CAPITAL BUDGETING

DECISION

INVESTMENT EVALUATION CRITERIA

Three steps are involved in the evaluation of

an investment:
Estimation of cash flows
Estimation of the required rate of return
Application of a decision making choice.

Investment Criteria
(1) Discounted Cash Flow (DCF) criteria
(i) Net present value
(ii) Internal rate of return.
(iii) Profitability index or Benefit-cost ratio.

(2) Traditional criteria

(i) Payback period
(ii) Accounting rate of return

 NET PRESENT VALUE METHOD

The steps involved in the NPV method are:

Cash flows of the investment projects should be
forecasted based on realistic assumptions.
Appropriate cost of capital should be selected to
discount cash flows.
The present value of investment proceeds (i.e., cash
inflows) and the present value of investment outlay (i.e.,
cash outflows) should be computed using cost of capital
as the discounting rate.
The net present value should be found out by subtracting
the present value of cash outflow from the present value
of cash inflows.
The project should be accepted if NPV is positive.

The Equation for the Net Present Value

The equation for the net present value, assuming
that all cash outflows are made in the initial year
(to), will be:

NPV= {A1/(1+k) + A2/(1+k)2 + + An/(1+k)n} - C

n

At / (1+k)t

-C

.. (1)

t =1

where A1, A2 ...represent cash inflows, k is the

firm's cost of capital, C is the initial outlay of the
investment proposal and n is the expected life of
the proposal.

Acceptance Rule
Accept if NPV > 0
Reject if NPV < 0
Marginal project if NPV = 0

ILLUSTRATION 1
Calculate the net present value for Project
A which initially costs Rs.2,500 and
generate year-end cash inflows of Rs.900.
Rs.800, Rs.700, Rs.600 and Rs.500 in
one through five years. The required rate
of return is assumed to be 10 per cent.

Net Present Value of Project A

Year

Cash inflows
(Rs)

Discounting factor at 10%

PV of cash inflows
(Rs)

1
2
3
4
5

900
800
700
600
500

.909
.826
.751
.683
.620
Total PV
Less: investment outlay
Net present value

818
661
526
410
310
2725
2,500
225

EVALUATION OF THE NPV METHOD

ADVANTAGE
Time value:

It recognizes the time value of money

Measure of true profitability

Shareholder value

Limitation
Cash flow estimation
Discount rate
Ranking of projects

Ranking of investment projects as per the NPV rule is

not independent of the discount rates.

Consider the following two projects A and B

Project

t0

t1

t2

A
B

-Rs50
-Rs50

Rs100
Rs30

Rs25
Rs100

Project

NPV at 5%

Rank

NPV at 10%

Rank

A
B

67.92
69.27

II
I

61.57
59.91

I
II

INTERNAL RATE OF RETURN METHOD

Assume that you deposit Rs1,000 in a
bank and would get back Rs1,100 after
one year.
What is the rate of return of investment?
Rate of return = (1,100 -1,000)/1,000
=100/1000=0.10 or 10 percent.

INTERNAL RATE OF RETURN METHOD

We can develop the formula

r = (C1-C0 ) /C0 = C1 / C0 - 1
Or 1+r = C1 / C0
Or C0 = C1 / (1+r)
(2)
This implies that the rate of return is the
discount rate which equates the present
value of cash inflow to the present value of
cash outflow.

INTERNAL RATE OF RETURN METHOD

The internal rate of return can be defined as that rate
which equates the present value of cash inflows with
the present value of cash outflows of an investment.
It can be determined by solving the following
equation:
C= A1/(1+r) + A2 /(1+r)2 + A3 /(1+r)2 +.+ An /(1+r)n

n
= A t /(1 + r)t
.(3)
t =1

ILLUSTRATION 2

A project costs Rs16,000 and is expected

to generate cash inflows of Rs8,000,
Rs7,000 and , Rs6,000 over its life of three
years. You are required to calculate the
internal rate of return of the project.

