Capital Budgeting Techniques

CAPITAL
BUDGETING
TECHNIQUES
Capital budgeting is the planning process used
to determine whether an organization's long term
investments or projects are worth pursuing.
It Includes:
Long term Decisions.
Large Expenditure.
Long term consequences.
 They may be difficult or expensive to reverse.
Capital Budgeting Process
1. Identification of Potential Investment Opportunity.

2. Assembling of Investment Proposals.
3. Decision Making.
4. Preparation of Capital Budget and Appropriation.
5. Implementation.
6. Performance Review.
Capital Budgeting Techniques
Discounting
Discounting Non-Discounting
Non-Discounting
Internal Rate of Discounted Accounting Rate of

NPV Benefit-Cost ratio
Return
Payback Period Payback Return
NET PRESENT
VALUE
The net present value of an investment is:
the value, an investment must represent today

on a discounted cash-flow basis
to make an investment worthwhile after taking into
account the cost of the investment
The net present value of a project is the sum of the present values
of all the cash flows(negative or positive) that are expected to
occur over the life of the project.
NPV analysis is sensitive to the reliability of future cash inflows

that an investment or project will yield.
NPV when the discounting rate is constant:
The difference between the net present value of cash inflows and the
present value of cash outflows.
From the present value Table:

NPV=C1(PVFt,r)+C2(PVFt,r)+ . . . . . + Cn(PVFt,r) – I.E.
C=Cash inflow of the year.

PVF=Present value of future.
I.E.= Initial Investment.
Acceptance rules of NPV Method
Accept the project when NPV is Positive.

NPV > 0
Reject the project when NPV is negative.

NPV<0
May accept or reject the project when NPV=0

(when project generate cash inflow at a rate
just equal to the opportunity cost of the capital)
Example
For the following Cash flow stream, Calculate the NPV if the
cost of project write now is Rs 2,500. The oppprtunity cost of
the capital may be assumed to be 10%
Year Cash Flow
1 900
2 800
3 700
4 600
5 500
By Formula:
[ 900/(1.10)1 + 800/(1.10)2 + 700/(1.10)3 + 600/(1.10)4 + 500/(1.10)5 ] – 2,500

=2,727-2,500
= Rs 225
With the help of table:
[Rs 900(PVF1,0.10) + Rs 800(PVF2,0.10) + Rs 700(PVF3,0.10) + Rs 600(PVF4,0.10) +

Rs 500(PVF5,0.10)] – Rs 2,500
= (900*0.909 + 800*0.826 + 700*0.751 + 600*0.683 + 500*0.621) – 2,500
= 2725 – 2,500
=Rs 225
Calculating of net present value when discounting rate is
fluctuating:
PV of C1= C1/ (1+r1)
PV of C2= C2/ (1+r1 * 1+r2)
PV of C3= C3/ (1+r1 * 1+r2 * 1+r3)

.
.
PV of Cn=Cn/ (1+r1 * 1+r2 * ……………… *1+rn)
NPV= (PV1 + PV2 +… + PVn) – Initial Investment

Discount Rate 14% 15% 16% 18% 20%
-12,000
Investment 4,000 5,000 7,000 6,000 5,000
cashflow
The present value will be:

PV of C-1 = 4,000/(1.14) = 3,509
PV of C-2 = 5,000/(1.14*1.15) = 3,814
PV of C-3 = 7,000/(1.14*1.15*1.16) = 4,603
PV of C-4 = 6,000/(1.14*1.15*1.16*1.18) = 3,344
PV of C-5 = 5,000/(1.14*1.15*1.16*1.18*1.20)=2,322
NPV = 3,509 + 3,814 + 4,603 + 3,344 + 2,322 - 12,000

= Rs 5,592
ADVANTAGES:
 Profitability and risk of the projects are given high priority.
 It considers Time value of money.
 NPV helps in maximizing the firm's value.
 It permits time varying discount rates.
 It is the true measure of profitability as it is uses the present value

of all cash flows.
 The NPV’s of individual project can be simply added to calculate

the value of the firm also known as
“Principal of additivity”.
Value of Firm
= Σ present value of projects + Σ NPV of expected future projects
Σ present value of projects is value of assets in place
Σ NPV of expected future projects is the value of growth opportunities.
Situations Value of firm

Termination of existing project with negative NPV Increase
Undertakes a project with a negative NPV Decrease
When a new project with positive NPV is taken effect on the value of
firm depends on whether its NPV is in line with expectations.
DISADVANTAGES:
 NPV can not give accurate decision if the amount of investment of
mutually exclusive projects are not equal.
 NPV may not give correct decision when the projects are of
unequal life.
 Difficult to obtain estimates of cash flow practically due to

uncertainty.
 Difficult to identify correctly the discount rates.

Benefit Cost Ratio
It is the comparison of the benefits with the cost of activity
PVB = Present value of benefit.

