Welcome to Capital Budgeting
Analysis…
Let’s go ahead
with some words
of wisdom…
Capital as such
“ is not evil.
It is the wrong
use that is evil.
Mahatma Gandhi (1869–1948)
So, it is imperative for us to
–
Make the best use of
CAPITAL!
Capital Budgeting
This takes us to an important financial
decision…
Decision
or
Investment Decision
Do not forget that the basic
OBJECTIVE of Finance is…
VALUE CREATION!
INVESTMENT
VALUE
CAPITAL
CAPITAL BUDGETING DECISIONS
▪ Capital budgeting decisions are related to the
allocation of investible funds to different long-
term assets.
▪ They represent a situation in which lump-sum
funds are invested in the initial stages of a
project and the returns are expected over a long
period.
BASIC NATURE OF CAPITAL BUDGETING
DECISIONS
▪ Long - term decisions.
▪ Involve one or few outflows of cash but promise a future stream
of cash-inflows.
▪ Involve huge amount of investment.
▪ Generally irreversible decisions; if tried then it is very costly to
undo them.
▪ Determine the assets side of a firm’s balance sheet.
▪ Determine the earning capacity of a firm.
▪ These decisions are highly risky.
▪ These decisions are of strategic importance.
▪ These decisions are taken at higher levels in the management.
Searching for a
suitable SELECTION
CRITERIA
TECHNIQUES OF EVALUATING CAPITAL
BUDGETING DECISIONS
1. Pay Back Period Method
2. Discounted Payback Period
3. Net Present Value
4. Profitability Index
5. Internal Rate of Return
TECHNIQUES OF EVALUATING CAPITAL
BUDGETING DECISIONS
Payback Period Method
▪ The Payback period for an investment
opportunity is the number of years needed
to recover the initial cash outlay required
to make the investment.
▪ Decision Criteria: Accept the project if the
payback period is less than a prespecified
duration.
EXAMPLE
ESTIMATING PAYBACK PERIOD
Consider the following project with associated cash
flows:
Year Cash Inflows (Rs. in Crores)
0 Rs. (100.00)
1 Rs. 15.00
2 Rs. 28.00
3 Rs. 40.00
4 Rs. 30.00
5 Rs. 50.00
EXAMPLE: ESTIMATING
PAYBACK PERIOD
CALCULATION OF THE PAYBACK PERIOD
Steps for calculation of Payback Period
Cash Inflows (Rs. CUMULATIVE
▪ Find the cumulative cash flows
Year
Crores) CASH FLOWS
0 Rs. (100.00) ▪ Look for the year when
1 Rs. 15.00 -85.000 cumulative cash flows turn 0
2 Rs. 28.00 -57.000 or they change from negative
3 Rs. 40.00 -17.000
to positive. If the cumulative
cash flows turn 0 in a given
4 Rs. 30.00 13.000 year, that year itself is the
5 Rs. 50.00 63.000 payback period.
▪ Consider the year of the last
PAY BACK PERIOD 3 + (17/30) = 3.57 Years
negative cumulative cash flow
in full.
that's - 3 Years and
7 Months ▪ Then, divide the last negative
cumulative cash flow by the
subsequent positive cash flow.
Add the result of this division
to the number of years
TECHNIQUES OF EVALUATING CAPITAL
BUDGETING DECISIONS
Limitations of Payback Period Method
1. It ignores the time value of money
2. It ignores cash flows that are generated by
the project beyond the end of the payback
period.
3. It utilizes an arbitrary cutoff criterion.
TECHNIQUES OF EVALUATING CAPITAL
BUDGETING DECISIONS
Discounted Payback Period Method
▪ Discounted payback period approach is
similar except that it uses discounted cash
flows to calculate the payback period.
▪ Decision Criteria: Accept the project if its
discounted payback period is less than the
pre-specified duration.