To start with, we select a rate of 20 per cent and

calculate the present value of cash inflows:
Year

Cash inflows Discount Present value

factor at (Rs)
(Rs)
20%

1
2
3

8,000
7,000
6,000

.833
.694
.579

6,664
4,858
3,474
_______
Total PV
14,994
Less: cash outflow 16,000
_______
NPV
(-)1,004

The net present value indicates that the chosen rate is a higher rate.
Therefore, lower rates should be tried. We try 18 per cent,16 per cent
and 15 per cent and obtain the following results:
Year

Cash
inflow
(Rs)

Discount
factor (DF)
18%

PV
(Rs)

DF 16% PV
(Rs)

DF 15% PV
(Rs)

8,000

.847

6,776

.862

6,896

.870

6,960

7,000

.718

5,026

.769

5,201

.756

5,292

6,000

.609

3,646

.641

3,846

.658

3,948

Total PV

15,456

15,943

16,200

Less: cash
outlay

16,000

16,000

16,00

NPV

(-)544

(-)57

200

 At 16 percent discount rate the projects NPV is (-)Rs57,

and 15 percent discount rate the NPV is Rs200.
Thus the true rate of return should lie between 15 and 16
percent.
We can find out a close approximation of the rate of
return by the method of linear interpolation as follows;
r =15% + (16% -15%) 200/257

=15%+ 0.80% = 15.8%

 Acceptance Rule
Accept if r>k
Reject if r<k

PROFITABILITY INDEX
It is the ratio of the present value of future cash benefits to the
initial cash outflow of the investment.
It may be gross or net, net being simply gross minus one.
The formula to calculate benefit-cost ratio or profitability index
is as follows:
PI = PV of Cash Inflows / Initial Cash Outlay
n

{At/ (1+k)t} / C
t =1

..(4)

 Acceptance Rule

Accept if PI > 1
Reject if PI < 1
Marginal project if PI = 1

 ILLUSTRATION 3
The initial cash outlay of a project is Rs.
100,000 and it generates cash inflows of
Rs.40,000, Rs.30,000, Rs.50,000 and Rs.
20,000 in the four years. Calculate the
NPV and PI of the project. Assume a 10
per cent rate of discount.

Calculation of NPV and Profitability Index

Year

Cash inflows
(Rs)

Discount factor

Present value
(Rs)

40,000

0.909

36,300

30,000

0.826

24,780

50,000

0.751

37,550

20,000

0.683

13,660

Total PV
Less: outlay

1,12,350
1,00,000

NPV
PI

12,350
1,12350/1,00,000 = 1.1235

PAYBACK PERIOD
The payback (or payout) period is one of the most
popular and widely recognized traditional methods of
evaluating investment proposals. It is defined as 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 dividing cash outlay by the annual cash inflow.
That is:
Payback period
=Cash outlay (investment) / Annual Cash inflow (A)
= C/A
..(5)

ILLUSTRATION 4
A project requires an outlay of Rs 50,000
and yields an annual cash inflow of Rs.
12,500 for 7 years. Calculate the payback
period.
The payback period for the project is:
Rs 50,000 / Rs12,500 = 4 years

ILLUSTRATION 5
Calculate the payback period for a project which
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.
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:

 When we add up the cash inflows, we find that in the first

three years Rs.19,000 of the original outlay is recovered.
In the fourth year cash inflow generated is Rs.3,000 and
only Rs.1,000
of the original outlay remains to be
recovered.
Assuming that the cash inflows occur evenly during the
year, the time required to recover Rs.1,000 will be (Rs.
1,000/Rs.3000) x 12 months =4 months. Thus, the
payback period is 3 years and 4 months. .

PAYBACK PERIOD DECISION RULE

1. Post payback Duration.
2. Payback should only be used as an initial
screening of projects.
3. The payback period also offers some indication
of risk.
4. Liquidity.

 Acceptance Rule
Accept if the calculated PB period < the
maximum PB period set up by the management.
Reject if the calculated PB period
> the
maximum PB period set up by the management.
Marginal project, if the calculated PB period =
the maximum PB period set up by the
management.

ILLUSTRATION 6
Calculate the payback periods of the following projects each
requiring a cash outlay of Rs.10,000. Suggest which ones are
acceptable if the standard payback period is 5 years.