I = initial Investment.
NBCR= Net Benefit Cost Ratio.
When BCR Or NBCR Rule is
>1 >0 Accept
=1 =0 Indifferent
<1 <0 Reject
BCR can be used to evaluate the economic merit of a project.

The results from a series of benefit-cost analyses can be used to
compare competing projects.
The comparison of a bigger project with a combined number of
smaller projects is not possible.
Problem
Initial Investment= Rs 100,000
Benefits:
Year- 1 25,000
Year- 2 40,000
Year- 3 40,000
Year- 4 50,000
25,000/(1.12) + 40,000/(1.12)2 + 40,000/(1.12)3 + 50,000/(1.12)4

BCR = = 1.145
100,000
NBCR= BCR-1 = 0.145

Internal Rate of Return
IRR is the rate of Return that equates PV of cash inflow with
the investment outlay of a project.
This is same as making the NPV = 0
CF = Cash Flow at the end of the year.

r = Internal Rate of Return (IRR)
n = Life of the Project.
Example for even cash flows:
Assume that an investment would cost Rs. 20,000 and provide an annual
cash flow of Rs 5,430 for 6 years. The IRR of the Investment will be:
NPV = - Rs 20,000 + Rs 5,430 (PVIFA6,r) = 0

Rs 20,000 = Rs 5,430 (PVIFA6,r)
(PVIFA6,r) = 20,000/5,430 = 3.683
Now referring the PVIFA table in the row for 6 years.
IRR = 16% approx.
For uneven cash flows select any discount rate to compute the
present value of the cash inflow.
If Calculated PV < PV of Cash Outflow then try a lower rate.
If Calculated PV > PV of Cash Outflow then try a higher rate.
NPV and IRR
K= Discount rate
IRR is the point at which the NPV profile crosses the X-axis.
The slope of the NPV profile reflects how sensitive the project
is to discount rate changes.
Advantages of IRR:
Considers Time value of money.
True measure of profitability.
In conventional independent projects NPV & IRR method
gives same decisions.
Disadvantages of IRR:
oMultiple IRR:
In unconventional cash flow more then one IRR generated.
oMutually Exclusive Projects:

NPV & IRR may conflict each other.
Problem with IRR
Lending Projects: Project with initial outflows followed by inflows
Borrowing Projects: Project with initial inflows followed by outflows
IRR method when used in such a non-

conventional investment having both lending
and borrowing features together can lead
multiple IRR because of more then one change
of signs in cash flows.
Modified Internal
Rate Of Return
n
PVC= ∑ [Cash outflowt / (1+r)t ] [R is cost of capital]
t=0
n
TV = ∑ Cash inflowt (1+r) n-t [TV is terminal value of cash
t=0 inflow except from the project]
TV
PVC =
(1 + MIRR)n
Payback Period
Payback period refers to the period of time
required to recover the cost of the original
investment.
=
Example : Even Cash Flows
Company C is planning to undertake a project requiring

initial investment of Rs100 million. The project is expected
to generate Rs25 million per year for 10 years. Calculate the
payback period of the project.
Solution
Payback Period = Initial Investment / Annual Cash

Flow:
Rs100M / Rs25M = 4 years

Example 2: Uneven Cash Flows
Company C is planning to undertake another project requiring initial
investment of $50 million and is expected to generate $10 million in
Year 1, $13 million in Year 2, $16 million in year 3, $19 million in Year
4 and $22 million in Year 5. Calculate the payback value of the project.
(cash flows in millions)
Cumulative
Year Cash Flow Cash Flow
0 (50) (50)
1 10 (40)
2 13 (27)
3 16 (11)
4 19 8
5 22 30
Payback Period = 3 + ( 11/ 19 )
Payback Period = 3 + 0.58
Payback Period = 3.58 years
Advantages:
Provide an indication of projects risk and liquidity.
Easy to calculate and understand.
Disadvantages:
It ignores the time value of money principle, which, in turn, can
produce unrealistic expectations.
It ignores any benefits generated after the payback period.
Under most analyses, projects with shorter payback periods rank
higher than those with longer paybacks, even if the latter promise
higher returns.
Discounted Payback Period
 Disadvantage of the payback period was that it does not
take time value of money into consideration by which
flaws may arise which will adversely affect the company.
 To overcome this the discounted payback period was
introduced which takes time value of money into
consideration and give much more accurate decisions.
B
Discounted Payback Period = A +
C
Where,
A = Last period with a negative cumulative discounted cash flow;
B = Absolute value of discounted cumulative cash flow at the end of the period A;
C = Discounted cash flow during the period after A.
Example
An initial investment of Rs.2,324,000 is expected to generate Rs.600,000 per year for 6
years. Calculate the discounted payback period of the investment if the discount rate
is 11%.
Solution:
Step 1: Prepare a table to calculate discounted cash flow of each period by multiplying the
actual cash flows by present value factor. Create a cumulative discounted cash flow
column.
Present Value Discounted Cumulative

