CAPITAL BUDGETINGINVESTMENT DECISION

Prepared by Sumit Goyal - LPU

CONTENTS
Introduction Techniques of capital budgeting Accounting Rate of Return Method Payback Period Method Net Present Value (NPV) Method Internal Rate Return (IRR) Method Issues with IRR Multiple IRRs Mutually Exclusive Projects Advantages of NPV Method Advantages of IRR Method Modified IRR Method
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LEARNING OBJECTIVES
Understand the nature and importance of investment decisions Explain the methods of calculating net present value (NPV) and internal rate of return (IRR) Show the implications of net present value (NPV) and internal rate of return (IRR) Describe the non-DCF evaluation criteria: payback and accounting rate of return Illustrate the computation of the discounted payback Compare and contrast NPV and IRR and emphasize the superiority of NPV rule
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Nature of Investment Decisions

The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions.
The firms investment decisions would generally include expansion, acquisition, modernisation and replacement of the longterm assets. Sale of a division or business (divestment) is also as an investment decision.
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Nature of 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.

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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

Capital budgeting decisions are characterized by:
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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CAPITAL BUDGETING PROCESS

Identification of investment proposals - where Screening and evaluation of the proposals Fixing priorities Final approval and preparation of capital expenditure budget Implementing proposals Performance review
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Investment Evaluation Criteria

Three steps are involved in the evaluation of an investment:
1. Estimation of cash flows 2. Estimation of the required rate of return (the opportunity cost of capital) 3. Application of a decision rule for making the choice

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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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Techniques Of Evaluation
The methods of financial evaluation of the projects are categorized into two: Discounted Cash Flow (DCF) techniques and Non DCF techniques. DCF techniques value the projects with time value of money and include a) NPV Method and b) IRR Method Non-DCF based techniques of a) Accounting Rate of Return and b) Pay Back Period.

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Evaluation Criteria
1. Non-discounted Cash Flow Criteria
Payback Period (PB) Accounting Rate of Return (ARR)

2. Discounted Cash Flow (DCF) Criteria

Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) Discounted payback period (DPB)

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

Example
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:
Rs 50,000 PB 4 years Rs 12,000

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.

Payback Period Method

Payback period of the project is the amount of time required to recover the original investment.

Initial cash outflow Cash inflows 1st Year 2nd Year 3rd Year 4th Year

10,00,000 3,00,000 5,00,000 4,00,000 5,00,000

Payback period for the project is 2 years.

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Payback period
A company is planning a major investment to expand its current manufacturing of digital clocks with initial outlay of Rs 350 Lakh. The finance department has projected a following cash flows over the next 7 years are, 100, 150, 400, 450, 300, 250, 50. What is the payback period of the project?

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Evaluation of Payback
Certain virtues:
Simplicity Cost effective Short-term effects Risk shield Liquidity

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

Accounting Rate Of Return

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

It is merely a number, which reflects the worthiness of the project in absolute terms. 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 METHOD

The accounting rate of return is the ratio of the average aftertax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly.

or
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.

Example
A project will cost Rs 40,000. Its stream of earnings before depreciation, interest and taxes (EBDIT) during first year through five years is expected to be Rs 10,000, Rs 12,000, Rs 14,000, Rs 16,000 and Rs 20,000. Assume a 50 per cent tax rate and depreciation on straight-line basis.

Calculation of Accounting Rate of Return

Practical Problem
A company is considering a proposal to purchase a new machine. The equipment would involve a cash outlay of Rs. 5,00,000 and working capital of Rs. 60,000. the expected life of the project is 5 years. Depreciation method is straight line method. The estimated before tax cash inflow (earnings before depreciation and tax) are as 180000, 220000, 190000, 170000, 140000. The applicable tax rate is 35%.

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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.

Accounting Rate Of Return

The advantage of the method is its simplicity of calculation

Limitations
Subjective Approach Ignore Time Value of Money Not Based on Cash Flow Inconsistent definition
Pre tax or post tax Accounting basis Total investment or equity

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Discounted Cash Flow Methods

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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.
Discounted Payback Illustrated

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. Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate. Net present value should be found out by subtracting present value of cash outflows from present value of cash inflows. The project should be accepted if NPV is positive (i.e., NPV > 0).

Steps And Meaning Of NPV

1. 2.
3. 4.

Estimate the initial cost to implement the project, CF0, Estimate the cash flows of the project for each period over its life, CFt, Sum the discount the cash flows at an appropriate rate to arrive at present value of the cash flows, Subtract the initial investment from the present value to get the Net Present Value of the project. NPV is value created by the acceptance of the project. It reflects the increase in the market value of the firm.

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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.

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.