Year

Project X

Project Y

Project Z

1
2
3
4
5

Rs 2,500
2,500
2,500
2,500
2,500

Rs 4,000
3,000
2,000
1,000
0

Rs 1,000
2,000
3,000
4,000
0

Payback period:

For Project X = Rs 10,000 / Rs 2,500 = 4 yrs

For Project Y =
Rs.4,000+ Rs.3,000+ Rs.2,000+Rs.1,000
= Rs.10,000 recovered in 4 years
For Project Z = Rs.1,000+Rs.2,000+Rs.3,000
+Rs.4,000

= Rs.10,000 recovered in 4 years

 The payback period in each case is 4

years, as at the end of fourth year the
initial cash outlay of each project is
recovered. All projects are acceptable
because the standard payback period is
higher than the actual payback periods of
all projects.

Evaluation
Advantages

Simplicity
Cost effective
Risk shield
Liquidity

Limitation
First, it fails to take account of the cash inflows earned after
the payback period.
Consider the following projects X and Y:

Project

C0

C1

C2

C3

Payback

NPV at k=.
10

X
Y

-4,000
-4,000

0
2,000

4,000
2,000

2,000
0

2 years
2 years

+806
-530

Limitation
Second, it fails to consider the pattern of cash inflows, i.e.,
magnitude and timing of cash inflows.
Consider the following projects X and Y:
Project

C0

C1

C2

C3

Payback

NPV at k=.
10

C
D

-5,000
-5,000

3,000
2,000

2,000
3,000

2,000
2,000

2 years
2 years

+881
+798

Limitation
Third, there is no rational basis for
setting a maximum payback period. It is
generally a subjective decision.
F o u r t h , i t i s i n c o n s i s t e n t w i t h
shareholder value.

Payback Reciprocal and the Rate of Return

Payback is considered theoretically useful

in a few situations. One significant
argument in favour of payback is that its
reciprocal is a good approximation of the
rate of return under certain conditions.
The payback period is defined as follows:
Payback

= Initial investment /Annual cash inflow (annuity)

= C /A

 In general terms, the PV of an annuity may

be expressed as follows:
PVA=
C = A/(1+r) + A/(1+r)2+ ..+ A/(1+r)n-1+ A/(1+r)n (6)
Where PVA = present value of an annuity which has a
duration of n periods, A= Annuity, r = discount rate.

 The formula for the PV of an annuity is derived as follows:

C = A/(1+r)+A/(1+r)2+ ..+ A/(1+r)n-1+ A/(1+r)n
(6)
Multiplying both sides of (6) by (1+r) gives:
C(1+r) = A + A/(1+r) + A/(1+r)2+ ..+ A/(1+r)n-1
Subtracting (6) from (7) yields:
Cr = A[1- (1+r)-n]

.(7)
..(8)

 Solving for r, we find

r = A[1- 1/(1+r) n] / C = A/C A/C [1/(1+r) n] (9)
Where C is the initial investment, A is annual cash inflow,
r is rate of return and n is the life of investment.
If n is very large or extends to infinity, the second term
becomes insignificant.
Thus r = A/C = the reciprocal of payback, if the following
two conditions are fulfilled:

(1) The life of the project is large.

(2) The project generates equal annual cash inflows.

DISCOUNTED PAYBACK PERIOD

One of the serious objections to the payback method is
that it does not consider the time value of money.
Thus we can discount cash flows and then calculate the
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 for two projects P and Q

C0

C1

C2

C3

C4

Simple
PB

Discounted
PB

NPV
at 10%

P
PV of
cash
flows

-4,000

3,000

1,000

1,000

1,000

2 yrs

-4,000

2,727

826

751

683

2.6 yrs

987

Q
PV of
cash
flows

-4,000

4,000

1,000

2,000

-4,000

3,304

751

1,366

2.9 yrs

1,421

2 yrs

NET PRFSENT VALUE Vs PROFITABILITY INDEX.