Year Cash Flow
Factor Cash Flow Discounted
n CF
CF×PV Cash Flow
0 −2,324,000 1.0000 −2,324,000 −2,324,000
1 600,000 0.9009 540,541 − 1,783,459
2 600,000 0.8116 486,973 − 1,296,486
3 600,000 0.7312 438,715 − 857,771
4 600,000 0.6587 395,239 − 462,533
5 600,000 0.5935 356,071 − 106,462
6 600,000 0.5346 320,785 214,323
Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 ≈ 5.32 years

ACCOUNTING
RATE OF RETURN
It is the ratio of
The average after tax profit divided by the average investment.
It is also known as Average Rate of Return.

Easy to understand
Dependency on the accounting data which is readily available.
Show the profitability of the project.
oBased on accounting profit rather then cash flow.

oTime value of money is ignored.
Where,
ARR>=Required RoR Accept

ARR < Required RoR Reject
EXAMPLE
Western Ltd has an option of two projects: A and B, with
the same initial capital investment of $100,000. The
profits for both projects are as follows:
Project A: Year 1 ($10,000), Year 2 ($5,000), Year 3

($15,000)
Project B: Year 1 ($12,000), Year 2 ($11,000), Year 3

($4,000)
The estimated resale value of both projects at the end of

year 3 is $22,000. Calculate the ARR for each project and
advise the firm.
Solution
For Project A:
Average profit = (10,000 + 5,000 + 15,000) / 3 = $10,000
Average investment = (100,000 + 22,000) / 2 = $61,000
Accounting rate of return = 10,000 / 61,000 = 16.39%
For Project B:
Average profit = (12,000 + 11,000 + 4,000) / 3 = $9,000
Accounting rate of return = 9,000 / 61,000 = 14.75%
Since Project A has a higher ARR, it should be chosen.

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You!!

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CAPITAL

1. Identification of Potential Investment Opportunity.

Internal Rate of Discounted Accounting Rate of

The net present value of an investment is:

the value, an investment must represent today

NPV analysis is sensitive to the reliability of future cash inflows

From the present value Table:

C=Cash inflow of the year.

Accept the project when NPV is Positive.

Reject the project when NPV is negative.

May accept or reject the project when NPV=0

Year Cash Flow

[ 900/(1.10)1 + 800/(1.10)2 + 700/(1.10)3 + 600/(1.10)4 + 500/(1.10)5 ] – 2,500

With the help of table:

[Rs 900(PVF1,0.10) + Rs 800(PVF2,0.10) + Rs 700(PVF3,0.10) + Rs 600(PVF4,0.10) +

= (900*0.909 + 800*0.826 + 700*0.751 + 600*0.683 + 500*0.621) – 2,500

PV of C1= C1/ (1+r1)

PV of C2= C2/ (1+r1 * 1+r2)

PV of C3= C3/ (1+r1 * 1+r2 * 1+r3)

NPV= (PV1 + PV2 +… + PVn) – Initial Investment

The present value will be:

NPV = 3,509 + 3,814 + 4,603 + 3,344 + 2,322 - 12,000

 It considers Time value of money.

 NPV helps in maximizing the firm's value.

 It permits time varying discount rates.

 It is the true measure of profitability as it is uses the present value

 The NPV’s of individual project can be simply added to calculate

Situations Value of firm

 Difficult to obtain estimates of cash flow practically due to

 Difficult to identify correctly the discount rates.

PVB = Present value of benefit.

>1 >0 Accept

<1 <0 Reject

BCR can be used to evaluate the economic merit of a project.

25,000/(1.12) + 40,000/(1.12)2 + 40,000/(1.12)3 + 50,000/(1.12)4

NBCR= BCR-1 = 0.145

CF = Cash Flow at the end of the year.

NPV = - Rs 20,000 + Rs 5,430 (PVIFA6,r) = 0

oMutually Exclusive Projects:

Borrowing Projects: Project with initial inflows followed by outflows

IRR method when used in such a non-

Company C is planning to undertake a project requiring

Payback Period = Initial Investment / Annual Cash

Rs100M / Rs25M = 4 years

Present Value Discounted Cumulative

Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 ≈ 5.32 years

It is also known as Average Rate of Return.

oBased on accounting profit rather then cash flow.

ARR>=Required RoR Accept

Project A: Year 1 ($10,000), Year 2 ($5,000), Year 3

Project B: Year 1 ($12,000), Year 2 ($11,000), Year 3

The estimated resale value of both projects at the end of

Since Project A has a higher ARR, it should be chosen.

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= (9000.909 + 8000.826 + 7000.751 + 6000.683 + 500*0.621) – 2,500