Practical Problem
A company is considering investment in a project that costs Rs. 200000. the project has an expected life of 5 years and zero salvage value. The company uses SLM of depreciation. The companys tax rate is 40%. .
Year EBDT

1
2 3 4

70000
80000 120000 90000

60000

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Practical Problem
A company is considering a proposal to purchase a new machine. The equipment would involve a cash outlay of Rs. 5,00,000 and working capital of Rs. 60,000. the expected life of the project is 5 years. Depreciation method is straight line method. The estimated before tax cash inflow (earnings before depreciation and tax) are as 180000, 220000, 190000, 170000, 140000. The applicable tax rate is 35%.

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Computing NPV Project A

Year Year 0 Year 1 Year 2 Year 3 Cash flow -10,00,000 Present Value at 10% -10,00,000

5,00,000 5,00,000/1.1 = 4,54,545 5,00,000 5,00,000/1.12 = 4,13,223 5,00,000 5,00,000/1.13 = 3,75,657 12,43,425 10,00,000 = 2,43,425

NET PRESENT VALUE

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Computing NPV Project B

Year Year 0 Year 1 Year 2 Cash flow -10,00,000 Present Value at 10% -10,00,000

8,00,000 8,00,000/1.1 = 7,27,273 2,00,000 2,00,000/1.12 = 1,65,289

Year 3

8,00,000 8,00,000/1.13 = 6,01,052

14,93,614 10,00,000 = 4,93,614

NET PRESENT VALUE

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Computing NPV Projects A & B Combined

Year Year 0 Year 1 Year 2 Cash flow -20,00,000 Present Value at 10% -20,00,000

13,00,000 13,00,000/1.1 =11,81,818 7,00,000 7,00,000/1.12 = 5,78,512

Year 3

13,00,000 13,00,000/1.13 = 9,76,709

27,37,039 20,00,000 = 7,37,039

NET PRESENT VALUE

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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 NPV of Project B NPV of A & B Combined 2,43,425 4,93,614 7,37,039

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Profitability index
Profitability index= present value of inflows/ present value of outflows

Net profitability index = P.I -1

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Advantages
In which different costs are there we can not rank as NPV method so profitability index can be used for the same.

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Internal Rate Of Return (IRR) Method

Internal Rate of Return (IRR) of the project is that rate of return at which the net present value is zero.
CF t CF0 t 1 (1+ r)
n

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

110 121 200 2 1 r (1 r )

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IRR Decision Rule And NPV

Decision Rule: The IRR of the project is 10%. It is compared with the cost of capital to make judgment about its desirability. ACCEPT IF IRR > COST OF CAPITAL REJECT IF < COST OF CAPITAL It is the maximum discount rate that the cash flows of the project can support.
Net Present Value, NPV = 110 121 - 200 1.08 1.082

= 101.85 +103.74 200 = Rs 5.59

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Practical Problem
Suggest the company whether they should invest in the project or not as per 1. 2. 3. 4. 5. 6. Pay back period method Discounted pay back period method Net present value Internal rate of return Accounting rate of return. Net Profitability index
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Practical Problem
A company is considering a proposal to purchase a new machine. The equipment would involve a cash outlay of Rs. 5,00,000 and working capital of Rs. 60,000. the expected life of the project is 5 years. Depreciation method is straight line method. The estimated before tax cash inflow (earnings before depreciation and tax) are as 180000, 220000, 190000, 170000, 140000. The applicable tax rate is 35%.

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NPV And Discount Rate

As discount rate increases NPV falls. The discount rate at which NPV is zero is called IRR.
Net Present Values & Discount Rate

80.00 60.00
NPV 40.00

20.00 0 (20.00) Discount Rate (%)

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10

20

28.23

35

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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Advantages Of NPV Method

Simplicity of NPV Re-investment rate

The implied assumption of IRR method is that interim cash flows are reinvested at IRR itself. NPV method assumes reinvestment at discount rate. This assumption of IRR is challenged as it defies conservatism

Flexibility in choosing discount rate Measuring wealth creation Ranking of the project in capital rationing situation Unambiguous acceptance and rejection criterion makes NPV rule superior to IRR rule.
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Advantages Of IRR Method

Despite its conflicts and drawbacks, IRR remains a popular method of evaluation of projects because of
Its ability to compare projects without the consideration of discount rate, Easier comprehension.

Cost of capital not required to find IRR. It is required to make selection or rejection decision. For comparative purposes no need to know the cost of capital. Priority for early cash flows.

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Inflation And Capital Budgeting

The principle of consistency in capital budgeting demands that nominal cash flows are discounted at nominal discount rate real cash flows are discounted at real discount rate.

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