Consider the following illustration where the two methods give
different ranking to the projects.
ILLUSTR.4TION 8
Project C
(Rs)

Project D
(Rs)

PV of Cash inflows

1,00,000

50,000

Initial cash outflow

50,000

20,000

NPV

50,000

30,000

PI

1,00,000/50,000 50,000/20,000
= 2.0
= 2.5

 Project C should be accepted if we use the NPV

method, but Project D is preferable according to
the PI. The question, therefore, to be answered
is: which method is better?
The NPV method should be preferred, except
under capital rationing, because the net present
value represents the net increase in the firm's
wealth.

Project C will also be acceptable if we calculate the

incremental profitability index. This is shown as follows

Project C
(Rs)

Project D
(Rs)

Incremental
flow (Rs)

PV of Cash
inflows

1,00,000

50,000

50,000

Initial cash
outflow

50,000

20,000

30,000

NPV

50,000

30,000

20,000

PI

1,00,000 /50,000
=2

50,000/20,000
= 2.5

50,000/30,000
=1.7

Consider a different situation

Project A
(Rs)

Project B
(Rs)

PV of Cash inflows 3,00,000

2,00,000

Initial cash outflow 2,00,000

1,00,000

NPV

1,00,000

1,00,000

PI

3,00,000/2,00,000 2,00,000/1,00,000
= 1.5
=2

NET PRESENT VALUE Vs INTERNAL RATE OF RETURN

Equivalence: Conventional investment

We know that
n

NPV = {At / (1+k)t} C

(11)

t =1

and IRR is defined to be that rate r which satisfies the following

equation:
n

0=

{At / (1+r)t} C

(12)

t =1

Subtracting Eq. (12) from (11), we get

n

NPV =

[ {At / (1+k)t} {At / (1+r)t}]

t =1

As we know that At , k, r, and t are positive,

NPV >0, if r>k.
NPV = 0, if r=k, and
NPV <0, it r<k.

.(13)

The following figure substantiates this above arguments

NPV
a2

a1

0
a3

r1

r2

r3

If the discount rate (say r1) is lower than r2, the NPV is positive. Thus the
project will be accepted under both the methods
If the discount rate is r2 which is also IRR, the NPV is zero
If the discount rate (r3) higher than r2, the NPV is negative. Thus the project
will be rejected under both the methods.

Difference: Case of Ranking Dependent

Projects

The conflicting ranking by the two

methods occurs under the following
conditions:

1. The cash flow pattern of the projects may

differ. That is, the cash flows of one project
may increase over time, while those of the
other decrease.
2. The projects have different expected lives.
3. The cash outlay of one project is larger than
that of the other.

Timing of cash flows

A commonly found condition for the conflict between the
two methods is the timing of the cash flows. Let us
consider the following illustration.

Project C0
M
N

C1

C2

-1680 1,400 700

-1680 140
840

C3

NPV at IRR
9%

140
1,510

301
321

Which project should we accept?

23%
17%

NPV Profiles of Projects M and N

Discount rate (%)

Project M

Project N

0
5
10
15
20
25
30

560
409
276
159
54
-40
-125

810
520
276
70
-106
-257
-388

NPV versus IRR

NPV
1000

800

400

Project N

Project M

600

200

0%
-200
-400

5%

10%

15%

20%

25%

30%

 The internal rates of the two projects are 23

percent and 17 per cent respectively.
At 10 per cent required rate both methods are
equally profitable if we use the NPV method.
It is also noticeable that if the required rate of
return is less than 10 percent (the rate at which
NPVs of both the projects are equal), project N
has the higher NPV but lower IRR, 17 per cent.
On the other hand, if the required rate of return
is greater than 10 per cent, project M has both
higher NPV as well as higher IRR, 23 per cent.

Which project should we choose between Projects M and N?

Both projects generate positive NPV at 9% cost of capital.

Therefore, both are profitable.
But Project N is better since it has higher NPV.
The IRR rule, however, indicates that we should choose Project M
as it has a higher IRR.
If we choose Project N, following the NPV rule, we shall be richer by
an additional value of Rs20.
Should we have the satisfaction of earning a higher rate of return, or
should we like to be richer?
The NPV rule is consistent with the objective of maximising wealth.