EXAMPLE: ESTIMATING DISCOUNTED
PAYBACK PERIOD
EXAMPLE: ESTIMATING DISCOUNTED
PAYBACK PERIOD
Calculation of Discounted Payback Period
1. Find the present values of future
cash flows
2. Find the cumulative present values
of cash flows
3. Look for the year when cumulative
present values of cash flows turn 0
or they change from negative to
positive. If the cumulative cash flows
turn 0 in a given year, that year itself
is the discounted payback period.
4. Consider the year of the last
negative cumulative present value of
cash flow in full.
5. Then, divide the last negative
cumulative present value of cash
flow by the subsequent positive cash
TECHNIQUES OF EVALUATING CAPITAL
BUDGETING DECISIONS
Net Present Value
▪ The net present value (NPV) is the
difference between the present value of
cash inflows and the present value of cash
outflows. NPV estimates the amount of
wealth that the project creates.
▪ Decision Criteria: Investment projects
should be accepted if the NPV of the
project is positive and should be rejected if
the NPV is negative.
TECHNIQUES OF EVALUATING CAPITAL
BUDGETING DECISIONS
Net Present Value
Cash Flow Cash Flow Cash Flow
Net Present Cash Flow for Year 1 (CF1 ) for Year 2 (CF2 ) for Year n (CFn )
1
2
n
Value (NPV ) for Year 0 (CF0 ) Discount Discount Discount
1 1 1
Rate (k ) Rate ( k ) Rate ( k )
Cost of making the
investment = Initial cash
flow (this is typically a
cash outflow, taking on a
negative value)
EXAMPLE: CALCULATING
NPV
CALCULATION OF NPV:
EXAMPLE
▪ Hari Om Electronics provides specialty
manufacturing services to defense
contractors located in Rameshwaram. The
firm has a potential project for investment.
▪ The initial outlay is INR 30 lakhs and,
management estimates that the firm might
generate cash flows for years one through
five equal to INR 5,00,000; INR 7,50,000; INR
15,00,000; INR 20,00,000; and INR
20,00,000.
▪ The firm uses a 20% discount rate for
CALCULATION OF NPV:
EXAMPLE
Cash flows 0 1 2 3 4 5
(in INR Lakhs)
−30 +5 +7.5 +15 +20 +20
Net
Present
Value = ?
NPV = −30 + 5/(1.2) + 7.5/(1.2)2 + 15/(1.2)3 + 20/(1.2)4 + 20/(1.2)5
NPV = −30 + 4.17 + 5.20 + 8.68 + 9.65 + 8.03
NPV = INR 5.738 Lakhs
Since the NPV is positive, the project is an acceptable project.
CALCULATING NPV IN MS
EXCEL
▪ Use NPV function in MS Excel to calculate NPV of a project
Profitability Index (PI)
▪ The profitability index (PI) is a cost-benefit
ratio equal to the present value of an
investment’s future cash flows divided by its
initial cost.
Decision Criteria
▪ If PI is greater than one, the NPV will be
positive and the investment should be
accepted
▪ When PI is less than one, which indicates a bad
Profitability Index (PI): Example
▪ Sun Pharmaceuticals is considering an investment in a
new automated materials handling system that is
expected to reduce its drug manufacturing costs by
eliminating much of the waste currently involved in its
specialty drug division. The new system will require an
initial investment of $50,000 and is expected to provide
cash savings over the next six-year period as shown
below. Calculate PI if discount
Year rate isCash
Expected 10%.Flow
0 −$50,000
1 $15,000
2 $8,000
3 $10,000
4 $12,000
5 $14,000
6 $16,000
Profitability Index (PI)
▪ Step 1: Computing PV of Expected Cash flows
Year Expected Cash flow Present Value at 10% discount rate
1 $15,000 $13,636.36
2 $8,000 $6,611.57
3 $10,000 $7,513.14
4 $12,000 $8,196.16
5 $14,000 $8,692.90
6 $16,000 $9,031.58
PV of Expected Blank $53,681.72
Cash flows
▪ Step 2: Compute the PI
PI = PV of expected CF ÷ Initial Outlay
= $53,681.72 ÷ $50,000
= 1.0733
Internal Rate of Return (IRR)
▪ The IRR is the discount rate that results in a zero NPV for
the project. Cash Flow Cash Flow
Net Present Cash Flow for Year 1 (CF1 ) for Year 2 (CF2 )
1
2
Value for Year 0 (CF0 ) Internal Rate Internal Rate
1 1
of Return (IRR ) of Return (IRR )
Cash Flow
for Year n (CFn )
n
0
Internal Rate
1
of Return (IRR )
▪ Decision Criteria: Accept the project if the IRR is
greater than the required rate of return or discount rate
used to calculate the net present value of the project,
ESTIMATING IRR: EXAMPLE
• Gupta Photostat is considering the purchase of a
new copying machine for the office that can copy,
fax, and scan documents. The new machine costs
Rs. 1,36,000 to purchase and is expected to
provide cash flows over the next five years of Rs.
