Introduction with an Example

• A truck manufacturer is considering investment in a

new plant.
• A commercial bank is thinking of an ambitious
computerisation programme.
• IFIM Institute is Tech oriented Insitute - huge
investment in technology
• All these situations involve a capital expenditure
decision.
• It involves a current outlay of funds in the expectation
of deriving a stream of benefits extending over a period
of time.
Objectives
• To understand the nature and importance of
investment decison making in organisations
• To understand investment appraisal techniques and to
evaluate investment opportunities through these
techniques.
• To provide ranking based on financial performance of
all competing projects
• To make recommendation for the best investment
opportunity
• Summarize merits & demerits of each evaluation
technique.
• It represents growing edge of a business.
• Important for 3 inter related reasons.
• 1. They have long term consequences
• 2. Involves substantial outlays.
• Difficult to reverse capital expenditure decisions
because the market for used capital equipments is
often imperfect.
• Considering the crucial significance, the firms spend
considerable time in planning these decisions and
involve top executives from production,
engineering, marketing and so on., in evaluating
capital expenditure proposals.
• These decisions are too important to be left to
financial managers alone.
Significance of capital budgeting
 The success and failure of business mainly
depends on how the available resources are
being utilised.
 Main tool of financial management
 All types of capital decisions are
budgeting exposed to risk and
 uncertainty.
 They arerationing
Capital irreversible in nature.
gives sufficient scope for the
financial manager to evaluate different proposals
and only viable project must be taken up for
investments.
 Capital budgeting offers effective control on cost
of capital expenditure projects.
 It helps the management to avoid over investment
and under investments.
Methods of capital budgeting
Traditional methods
 Payback period
 Accounting rate of return method

Discounted cash flow methods

 Net present value method
 Profitability index method
 Internal rate of return
Pay back period method
It refers to the period in which the project will
generate the necessary cash to recover the initial
investment.
It does not take the effect of time value of money.
It emphasizes more on annual cash inflows,
economic life of the project and original
investment.

The selection of the project is based on the earning

capacity of a project.
It involves simple calcuation, selection or rejection of
the project can be made easily, results obtained
is more reliable, best method for evaluating high
Cons
 It is based on principle of rule of thumb,
 Does not recognize importance of time value
of money,
 Does not consider profitability of economic
life of project,
 Does not recognize pattern of cash flows,
 Does not reflect all the relevant dimensions
of profitability.
Accounting Rate of Return method
IT considers the earnings of the project of the economic life.
This method is based on conventional accounting concepts.
The rate of return is expressed as percentage of the
earnings of the investment in a particular project. This
method has been introduced to overcome the disadvantage
of pay back period. The profits under this method is
calculated as profit after depreciation and tax of the entire
life of the project.
 This method of ARR is not commonly accepted in assessing
the profitability of capital expenditure. Because the method
does to consider the heavy cash inflow during the project
period as the earnings with be averaged. The cash flow
advantage derived by adopting different kinds of
depreciation is also not considered in this method.
Accept or Reject Criterion: Under the method, all project,
having Accounting Rate of return higher than the minimum
rate establishment by management will be considered and
those having ARR less than the pre-determined rate. This
method ranks a Project as number one, if it has highest
ARR, and lowest rank is assigned to the project with the
lowest ARR.
Merits
 It is very simple to understand and use.
 This method takes into account over the entire
saving
economic life of the project. Therefore, it provides a better
means of comparison of project than the pay back period.
 This method through the concept of "net earnings" ensures a
compensation of expected profitability of the projects and
 It can readily be calculated by using the accounting data.
Demerits
 1. It ignores time value of money.
 2. It does not consider the length of life of the projects.
 3. It is not consistent with the firm's objective of maximizing
the market value of shares.
 It ignores the fact that the profits earned can be
reinvested. -
Net present value method
It recognises the impact of time value of money. It is
considered as the best method of evaluating the
capital investment proposal.
It is widely used in practice. The cash inflow to
be received at different period of time will be
discounted at a particular discount rate.
The present values of the cash inflow are
compared with the original investment. The
difference between the two will be used for
accept or reject criteria. If the different
yields (+) positive value , the proposal is
selected for invesment. If the difference
shows (-) negative values, it will be rejected.
Pros:
It recognizes the time value of money.
It considers the cash inflow of the entire project.
It estimates the present value of their cash inflows by
using a discount rate equal to the cost of capital.
It is consistent with the objective of
maximizing the welfare of owners.
Cons:
It is very difficult to find and understand the concept
of cost of capital
It may not give reliable answers when dealing with
alternative projects under the conditions of unequal
lives of project.
Internal Rate of Return
It is that rate at which the sum of discounted
cash inflows equals the sum of discounted
cash outflows. It is the rate at which the net
present value of the investment is zero.
It is the rate of discount which reduces the NPV
of an investment to zero.It is called internal
rate because it depends mainly on the outlay
and proceeds associated with the project and
not on any rate determined outside the
investment.
Merits of IRR method
 It consider the time value of money
 Calculation of cost of capital is not a
prerequisite for adopting IRR
 IRR attempts to find the maximum rate of
interest at which funds invested in the project
could be repaid out of the cash inflows
arising from the project.
 It is not in conflict with the concept of
maximising the welfare of the equity
shareholders.
 It considers cash inflows throughout the life
of the project.
Cons
 Computation of IRR is tedious and difficult to
understand
 Both NPV and IRR assume that the cash
inflows can be reinvested at the discounting
rate in the new projects. However,
reinvestment of funds at the cut off rate is
more appropriate than at the IRR.
 IT may give results inconsistent with NPV
method. This is especially true in case of
mutually exclusive project.
1. In NPV, PV is determined by discounting the future cash flows of a project
at a pre determined rate called the cutoff rate based on cost of capital.
Under IRR, the cash flows are discounted at suitable rate by hit and trial
method which equates the NPV. Discount rate is not predetermined.