Incremental approach
If we prefer Project N to Project M, there should be incremental
benefits in doing so. To see this let us calculate the incremental flows
of Project N over Project M. We obtain the following cash flows:

Project

C0

C1

C2

C3

NPV
at 9%

IRR

(N-M)

-1,260

140

1370

20

10%

2.The projects have different expected lives.

Project

t0

t1

-10,000

12,000

-10,000

t5

20,120

NPV
(k=10%)

IRR

909

20%

2,493

15%

Incremental Approach
Project

t0

t1

t5

NPV
(k=10%)

IRR

Y-X

-12,000

20,120

1,584

13.8%

 NPV = PV of inflow PV of outflow

= 20,120 / (1.1)5 - 12,000/(1.1)

=12493 10909 = 1,584

IRR is calculated as follows:

12,000 / (1+r) = 20120 / (1+r)5
(1+r)4 = 20,120 / 12,000 = 1.67 = (1.138)4 = (1+.138)4
r = 0.138 = 13.8%

3. Scale of Investment
Project

t0

t1

NPV
(k=10%)

IRR

-1,000

1,500

363.50

50%

-100,000

120,000

9080

20%

Incremental Approach
Project

t0

t1

NPV at 10%

IRR

(N-M)

-99,000

118,500

8,727

19.75

Non-conventional Investments :
Problem of Multiple IRRs
Let us consider the following project I:
Project

C0

C1

-1000

4,000 -3750

C2

We can use the IRR formula to solve the internal rate of return of
this project
4000 / (1+r) - 3750 / (1+r)2 =1,000

 Assuming 1/(1+r) = x, we obtain

-3750 x2 + 4000x 1000 =0
This is the quadratic equation of the form: ax2 + bx +c =0, and we
can solve it by using the following formula:
x = [-b (b2-4ac)1/2 ] / 2a
Substituting values in the above equation, we obtain
x= [-4000 {40002-4(-3750)(-1000)}1/2 ] / 2(-3750)
= [-4000 1,000]/ (-7500) = 2/5, 2/3
Since x= 1/(1+r) , therefore
1/(1+r) = 2/5, 1/(1+r) = 2/3
r = 3/2 or 150%, r=1/2 or 50%

 Assuming 1/(1+r) = x, we obtain

-3750 x2 + 4000x 1000 =0
This is the quadratic equation of the form: ax2 + bx +c =0, and we
can solve it by using the following formula:
x = [-b (b2-4ac)1/2 ] / 2a
Substituting values in the above equation, we obtain
x= [-4000 {40002-4(-3750)(-1000)}1/2 ] / 2(-3750)
= [-4000 1,000]/ (-7500) = 2/5, 2/3
Since x= 1/(1+r) , therefore
1/(1+r) = 2/5, 1/(1+r) = 2/3
r = 3/2 or 150%, r=1/2 or 50%

Dual Rates of Return

NPV

250

0
-250

-500

-750

50%

100%

150%

200% discount rate

NPV, IRR, REINVESTMENT ASSUMPTION and MIRR

Consider two projects A and B both of which have initial cash outlay
of Rs1000,000. Cash inflows of both the projects are as follows:

Project A
Project B

C1

C2

C3

C4

C5

400,000
100,000

400,000
100,000

400,000
100,000

400,000
1000,000

400,000
1000,000

NPV of Project A using 10% cost of capital

Year

Cash flow

PV factor at 10% PV

1
2
3
4
5

400,000
400,000
400,000
400,000
400,000

0.90909
0.82644
0.75131
0.68301
0.62092

363,636
330,579
300,526
273,206
248,369
________
PV of inflows
1516,315
PV of outflows 1000,000
__________
NPV
516,315

NPV of Project B using 10% cost of capital

Year

Cash flow

PV factor at 10% PV

1
2
3
4
5

100,000
100,000
100,000
1000,000
1000,000

0.90909
0.82644
0.75131
0.68301
0.62092

90,909
82,645
75,131
683,013
620,921
________
PV of inflows
1552,620
PV of outflows 1000,000
__________
NPV
552,620

Calculation of IRR
Calculation of IRR of project A
Let IRR be r, then
1000,000 = 400,000/(1+r) + 400,000/(1+r)2 + 400,000/(1+r)3 +

400,000/(1+r)4 + 400,000/(1+r)5
Solving this equation we get IRR for project A is 28.65%

Calculation of IRR of project B

Let IRR be r, then
1000,000 = 100,000/(1+r) + 100,000/(1+r)2 + 100,000/(1+r)3 +

1000,000/(1+r)4 + 400,000/(1+r)4
Solving this equation we get IRR for project B is 22.8%

Mutually Exclusive Projects

We have got the following results
Project

NPV

IRR

A
B

Rs516,315
Rs552,620

28.65%
22.8%

If the projects A and B are mutually exclusive, which project

should we select?

 If for both A and B the cost of capital were different, say 25%, we
would calculate different NPVs and come to a different conclusion.
In this case:
Project

NPV

IRR

A
B

Rs75,712
-Rs67,520

28.65%
22.8%

Project A still has a positive NPV, since its IRR > 25%, but B has a
negative NPV, since its IRR<25%.

Reinvestment assumption
When evaluating mutually exclusive projects, the one
with the highest IRR may not be the one with the best
NPV. The IRR may give a different decision than NPV
when evaluating mutually exclusive projects because of
the reinvestment assumption:

NPV assumes cash flows are reinvested at the cost of capital.

IRR assumes cash flows are reinvested at the internal rate of return

NPV assumes cash flows are reinvested at the cost of capital.

Assume cash flows of a project are Rs100 ,

Rs10 and Rs110 for the year t = 0,1,and 2.
If the cost of capital is k=9%, NPV of the project
is
NPV = 10/(1.09) + 110/(1.09)2 - 100

=9.1743+92.5847 100 = 1.759

NPV assumes cash flows are reinvested at the cost of capital.

If the cash inflow of Rs10 received at the end of

year 1 is reinvested @9%, it would be Rs10(1+.
09) = Rs10.90 at the end of year 2.
Thus the total inflow at the end of year 2 is
Rs(110+10.9) = Rs120.9.
Using cost of capital of k=9%, NPV is again the
same amount
NPV = 120.90/(1.09)2 - 100 = 101.759 100 = 1.759

IRR assumes cash flows are reinvested at the internal rate of return

Assume cash flows of a project are Rs100 ,

Rs10 and Rs110 for the year t = 0,1,and 2. Find
the IRR of the project.
Assuming IRR =r, we get
100 = 10/(1+r) + 110/(1+r)2
Solving this equation we get r=10%.

IRR assumes cash flows are reinvested at the internal rate of return

If the cash inflow of Rs10 received at the end of year 1 is

reinvested @10%, it would be Rs10(1+.1) = Rs11 at the
end of year 2.
Thus the total inflow at the end of year 2 is Rs(110+11) =
Rs121.
Assuming IRR =r, we get
100 = 121/(1+r)2 or (1+r)2 = 121/100 = 1.21 =(1+0.1)2
Thus we get r=10%.

What do you do with the cash

inflows when you get them?
We generally assume that if you receive cash inflows,
youll reinvest those cash flows in other assets.
Suppose we can reasonably expect to earn only the cost
of capital on our investments. Then for projects with an
IRR above the cost of capital, we would be overstating
the return on the investment using the IRR.
Consider project A once again. If the best you can do is
reinvest each of the Rs400,000 cash flows at 10%, these
cash flows are worth Rs2442,040:

 Future value of project As cash inflows each invested at 10%

= Rs400,000 (FVAF10%, 5)
=Rs400,000 (6.2051) = Rs2442,040
Investing Rs1000,000 at the beginning of the year 1 produces a
value of Rs2442,040 at the end of year 5 (cash flows plus the
earnings on these cash flows at 10%).
This means that if the best you can do is reinvest cash flows at 10%,
then you earn not the IRR of 28.65%, but rather 19.55%:
FV = PV (1+i)n
Rs2442,040 = Rs1000,000 (1+i)n
i = 19.55%

 Consider projects A and B and their MIRRs with reinvestment at the

cost of capital:

Project

MIRR

IRR

NPV

A
B

19.55%
20.12%

28.65
22.79%

Rs516,315
Rs552,619