Evaluating Projects

Capital Budgeting Concepts

Tanvi Gupta

IBS

Sessions 12 -13
Sessions 12 -13
Project Initiation &
Project Initiation &
Resource Allocation-
Resource Allocation-
Presentations & Discussions
Presentations & Discussions
Market and demand Analysis
Market and demand Analysis
Forecasting
Forecasting
Technical Analysis –
Technical Analysis –
Presentations
Presentations
Sessions 7-12
Sessions 7-12
Selection Contd…
Selection Contd…
Project Risk Analysis
Project Risk Analysis
Sensitivity, Hiller Model & Decision Tree
Sensitivity, Hiller Model & Decision Tree
Project Rate of Return, Real Options
Project Rate of Return, Real Options
Sessions 6
Sessions 6
Project
ProjectAppraisal
CEC
CEC11
Sessions 3-5
Sessions 3-5
Project Selection- Appraising
Project Selection- Appraising
Projects
Projects
Time Value of Money – A recap
Time Value of Money – A recap
Investment Criteria
Investment Criteria
Modified NPV, IRR , Simple, Non-
Modified NPV, IRR , Simple, Non-
Simple , Pure and Mixed
Simple , Pure and Mixed
Investment
Investment
Session 1 -2
Session 1 -2
Overview: Capital Investments
Overview: Capital Investments
Process
Process
Key Issues in major investment
Key Issues in major investment
IBS
decisions
decisions
Structure
Sessions Session 15-16
Sessions14
14 Session 15-16
Structuring Projects:
Mid Structuring Projects:
MidSem
Sem Application of Portfolio
Application of Portfolio
Theories to Capital
Theories to Capital
Budgeting- Asset Beta
Budgeting- Asset Beta
from Equity Beta
from Equity Beta
Session 17-22
Session 17-22
Cost of Project, Means of
Cost of Project, Means of
Finance, Estimation of Working
Finance, Estimation of Working
Capital, Profitability Estimations,
Capital, Profitability Estimations,
Balance Sheet Projections etc.
Balance Sheet Projections etc.
CEC -3
CEC -3
Sessions 23-25
Sessions 23-25
Semester
SemesterIII
III Environment Appraisal of
Environment Appraisal of
Projects – Presentations
Appraisal&& Projects – Presentations
Social Cost Benefit Analysis-
Social Cost Benefit Analysis-
Finance Presentations & Discussions
Finance Presentations & Discussions
Session 26-27
Session 26-27
Multiple Projects & Constraints
Multiple Projects & Constraints
Ranking, Feasible Combinations
Ranking, Feasible Combinations
Approach. Integer programming, Goal
Approach. Integer programming, Goal
Programming – An overview
Programming – An overview
Sessions 28-29
Sessions 28-29
Project Review,
Project Review,
Sessions
Sessions30
30
Abandonment Analysis
Abandonment Analysis
Detailed Project Reports –
Revision & Quiz
Revision & Quiz
Detailed Project Reports –
Discussions
Discussions
 Session Plan

1. Capital Budgeting Concepts

2. Features of Capital Budgeting Decision
3. Techniques of evaluation
4. Criteria for viability testing
5. NPV V IRR
6. Indifference Point
7. Modified NPV
8. Modified IRR
9. Annual Capital Charge
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Capital Budgeting
Capital budgeting decisions relate to
acquisition of assets that generally have
long-term strategic implications for the firm.
Capital budgeting decisions become fairly
intricate as it impacts other areas of
corporate finance like capital structure,
dividends and cost of capital.

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Features Of Capital Budgeting Decision

Non-reversible,
Large initial outflow followed by small
periodic inflows,
Information gap and inexperience,
Strategic and risky in nature,
No scope of learning and correcting from past
experience
Little flexibility.

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Types Of Projects
Small vs Large Projects
New vs Expansion Projects
Independent and Mutually Exclusive
projects
Mutually exclusive projects are those where
acceptance of one implies automatic
rejection of the other.
Research & Development and
Mandatory Projects

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 Financial Appraisal
Financial appraisal of any project looks at return and risk
characterising that particular project and examines whether
return exceeds the cost of financing the project.

