Capital Budgeting: Financial

Appraisal of Investment Projects

Welcome to the Power Point
Presentation

T h e P o s itio n o f C a p ita l B u d g e tin g

F in a n c ia l G o a l o f th e F irm :
W e a lth M a x im is a tio n
In v e s tm e n t D e c is o n
L o n g T e rm A s s e ts

C a p ita l B u d g e tin g

S h o rt T e rm A s s e ts

F in a n c in g D e c is io n

D iv id e n d D e c is io n

D e b t/E q u ity M i x

D iv id e n d P a y o u t R a ti o

CAPITAL BUDGETING
The investment decisions of a firm are generally
known as the capital budgeting, or capital
expenditure decisions.
It consist of two words: capital & budgeting.

Capital refers to scarce resources of the

organisation which can be put to alternative uses.
Budgeting refers to the process of systematic
business planning so as to fulfil the objective of
wealth maximisation.

Examples of Long Term Assets

Nature of Investment 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.

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

Evaluation Criteria
1. Non-discounted Cash Flow
Criteria

Payback Period (PB)

Discounted Payback Period (DPB)
Accounting Rate of Return (ARR)

2. Discounted Cash Flow (DCF) Criteria

Net Present Value (NPV)

Internal Rate of Return (IRR)
Profitability Index (PI)

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:
C0
Initial Investment
Payback =
=
Annual Cash Inflow
C

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:

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.

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.

Evaluation of Payback
Certain virtues:

Simplicity
Easy to apply
Cost effective
Short-term effects
Risk shield
Liquidity (early recovery)

Serious limitations:
Cash flows after payback
Cash flows ignored
Cash flow patterns
Administrative difficulties
Inconsistent with
shareholder value

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.
Average income
ARR =
Average investment

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.

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 shortcoming
Cash flows ignored
Time value ignored
Arbitrary cut-off

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. The
appropriate discount rate is the projects
opportunity cost of capital.
Present value of cash flows should be calculated
using the opportunity cost of capital as the
discount rate.
The project should be accepted if NPV is positive
(i.e., NPV > 0).

Net Present Value Method

Net present value should be found out
by subtracting present value of cash
outflows from present value of cash
inflows. The formula for the net present
value can
be CwrittenC as follows:
C
C
NPV

(1 k ) (1 k )
n
Ct
NPV
C0
t
t 1 (1 k )

(1 k )

C0

(1 k )
n

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.

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.

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.
C0

C3
Cn
C1
C2

L
2
3
(1 r ) (1 r )
(1 r )
(1 r ) n
n

C0
t 1
n

t 1

Ct
(1 r )t
Ct
C0 0
t
(1 r )

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.

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.

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 per cent rate of discount. The PV
of cash inflows at 10 per cent discount rate is:

Profitability Index
When resources are limited, the profitability
index (PI) provides a tool for selecting among
various project combinations and alternatives
A set of limited resources and projects can yield
various combinations.
The highest weighted average PI can indicate
which projects to select.

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
It recognises the time value of money.
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.
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.

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 viceversa.
The cash outlays of the projects may differ.
The projects may have different expected lives.

Timing of Cash Flows

Cash Flows (Rs)
Project
M
N

C0
1,680
1,680

C1
1,400
140

C2
700
840

NPV
C3
140
1,510

at 9%
301
321

IRR
23%
17%

Scale of Investment
Cash Flow (Rs)
Project
A
B

C0
-1,000
-100,000

C1
1,500
120,000

NPV
at 10%
364
9,080

IRR
50%
20%

Project Life Span

Cash Flows (Rs)
Project
X
Y

C0
10,000
10,000

C1

C2

C3

C4

C5

NPV at 10%

IRR

12,000
0

20,120

908
2,495

20%
15%

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. 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. Follow NPV method: