital budgeting along with appropriateness preparation should be ensured

(v)

from time to time.

Implementation of project after ensuring that the cash budgets were properly

(vi)

assessed and gauged.

Monitoring the project and reviewing the performance of the project from time
to time.

There are many tools that are used while appraising the projects with the help of capital
budgeting and some of those capital budgeting tools are highlighted below:
(a)
(b)
(c)
(d)
(e)

Net Present Value (NPV).

Internal Rate of Return (IRR).
Profitability Index (PI).
Modified Internal Rate Of Return (MIRR).
Discounted Payback Period (DPB)

Let us discuss each tool in detail as mentioned below:

(a) Net Present Value (NPV): Net present value is nothing but the sum of all the present
value of all the cash flows both positive and negative, which are expected to occur over
the project life and these cash flows are discounted at the cost of capital, which happens
to be discounted over the period for the project. Generally a discount rate is used to
discount the cash flows of the project. The formula that is used to calculate the Net
Present Value of the project is :
NPV of Project = {Net Period Cash Flow/ (1+R) ^T} - Initial Investment
Where R = Discount Rate used to discount the cash flows.
T = Time Period
Let us try to understand this with an example. To illustrate, the calculations of net
present value, consider a project which has the initial cash out flow of $1.00 Million and this
project will life of five years. The project will generate $200,000 in the first two years,
$300,000 in the second two years and $350,000 in the fifth year. The cost of capital, for the
firm is 10%. The net present value of the firm of the proposal is:
NPV = {-1,000,000/ (1.10)0} + {200,000/ (1.10)1} + {200,000/ (1.10)2} + {300,000/
(1.10)3} + {300,000 / (1.10)4} + {350,000 / (1.10)5}
= ($5,273)
The net present value presents the net benefit over and above compensation for every
risk and time. So the rule of decision attached with the Net Present Value is considering the
positive or negative net present value. If the NPV is positive then ,the rule says that, we
should accept the project and similarly if the NPV of the project is negative, then we should
reject the project.
Advantage:
(i)

Net Present Value gives the correct assessed value of the project and hence it
is widely accepted as it is (Advantages and Disadvantages of Net Present

(ii)

Value (NPV). (n.d.).) .

It discounts all the cash flows at a particular rate, which helps us in giving a

(iii)

clear picture of the project.

The best method in capital budgeting is Net Present Value. The Net Present

(iv)

Value (NPV) gives more respects to the time value of money.

Net Present Value (NPV) helps in maximizing value of firm.

Disadvantages:
(i)

NPV is arrived at, based on the projected cash flows and the cash flows may
change with the economic and project conditions and it is difficult to use Net
Present Value (NPV).

(ii)

The discount rate used, may not be the appropriate and if the higher risk factor is

(iii)

loaded in the discount rate, viable projects will be rejected as well.

There are certain they will have marginal positive or negative values and the

(iv)

decision regarding this may not be precise here.

Net Present Value may not give the correct decision in case projects that are unlike

in their life span.

(b) Internal Rate OF Return (IRR): Internal Rate of Return (IRR) is calculated when the
Net Present Value (NPV) of the project is Zero and it is normally calculated by equating
the present value of cash flows to Zero. Internal Rate of Return (IRR) should be the rate
at which it is more than the discount rate of the project, so that the project may be
accepted. If the Internal Rate of Return (IRR) is less than the discount rate, then the
project should be rejected as accepting the project does not really serve the purpose.
From the example used in Net Present Value (NPV), the IRR may be calculated. Let us
try to understand Internal Rate of Return with an example. To illustrate, the calculations of
Internal Rate of Return (IRR), consider a project, where there is $1.00 Million of cash
outflows in the 0 year and $200,000 is the cash generated in the first two years of the
project, $300,000 is the cash generated in the second two years and $350,000 in the fifth year.
The cost of capital, for the firm is 10%. So the Internal Rate of Return of the firm for this
proposal is:
0

= {-1,000,000/ (1.R)0} + {200,000/ (1.R)1} + {200,000/ (1.R)2} + {300,000/

(1.R)3} + {300,000 / (1.R)4}+ {350,000 / (1.R)5}

By solving the equation on hit and trial basis, we calculate the Internal Rate of Return
(IRR) is 9.81%. As cost of capital for the project is 10%, but the Internal Rate of Return
(IRR) is 9.81% which is less than the cost of capital, we have to reject the project as per the
practices.
Advantages:
(i)
IRR considers the time value of money and helps in understanding the project
(ii)

viability.
IRR considers the present value of all the cash flows and hence it so simple to
use I,e when we compare the cost of capital with that of internal rate of return,
we know what to do (Advantages and Disadvantages of Internal Rate of

(iii)

Return (IRR). (n.d.).)

There is no need of hurdle rate or required rate of return while assessing the
internal rate of return.

Disadvantages:
(i)

IRR never consider the interim negative cash flows and hence the internal rate

(ii)

of return may not be reliable.

If the IRR is exactly same as that of cost of capital, we may reject good

projects, where as they really turn good if project is taken up correctly.

(iii)
IRR never considers the economies of scale.
(c) Profitability Index (PI): Profitability Index is an appraisal technique in investment
which is a ratio calculated by dividing Present Value of all the Future Cash Flows to that
of Initial Investment required for the project. If the Profitability Index is more than 1, we
should accept the project and if the Profitability Index is less than 1, we have to reject the
project.
Advantages:
(i)
It considers time value of money along with consideration of all cash flows of the
entire life of the project.
PI is absolutely right in case the projects where, there are interim cash outflows

(ii)

and ascertains the precise rate of return of project (Advantages And Disadvantages
Of Profitability Index (PI). (n.d.).).
Disadvantages:
(i)
(ii)

It is extremely difficult to understand the discount rate or the interest rate.

In case of two projects, calculating Profitability Index is a tough task.

(d) Modified Internal Rate OF Return (MIRR): As per the Modified Internal Rate Of
Return (MIRR), it assumes that, firms positive cash flows are reinvested at cost of capital
, where as initial investment is reinvested at financing cost.
Advantage:
(i)

MIRR is an improved and better method in terms of project evaluation as it

(ii)

addresses all the shortcomings of NPV & IRR.

Considers the practical reinvestment rate.

Disadvantages:
(i)

Asks for two factors like financing rate and cost of capital.

(e) Discounted Payback Period (DPB): Discounted Payback Period is calculated by

considering the discounted cash flows each year and they are looked at , how early the
initial investment is recovered. Earlier the recovery of the initial investment, better it is.

Advantages:
(i)

Considers the time value of money (Discounted Payback Period. (n.d.).)

Disadvantages:
(i)

Does not consider post pay-back period cash flows.

From the analysis we have done, it may be noted that, at the discounted rate of 8%, we get a
Net Present Value of $1,148 Thousands, which is very acceptable. Viewing the NPV of
project with different discount rates with change in the new equipment salvage value and
sales changes from the year one onwards, we accept the project as the Net Present Value
(NPV) of the project is positive.
Based on my NPV Scenario / Risk Analysis Grids, NPV is more sensitive to changing cost of
capital because we find the difference between the NPV value of one cost of capital rate to
that of other cost of capital, it is very high when go vertically instead of going horizontally.
Similarly, based on my NPV Scenario / Risk Analysis Grids, NPV more sensitive to changing
Sales because we find the difference between the NPV value of one change in sales value
to that of other and it is very high when go horizontally instead of going vertically.

References:
Advantages And Disadvantages Of Net Present Value (NPV). (n.d.). Retrieved July 18, 2015,
from http://accountlearning.blogspot.in/2011/07/advantages-and-disadvantages-of-net.html

Advantages and Disadvantages of Internal Rate of Return (IRR). (n.d.). Retrieved July 18,
2015, from http://www.efinancemanagement.com/investment-decisions/advantages-anddisadvantages-of-internal-rate-of-return-irr
Advantages And Disadvantages Of Profitability Index (PI). (n.d.). Retrieved June 18, 2015,
from http://accountlearning.blogspot.in/2011/07/advantages-and-disadvantages-of_04.html
Discounted Payback Period. (n.d.). Retrieved July 18, 2015, from http://accountingsimplified.com/management/investment-appraisal/discounted-payback-period.html