The first step is appropriate compilation of data on cost of the

project, means of financing and projected revenues and costs.

The next step is to appraise the viability of the project using

different criteria of merit.

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Techniques Of Evaluation

The methods of financial evaluation of the

projects are categorized into two:
Non DCF techniques.
Discounted Cash Flow (DCF) techniques

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 Appraisal Criteria

Evalu at io n Cr it e r ia

Non- D is count in g Cr it e r ia Dis count in g Cr it e r ia

Payback Per io d Account in g Rat e of Ret u r n Net Pr e sent Valu e Benef it Cost Rat io I n t e r n al Rat e of Ret u r n
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 Payback Period Method

Payback period of the project is the amount of time

required to recover the original investment.
• Simple in both concept and application.
• Weeds out risky project ensuring acceptance of
those with substantial earlier inflows.

When done on discounted cash flow basis it is

called discounted payback period.

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Payback period contd…

An illustration:
A project with an initial outflow of Rs 10 lakhs is
expected to generate a constant inflow of Rs
2,50,000 for a period of 10 years.
Pay back period = 10 / 2.5 = 4 years
The project is paying you back the amount invested
in four years. Shorter the PB period, the better.

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 Payback Period-Illustration -1

• Find the payback period

Initial cash outflow 10,00,000
Cash inflows 1st Year 3,00,000
2nd Year 5,00,000
3rd Year 4,00,000
4th Year 5,00,000

Payback period for the project is 2½

years.

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 Pay Back Period- Illustration 2

 For Projects with uneven inflows :

The inflows are cumulated to find the payback period. An illustration:

Initial outflow of the project is 10 lakhs. The inflows are as under:
Inflows Cumulative Inflows
1. 150000 150000
2. 300000 450000
3. 320000 770000
4. 230000 1000000 The payback period is 4 years
5. 350000
6. 320000
7. 350000
8. 270000
9. 280000
10. 400000

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 Decision Rule
 If the project’s PB period is less than a cut-
off period earmarked for similar projects,
accept it.

 If there are multiple projects, accept the one

with lowest PB period.

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 Shortcomings of PB Period Criteria

The time value of money is not considered. This can

be overcome by introducing discounting factor in the
inflows of the project.
 Ignores post PB period cash inflows. It is more a
measure of capital recovery.
 Inability to handle Multiple Cash Out Flows

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 Accounting Rate Of Return

Accounting Rate of Return is defined as

average profit as % of average investment
over the life of the project
Average Profit
Accounting Rate of Return =
Average Investment

To enable the firm make a conscious decision

whether to accept or reject a proposal, it
needs to be compared with some acceptance/
rejection criteria.

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 Accounting Rate Of Return- Illustration
Accounting rate of return =
Average PAT/ Average book value of investment
An illustration:
Year Sales Revenue Opex Depreciation Annual Income
0 (90000)
1 120000 60000 30000 30000
2 100000 50000 30000 20000
3 80000 40000 30000 10000
Average annual income = (30000+20000+10000)/3
= 20000
Average book value of investment = (90000 + 0) /2 = 45000
ARR = 20000/45000 = 44%

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 Decision Rule

If ARR is greater than the external yardstick of similar

projects or of industry, accept the project.
For Multiple projects project with highest ARR should
be accepted.

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 Merits & Shortcomings of ARR criteria

Merits:
Return on investment unlike return of investment as in
PB period
Considers returns over entire life of project
Shortcomings:
Time Value of money is ignored
Accounting income and not cash flows are
considered.

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 Net Present Value (NPV)

 NPV is the difference between present value of inflows and

present value of outflows.
 Money has time value.
Firstly, money can be employed productively to generate real
returns
Secondly, due to uncertainties in future , individuals prefer
current consumption to future consumption
Thirdly, due to inflation a rupee today has a higher purchasing
power than a rupee in the future.
 The three components of nominal or market interest rate = Real
rate of interest or return + expected rate of inflation + risk
premium to compensate for uncertainty.
 To calculate present value of future flows, an appropriate
discounting rate is used.
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 NPV - Illustration 1
 That discounting rate can be comprehended as cost of capital
An illustration:
Initial outflow of the project is 10 lakhs. The inflows are as under:
Yr Inflows PVIF(10%) PV inflows
1. 150000 .909 136350
2. 300000 .826 247800
3. 320000 .751 240320
4. 230000 .683 157090
5. 350000 .621 217350
6. 320000 .564 180480
7. 350000 .513 179550
8. 270000 .467 126090
9. 280000 .424 118720
10. 400000 .386 154400
------------
PV of inflows 18,08,150
=======
NPV = PV of inflows – PV of outflows
= 18,08,150 – 10,00,000
= ₹ 8,08,150
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 Decision Rule
If NPV is positive, accept the project as after taking
into consideration the uncertainties and riskiness the
project is generating positive returns.
If NPV is negative , reject the proposed project.
If NPV is zero , theoretically one should be indifferent
but in practice marginally viable projects should be
rejected.
In case of multiple projects, project with highest NPV
should be accepted.

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Computing NPV Illustration 2
Project ‘A’

Year Cash flow Present Value at 10%

Year 0 -10,00,000 -10,00,000
Year 1 5,00,000 5,00,000/1.1 = 4,54,545
Year 2 5,00,000 5,00,000/1.12 = 4,13,223
Year 3 5,00,000 5,00,000/1.13 = 3,75,657
NET PRESENT VALUE 12,43,425 – 10,00,000
= 2,43,425

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Computing NPV – Illustration 2 contd
Project ‘B’

Year Cash flow Present Value at 10%

Year 0 -10,00,000 -10,00,000
Year 1 8,00,000 8,00,000/1.1 = 7,27,273
Year 2 2,00,000 2,00,000/1.12 = 1,65,289
Year 3 8,00,000 8,00,000/1.13 = 6,01,052
NET PRESENT VALUE 14,93,614 – 10,00,000
= 4,93,614

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Additive Property Of NPV

NPVs of different projects can be added to

arrive at total NPV.
NPV (A+B) = NPV (A) + NPV (B)
Additive property of NPVs helps in isolating the
impact that each project makes on the value of
the firm.
NPV of Project ‘A’ 2,43,425
NPV of Project ‘B’ 4,93,614
NPV of A & B Combined 7,37,039

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Excel Formula for NPV
 Net Present Value: Illustration

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 Merits & Shortcomings of NPV Criteria
Merits:
 Recognizes time value of money
 Considers entire stream of cash flows

Shortcomings:
 Change in discounting rate affects the desirability of
project
 As an absolute measure, acceptance of project with
higher NPV may involve acceptance of project with
higher initial outflow. (16-8=8 – Project A, 12-5= 7 – Project B)
 According to NPV Project A is better but a comparison at the outflow clearly
entails Project A with higher outflow (BCR would have been a better
proposition in such cases
 Not suitable for comparison of projects with different
economic lives Project with higher PV may also have a
longer economic life –funds getting blocked for a longer
period. (We use Equivalent Annual Charge)
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 Benefit-cost ratio (BCR)criteria
Popularly known as Profitability Index
BCR is the ratio of PV of inflows to Outflows
It is a relative measure
BCR = PV of Inflows/PV of outflows.
Continuing with the same illustration, BCR =
18,08,150/10,00,000
=1.808 > 1, the project can be accepted.

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 Decision Rule

If BCR > 1 project is qualified for acceptance

If BCR < 1 the project should be rejected

If BCR = 1 then one is indifferent about the project

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 Merits & Shortcomings
Merits :
Recognises time value of money
Totality of benefits are considered
Relative Measure

Shortcomings:
In Multiple projects situations with limited funds ,
wherein more than one project can be accepted, BCR
cannot be used as index cannot be aggregated

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 Internal Rate of Return(IRR)
Also known as yield on investment, marginal
efficiency of capital
IRR is the rate at which present values of inflows are
just equal to outlays.
Under NPV criterion, discounting factor taken is as
per the external factors like risk, uncertainties and
cost of funding the project, While IRR is based on the
facts internal to the proposal, hence it is named so.
Mathematically, IRR is the discounting rate (internal)
which makes its NPV zero. But actually, It is return on
investment taking time value in consideration.

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IRR….
At Internal Rate of Return (IRR) of the project the net
present value (calculated at IRR) is zero.
n
CFt
∑ (1+ r)t = CF0
1

For a project outlay of Rs. 200 and cash inflows for next
2 years at ₹ 110 and ₹ 121, the IRR may be found as
follows:

110 121
+ = 200
1 + r (1+ r )2

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 IRR- Illustration - 2
An initial outflow of ₹ 135000
Yr Cash Flow
1 30000
2 40000
3 45000
4 47500
5 50000

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IRR- Illustration - 2 contd
 IRR is that rate of return which equates PV of inflows to outflow

135000 = 30000/(1+r) + 40000/(1+r)2 + 45000/(1+r)3 + 47500/(1+r)4 +

50000/(1+r)5

Thus IRR is the r to be found out from the above equation

 Steps for finding out IRR:
1. Fake Payback period to be calculated. Add up all the inflows and find
an average inflow. Based on average inflow , rate/rates from the
table of PVIFA to be taken against respective life of the project.
2. Adjust it for the pattern of cash flow. (whether it is increasing or
decreasing)
3. Calculate the PV using the rates and interpolation technique

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 Example 2 contd….
 Average of inflows is 42500.(Adding up all inflows and dividing by
5)
 Fake PB period = 135000/42500 = 3.1764 years.
 Looking for the above factor in PVIFA table in the row of 5 years,
the nearest figure is 3.127 against 18% and 3.199 against 17%( or
3.2743 against 16%)
 Adjusting for the pattern of flows, as the cash flows are in
increasing order the discounting rates should be reduced by say
2%. (As IRR is return, due to the higher discounting at the later
years , lesser return is generated)
 Then substituting the values of 15% and 16% the PV of inflows are
respectively 137938.05 and 134457.66. One greater than the initial
outflow and one less.
 Interpolating between the two we get
 15 % + (137938.05-135000)/(137938.05-134457.66) X (16% -
15%) = 15.84 % IBS
 IRR- Illustration - 2
An initial outflow of ₹ 135000
Yr Cash Flow PV(15%) PV (16%)

1 30000 30000 x.870 30000x.862

2 40000 40000x.756 40000x.743
3 45000 45000x.658 45000x.641
4 47500 47500x.572 47500x.552
5 50000 50000x.497 50000x.476
---------------- ------------------
Total 137938.05 134457.66
========= ==========

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 Decision Criteria

If IRR > Cost of funds, accept the project

If IRR < Cost of funds, reject the project
If IRR = Cost of funds, One is indifferent about the
project.
If there are two or more projects, project generating a
higher IRR, should be accepted.

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 Merits & Shortcomings
Merits:
Recognizes time value of money
Cash flow considered in its entirety
Helps in assessing margin of safety of project
Variations in cost of capital does not change ranking
of projects
Shortcomings:
Projects with mixed stream of flows may have more
than one IRR

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NPV And IRR

Under most circumstances the priorities of the

projects as given by NPV rule and IRR rule are
identical.
Under cases of non-conventional cash flows and
mutually exclusive projects there is a possibility of
the conflict in decision-making rules of NPV and IRR.

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NPV And Discount Rate
As discount rate increases NPV falls.
The discount rate at which NPV is zero is the IRR.

Net Present Values & Discount Rate

80.00

60.00

NPV 40.00

20.00

-
0 10 20 28.23 35
(20.00)
Discount Rate (%)

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NPV And IRR – Decision Rules
A Comparison
As per NPV rule:
The project is accepted as long as the discount rate is
below 28.23% because the net present value remains
positive till then.
It is rejected for discount rate beyond 28.23%.
As per IRR rule:
The project is accepted as long as cost of capital
remains below 28.23%, the IRR of the project.
It is rejected if cost of capital exceeds 28.23%.

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Mutually Exclusive Projects
NPVs and IRRs
NET PRESENT VALUES OF PROJECT A & B

100.00

80.00

60.00

NPV
( Rs.)
40.00

20.00

-
- 5.00 10.00 15.00 20.00 25.00 30.00

(20.00)
Discount Rat e ( % )
NPV(A) NPV(B)

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Point Of Indifference
Due to varying sensitivities to the discount rate, the
NPVs of two project would intersect at some point.
The point of indifference is that discount rate at which
the NPV of two projects is equal.
NPVA = NPVB
IRR of the differential cash flow gives the
discount rate at which NPVs of the two projects,
is equal.

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NPV And IRR
Under most circumstance the priorities of the projects
as given by NPV rule and IRR rule are identical.
Under cases of non-conventional cash flows and
mutually exclusive projects there is a possibility of
the conflict in decision-making rules of NPV and IRR.

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Mutually Exclusive Projects
NPVs and IRRs
NET PRESENT VALUES OF PROJECT A & B

100.00

80.00

60.00

NPV
( Rs.)
40.00

20.00

-
- 5.00 10.00 15.00 20.00 25.00 30.00

(20.00)
Discount Rat e ( % )
NPV(A) NPV(B)

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NPV V IRR
NET PRESENT VALUES OF PROJECT A & B

100.00

NPV(B) > NPV(A)

80.00
Project B is
preferable over
Project A
60.00

NPV
( Rs.)
40.00

20.00

-
- 5.00 10.00 15.00 20.00 25.00 30.00

NPV(A) > NPV(B)

(20.00)
Project A is
preferable over Di scou n t Rat e ( % )
Project B NPV(A) NPV(B)

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 Modified NPV

The standard net present value method is based

on the assumption that the intermediate cash flows are
re-invested at a rate of return equal to the cost of capital.

When this assumption is not valid, the re-investment

rates applicable to the intermediate cash flows need to
be defined for calculating the modified net present value

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 Modified NPV
Calculate the terminal value of the project’s cash inflows using the
explicitly defined reinvestment rate(s) which are supposed to reflect the
profitability of investment opportunities ahead of the firm.
n
TV = Σ CFt (1+r t)n-t
t=1

Step 2: Determine the modified net present value

TV
NPV* = -I

(1+ r)n

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Modified NPV – Illustration Contd.. With Two
Different Reinvestment rate Project X
Project X Cost of capital
Investment outlay 1,10,000 Terminal value
1,10,000 10%
on reinvestment when
Cash inflows interest rate is
Year Project X 14% 20%
1 31,000 45,928 53,568
2 40,000 51,984 57,600
3 50,000 57,000 60,000
4 70,000 70,000 70,000
2,24,912 2,41,168
Formula for Project X at 14%
Modified Net Present
Value of Project X 43,618 54,721

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Modified NPV – Illustration Contd.. With Two
Different Reinvestment rate Project Y
Terminal value on reinvestment when
Cash inflows interest rate is
Year Project Y 14% 20%
1 71,000 1,05,190 1,22,688
2 40,000 51,984 57,600
3 40,000 45,600 48,000
4 20,000 20,000 20,000
2,22,774 2,48,288
Formula for Project Y at 14%
Modified Net Present
Value of Project Y 42,157 59,584

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 Problems with IRR
• Non-Conventional Cash Flows

• Mutually Exclusive Projects

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 Non-Conventional Cash Flows

C0 C1 C2
-160 +1000 -1000

TWO IRRs : 25% & 400%

NO IRR : C0 C1 C2
150 -450 375

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 Mutually Exclusive Projects

C0 C1 IRR NPV
(12%)

P -10,000 20,000 100% 7,857

Q -50,000 75,000 50% 16,964

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 Modified IRR

 Modified IRR method is an attempt to reconcile with NPV

method by overcoming the objection of reinvestment rate
 Under the modified IRR method the cash in flows of each
year are converted to terminal year by compounding them
at cost of capital/any other suitable reinvestment rate.

It is consistent with NPV method.

It eliminates the problem of multiple IRRs if it exists
by taking a single flow at beginning and single cash
flow at the end of the project.
 It assumes a more realistic reinvestment rate (Usually
Cost of Capital) consistent with conservatism policy.
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Modified IRR – An Illustration
Modified IRR : Illustration
( All amounts in Rs. Million)
Terminal value
Present value of the cash
Year Cash flow of costs inflows
0 -120 120
1 -80 69.57
2 20 34.98
3 60 91.25
4 80 105.80
5 100 115.00
6 120 120.00
189.57 467.03
Cost of capital 15%

MIRR 16.22%
Formula MIRR(B4:B10,0.15,0.15) 16.22%

189.57 = 467.03/(1+r)^6
r = 16.2%

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Annual Capital Charge- An appraisal
Criteria

Annual Capital Charge is an appraisal criteria for

projects:
1. With unequal life spans
2. Mutually exclusive providing similar services
3.Differing in Cost Patterns

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 Steps for Computing ACC
Present Value of Initial Investment and Operating
Costs using appropriate discount rate
Divide the sum ( as computed in the first step) by
PVIFA of the life of the projects
Quotient is denoted as the ACC or Annual Capital
Charge or Equivalent Annual Cost

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Criteria for ACC

Compare the two or more projects/ alternatives

The Project/alternative with minimum annual capital
charge (ACC) is to be selected.

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Illustration
 Hindustan Forge Ltd is evaluating two alternative systems A and
B for internal transport. While the two system serve the same
purpose, system A has a life span of 7 years and system B , a
life of 5 years. Assume cost of capital to be 12%.( Salvage value
can be assumed to be nil) The initial outlay and operating costs
associated with the system are:
Year A B
- 1,000,000 800,000
1 100,000 75,000
2 125,000 100,000
3 150,000 120,000
4 175,000 140,000
5 200,000 100,000
6 225,000
7 200,000

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Solution

Year A PV (12%) B PV(12%)

- 1,000,000 1,000,000 800,000 800,000
1 100,000 89,286 75,000 66,964
2 125,000 99,649 100,000 79,719
3 150,000 106,767 120,000 85,414
4 175,000 111,216 140,000 88,973
5 200,000 113,485 100,000 56,743
6 225,000 113,992
7 200,000 90,470
Total 1,724,865 1,177,813
PVIFA (12, 7) 4.564
PVIFA (12, 5) 3.605
ACC 377,928.32 326,716.37

As ACC for System B is lower, System B is preferred

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An Illustration
A project with the following inflows:

Year Cash Flow

0 -300000
1 0
2 417000
3 117000

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 IRR- Unrecovered Investment Balance

Year Unrecovered Interest for Cash Flow at Unrecovered

Investment the year Ft-1 the end of Investment
Balance *r the year Ct Balance at
the end Ft-1
(1+r)+Ct
1 -300000 -90000 0 -390000
2 -390000 -117000 417000 -90000
3 -90000 -27000 117000 0

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 Summary

1. Cash Flow to be used for Capital Budgeting decisions.

2. For Financial appraisal of projects, non-discounting and discounting
techniques are used
3. Payback period and Accounting rate of return are simple non-discounting
technique used
4. PB period shows capital recovery
5. ARR takes Accounting income as the base
6. NPV is the difference between cash inflows and outflow after taking time value
and discounting factor into consideration
7. BCR is a relative measure – ratio of PV of inflows to outflow
8. IRR is the rate of return of the project wherein its inflows just equal outflows
9. NPV & IRR may differ in their viability decision for non-conventional flows.
10. Modified IRR (closer to NPV criteria )
11. Annual Capital Charge for comparing projects with unequal lives.
12. Unrecovered Investment Balance – An Introduction

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 Any Queries?

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