30,000, Rs. 40,000, Rs. 60,000, Rs. 30,000 and Rs.
20,000. Calculate the IRR for the machine. Use
10% as a starting point for discount rate in your
calculation.
ESTIMATING IRR: EXAMPLE
FORMULA FOR CALCULATION OF IRR THROUGH
INTERPOLATION
CALCULATION OF IRR THROUGH INTERPOLATION
Year Cash flows Disc. Factor at 10% P. V. at 10% Disc. Factor at 12% P. V. at 12%
0 Rs.(1,36,000) 1.000 Rs. (1,36,000) 1.000 Rs. (1,36,000)
1 Rs. 30,000 0.909 Rs. 27,273 0.893 Rs. 26,786
2 Rs. 40,000 0.826 Rs. 33,058 0.797 Rs. 31,888
3 Rs. 60,000 0.751 Rs. 45,079 0.712 Rs. 42,707
4 Rs. 30,000 0.683 Rs. 20,490 0.636 Rs. 19,066
5 Rs. 20,000 0.621 Rs. 12,418 0.567 Rs. 11,349
Net Present Value Rs.2,318.30 Rs.(4,205.64)
ESTIMATING IRR: EXAMPLE
FORMULA FOR CALCULATION OF IRR THROUGH
INTERPOLATION
2318.30
IRR=0.10 + ∗(0.12 −0.10)
2318.30 −(− 4205.64 )
IRR =10.7 %
UNDERSTANDING LINEAR
INTERPOLATION
FORMULA FOR
CALCULATION OF IRR
THROUGH
INTERPOLATION
Recall the concept of
similar triangles.
250-0
The ratio of
250-(-100) perpendicular to base
i%-5% is equal for similar
triangles.
8%-5%
UNDERSTANDING LINEAR
INTERPOLATION
,
,
ESTIMATING IRR IN MS EXCEL
▪ Use IRR function in MS Excel (when cash
flows are equidistant across time).
NPV vs IRR
▪ In majority of the cases, both criteria give
But, there
the same are some
acceptance cases when
or rejection we
decision
get
whenconflicting
two mutuallyresults.
exclusiveThese
projectscases
are
being evaluated.
occur when there is difference in
the scale of projects or timing of
cash flows or pattern of the cash
flows.
▪ In case of a conflict between NPV and IRR,
choose the project according to NPV since it
Decision Time: Take your pick –
Project 1 or Project 2?
What do NPV and IRR
suggest?
Project 1 or Project 2?
Project 2 has
higher NPV
Project 1 has
higher IRR
Notice the difference
in the size of initial
investment!
Project A or Project B?
V
r NP
i ghe
s h
A ha
je ct
Pro
Notice the difference
in timing and pattern
of cash flows!
IRR
i gher
h
B has
je ct
Pr o
NPV vs. IRR
NPV is a better selection criterion for
selecting a project
- it is simple to calculate and has a
unique value
- it directly resonates with the objective
of ‘VALUE MAXIMIZATION.’
Thank
you!