2. NPV recognises the importance of market rate of interest or cost of

capital. It arrives at the amount to be invested in a given project so that its
anticipated earnings would recover the amount invested in the project at
market price.
Opposite to this the IRR, does not consider the market interest and seeks to
determine the maximum rate of interest at which funds invested in any
project could be repaid with the earnings generated by the project.

3. NPV assumes that intermediate cash inflows are reinvested at cutoff rate
where as IRR assumes intermediate cash flows are reinvested at IRR.

4. Results shown by NPV and IRR are similar in certain situations where as
contradictory results in some other situations, however NPV’ is considered
always superior since it uses cutoff rate and more reliable than IRR.
NPV (Net Present Value) and IRR (Internal Rate of Return) are both
widely used methods for evaluating investment projects. They
have some similarities in that they both consider the time value of
money and help in decision-making by providing a basis for
comparing projects. However, they differ in their approach and
interpretation.
NPV is the difference between the present value of cash inflows
and the present value of cash outflows, and it is used in capital
budgeting and investment planning to analyze the profitability of a
projected investment or project. NPV takes into account the cost
of capital, opportunity cost, and risk tolerance through the
discount rate, and it is considered a good indicator if it is greater
than zero. The higher the NPV, the more profitable the project.
IRR, on the other hand, is the discount rate that would cause the
NPV of an investment to be zero. It is the equivalent annual rate
of return that an investor would receive if they were to invest in
the project. IRR is a useful indicator for comparing projects with
different investment amounts and cash flow patterns, and it is
often used in conjunction with NPV.
Both NPV and IRR have advantages and disadvantages. NPV is a
more reliable indicator when comparing mutually exclusive
projects, while IRR is useful for comparing projects with different
investment amounts and cash flow patterns. However, IRR can be
misleading when analyzing projects with different durations, and
it can also give conflicting results when comparing mutually
exclusive projects.
In summary, NPV and IRR are both useful methods for
evaluating investment projects, but they differ in their
approach and interpretation. NPV is a more reliable indicator
for comparing mutually exclusive projects, while IRR is useful
for comparing projects with different investment amounts and
cash flow patterns. When analyzing investment projects, it is
important to consider both NPV and IRR to make informed
decisions.
Profitability Index:

Another time adjusted method of evaluating the investment proposals is

benefit cost ratio or profitability index.

It is the ratio of the PVCI to the PVCO.

The higher the profitability index, the more desirable is the investment.
Thus, this index provides a ready compatibility of investment having various
magnitudes.
The financial manager can rank them in order of their respective rates of
profitability.

PI>1 = accept
PI<1 = reject
PI = 1 may be accepted or rejected.
Step 1:Calculation of cash outflow

Cost of project/asset xxxx

Transportation/installation charges xxxx
Working capital
Cash outflow xxxx
xxxx
Step 2: Calculation of cash inflow
Sales xxxx
Less: Cash expenses
PBDT xxxx
Less: Depreciation
PBT xxxx
less: Tax
PAT xxxx
Add: Depreciation xxxx
Cash inflow p.a xxxx
Note:
 Depreciation = St.Line method
 PBDT – Tax is Cash inflow ( if the tax
amount is given)
 PATBD = Cash inflow
Step 3: Apply the different techniques
 Pay back period= No. of years + Amt to recover/
total cash of next years.
 ARR = Average Profits after tax/ Net investment x
100
 NPV= PV of cash inflows – PV of cash outflows
 Profitability index = PV of cash inflows/ PV of cash
outflows
 IRR :
Pay back factor: Cash outflow/ Avg cash inflow
p.a.
Find IRR range
PV of Cash inflows for IRR range and then calculate
IRR
Thank You