Project Appraisal and Financing:

Profitability Index, PB, DPB, and ARR

methods

@ Ravindra Nath Shukla

Assistant Professor
ITM University, Gwalior
 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
What is Capital Budgeting?

A capital budgeting decision may

be defined as the firm’s decision to
invest its current funds most efficiently
in the long-term assets in anticipation
of an expected flow of benefits over a
series of years.
Nature of Investment Decisions

 The investment decisions of a firm are generally known

as the capital budgeting, or capital expenditure
decisions.

 The firm’s 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 firm’s 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.
Importance of Investment Decisions

 Growth

 Risk

 Funding

 Irreversibility

 Complexity
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
Investment Evaluation Criteria

 Threesteps 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
 Investment Decision Rule

 It should maximise the shareholders’ wealth.

 It should consider all cash flows to determine the true
profitability of the project.
 It should provide for an objective and unambiguous way of
separating good projects from bad projects.
 It should help ranking of projects according to their true
profitability.
 It should recognise the fact that bigger cash flows are
preferable to smaller ones and early cash flows are preferable
to later ones.
 It should help to choose among mutually exclusive projects
that project which maximises the shareholders’ wealth.
 It should be a criterion which is applicable to any conceivable
investment project independent of others.
Evaluation Criteria

 1. Discounted Cash Flow (DCF) Criteria

 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Profitability Index (PI)
 2. Non-discounted Cash Flow Criteria
 Payback Period (PB)
 Discounted payback period (DPB)
 Accounting Rate of Return (ARR)
1(a) Net Present Value
Method
 The net present value (NPV) method is the classic
economic method of evaluating the investment
proposals. It is a DCF technique that explicitly
recognizes the time value of money.
 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).
 Net Present Value Method

 The formula for the net present value can be written as follows:

 C1 C2 C3 Cn 
NPV   2
 3
   C0
 (1  k ) (1  k ) (1  k ) (1  k ) n 
n
Ct
NPV  t
 C0
t 1 (1  k )
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.
Example : A company is considering
the following investment projects:
Cash Flows in INR
Projects C0 C1 C2 C3
A – 10,000 10,000
B – 10,000 17,500 7,500
C – 10,000 12,000 4,000 12,000
D – 10,000 10,000 3,000 13,000

a) Rank the projects according to NPV methods, assuming discount

rates of 10% and 30% respectively.
b) Assuming the projects are independent, which one should be
accepted?
c) If the projects are mutually exclusive, which project is the best?
Why is NPV Important?

 Positive net present value of an investment represents

the maximum amount a firm would be ready to pay for
purchasing the opportunity of making investment, or
the amount at which the firm would be willing to sell
the right to invest without being financially worse-off.

 The net present value can also be interpreted to

represent the amount the firm could raise at the
required rate of return, in addition to the initial cash
outlay, to distribute immediately to its shareholders
and by the end of the projects’ life, to have paid off all
the capital raised and return on it.
 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
Example : 1

 Calculatethe net present value of the

project at discount rates of 0, 10, 40,
50 and 100 per cent.
1(b) INTERNAL RATE OF RETURN METHOD
 The internal rate of return (IRR) method is another
discounted cash flow technique, which takes account
of the magnitude and timing of cash flows
 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.

∑
∑
 It can be noticed that the IRR equation is the same
as the one used for the NPV method.
 In the NPV method, the required rate of return, k, is
known and the net present value is found,
 while in the IRR method the value of r has to be
determined at which the net present value becomes
zero.
 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.
Example
 A project costs Rs.16,000 and is expected to generate cash inflows of
Rs.8,000, Rs.7,000 and Rs.6,000 at the end of each year for next 3 years.
 We know that IRR is the rate at which project will have a zero NPV. As a
first step, we try (arbitrarily) a 20 per cent discount rate. The project’s
NPV at 20 per cent is:

 A negative NPV of Rs.1,004 at 20 per cent indicates that the project’s

true rate of return is lower than 20 per cent. Let us try 16 per cent as the
discount rate.
Example
A project costs Rs.16,000 and is
expected to generate cash
inflows of Rs.8,000, Rs.7,000
and Rs.6,000 at the end of each
year for next 3 years.
 At 16 per cent, the project’s NPV is:

 Since the project’s NPV is still negative at 16 per

cent, a rate lower than 16 per cent should be tried.
Let’s try to calculate NPV at 15 per cent as the trial
rate.
 The 15% discount rate the project’s NPV is :

 When we select 15 per cent as the trial rate, we find that the project’s
NPV is Rs.200. Thus the true rate of return should lie between 15–16
per cent.
 We can find out a close approximation of the rate of return by the
method of linear interpolation as follows:
CALCULATION OF IRR

 Level Cash Flows

 Let us assume that an investment would cost Rs.20,000 and provide
annual cash inflow of Rs.5,430 for 6 years. If the opportunity cost of
capital is 10 per cent, what is the investment’s NPV?
 The Rs.5,430 is an annuity for 6 years. The NPV can be found as follows:

 The IRR of the investment can

be found out as follows
 The rate, which gives a PVFA of 3.683 for
6 years, is the project’s internal rate of
return. Looking up PVFA in Table across
the 6-year row, we find it approximately
under the 16 per cent column. Thus, 16
per cent is the project’s IRR that equates
the present value of the initial cash
outlay (Rs.20,000) with the constant
annual cash inflows (Rs.5,430 per year)
for 6 years.
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
Example
 2. A project costs Rs.81,000 and is expected
to generate net cash inflow of Rs.40,000,
Rs.35,000 and Rs.30,000 over its life of 3
years. Calculate the internal rate of return of
the project.

 3. A machine will cost Rs.100,000 and will

provide annual net cash inflow of Rs.30,000
for six years. The cost of capital is 15 per
cent. Calculate the machine’s net present
value and the internal rate of return. Should
the machine be purchased?
Examples

 4. Consider the following three investments:

The discount rate is 12 per cent. Compute the net

present value and the rate of return for each
project.
Example
 5. Consider the following two mutually
exclusive investments:

 (a) Calculate the NPV for each project assuming discount rates
of 0, 5, 10, 20, 30 and 40 per cent;
 (b) draw the NPV graph for the projects to determine their IRR,
 (c) show calculations of IRR for each project confirming results
in (b).
 Also, state which project would you recommend and why?
Example
 6. For Projects X and Y, the following cash
flows are given:

 (a) Calculate the NPV of each project for discount rates 0, 5, 8,

10, 12 and 20 per cent. Plot these on an PV graph.
 (b) Read the IRR for each project from the graph in (a).
 (c) When and why should Project X be accepted?
 (d) Compute the NPV of the incremental investment (Y – X) for
discount rates, 0, 5, 8, 10, 12 and 20 per cent. Plot them on
graph.
 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.
 The formula for calculating benefit-cost ratio or profitability
index is as follows:

∑
 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 percent rate of
discount. The PV of cash inflows at 10 percent discount rate is:

∑
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

 Theproject with positive NPV will have PI greater than

one. PI less than means that the project’s NPV is
negative.
 Evaluation of PI Method

 Time value:It recognises the time value of money.

 Value maximization: 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.

 Relative profitability: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 project’s 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.
Example
 A company is considering the following six projects:

You are required to calculate the profitability index for each

project and rank them ?
Solution

Projects 2 and 1 are best in terms of 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:
Initial Investment C0
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 project’s 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.
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
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
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.

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
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

 TheARR method may claim some

merits
 Simplicity
 Accounting data
 Accounting profitability
 Serious shortcomings
Cash flows ignored
Time value ignored
Arbitrary cut-off
THANK YOU!