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Capital Budgeting Rules: NPV, IRR,

Payback, Discounted Payback, AAR


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The material in this blog post is useful to the candidates preparing for: Level I of CFA Exams.
Today, we talk about an important topic that appears in corporate finance of level I which is the
criteria used for capital budgeting. That is, we talk about techniques used in deciding whether to
accept new projects or not: NPV, IRR, Payback, Discounted Payback, AAR.
Categories of Plans
1.

Replacement Projects: decisions to replace old equipment those are among the easier of
capital budgeting techniques. It is important to decide whether to replace the equipment when
it wears out or to invest in repairing the machine.

2.

Expansion Projects: These are decisions whether to increase the size of business or not
they are more uncertain than replacement projects.

3.

New products and services: These are decisions whether to introduce new products and
services or not they are more uncertain than both replacement and expansion projects.

4.

Safety and environmental projects: These are the projects required by governmental
agencies and insurance companies these projects might not generate revenue and are not
for profits; however, sometimes it is important to analyze the cash flows because the costs
might be very high that they require analysis.

Basic Principles of Capital Budgeting


Capital budgeting usually uses the following assumptions:
1.

Decisions are based on cash flows not income

2.

Timing of cash flows is important

3.

Cash flows are based on opportunity cost: cash flows that occur with an investment
compared to what they would have been without the investment

4.

Cash flows are analyzed on after-tax basis:

5.

Financing costs are ignored because they are incorporated in WACC that is why counting
them twice would be considered double counting

Costs Concepts of Capital Budgeting


Some important capital budgeting concepts that managers find very useful are given below:
1.

Sunk costs: costs that already incurred (i.e. paid for marketing research study) Today costs
should not be affected by sunk costs

2.

Opportunity costs: what a resource is worth for next-best use Those costs should be
considered (i.e. if you use a warehouse, the current market value should be considered)

3.

Incremental cash flow: the cash flow that is realized with the project that is, the cash flow
with a decision minus the cash flow without the decision

4.

Externality: the effect of an investment on other things apart from the investment. Those can
be positive or negative and should both be considered.

Cannibalization is an example of an externality where an investment takes customers and


sales from another part of the company those should be considered in the analysis because
they are incremental cash flows (i.e. they wouldnt occur unless for the project)

More about projects


Some important comparisons in capital budgeting are:
Conventional versus nonconventional cash flows:

Conventional: Initial outflow followed by series of inflows (i.e. change of sign only occurs
once). That is, you can have + + + + + +, + + +, or + and still be considered
conventional cash flows because the sign changes only once.

Nonconventional: Initial outflow followed by series of inflows and outflows (i.e. change of
sign occurs more than once). Examples of those include + + + -, + + -, or + + +.

Independent versus mutually exclusive projects:

Independent projects: Cash flows are independent of each other. You can use both A and
B; there isnt overlap between projects. Projects here are being evaluated that could potentially
all be selected as long as their projected cash flows will produce a positive NPV or generate an
IRR greater than the firms hurdle rate.

Mutually exclusive projects: Projects that compete directly with each other (i.e. you own
some manufacturing equipment that must be replaced. Two different suppliers present a
purchase and installation plan for your consideration). Sometimes there are more than two
projects and you select one from group.

Unlimited funds versus capital rationing

Unlimited funds: It assumes the company can raise funds for all profitable projects.

Capital rationing: It exists when a company has fixed amounts of funds to invest. If the
company has more project than funds, it must allocate the funds among the projects.

Project sequencing:

One last important concept here is project sequencing where many projects are evaluated
through time; that is, investing in one project gives the option to invest for other projects in the
future. For example, you can decide to open a mall this year and if the financial results are
favorable after 5 years, you will build a hotel next to the mall.

Investment Decision Criteria


We need to ask ourselves the following questions when evaluating decision criteria:
1.

Does the decision rule adjust for the time value of money?

2.

Does the decision rule adjust for risk?

3.

Does the decision rule provide information on whether we are creating value for the firm?

Investment Decision Criteria: (1) Payback Period


Payback is the number of periods after which the initial investment is covered. The main question
used in the payback period is: how long does it take to get the initial cost back in a nominal sense?
Computation Method:
1.

Estimate the cash flows

2.

Subtract the future cash flows from the initial cost until the initial investment has been
recovered

Decision Rule:
The decision rule is to accept if the payback period is less than some preset limit.
Pros and Cons:
Pros

Cons

1.

Easy to understand.

1.

Ignores the time value of money.

2.

Biased towards liquidity.

2.

Uses an arbitrary cutoff point.

3.

Ignores cash flows beyond the cutoff date.

4.

Biased against long-term projects such as R&D and new projects

Example:
Estimate the payback period for:
Year

CF

-10,000

4,500

4,500

3,000

2,000

Solution:
To find the payback period, we need to find the cumulative cash flows first
Year

CF

-10,000

4,500

4,500

3,000

2,000

CCF

-10000

-5500

-1000

2000

4000

The payback period occurs when the cumulative cash flows changes from negative to positive. That
is, it occurs between years 2 and 3. Because we still have to recover 1000 after second year, the
payback period is: 2 + 1000/3000 = 2.33 years.

Investment Decision Criteria: (2) Discounted Payback Period


Discounted payback is the number of periods for the cumulative discounted cash flows to recover the
initial investment. The main question used in the discounted payback period is: how long does it take
to get the initial cost back in a real sense?
Computation Method:
1.

Estimate the cash flows

2.

Discount these cash flow

3.

Subtract the future discounted cash flows from the initial cost until the initial investment has
been recovered

Decision Rule:
The decision rule is to accept all projects with the discounted payback period less than a preset
limit.
Pros and Cons:
Pros

Cons

1.

Considers time value of money.

2.

Easy to grasp.

3.

1.

If you discount values, then you might want to use NPV because
discounted payback wont be easier to analyze.

2.

It may reject projects with NPV > 0.

3.

Uses an arbitrary cut-off point

4.

It ignores cash flows after cut-off point.

5.

Biased against long-term projects (new R&D projects).

Biased towards liquidity.

Example:
Estimate the discounted payback period at 10% discount rate for:
Year

CF

-10,000

4,500

4,500

3,000

2,000

Solution:
To find the discounted payback period, we need to find the cumulative discounted cash flows first:
Year

CF

-10,000

4,500

4,500

3,000

2,000

DCF

-10,000

4,090.91

3,719.01

2,253.94

1,366.03

CDCF

-10,000

-5,909.09

-2,190.08

63.86

1,429.89

The discounted payback period occurs when the cumulative discounted cash flows changes from
negative to positive. That is, it occurs between years 2 and 3. Because we still have to recover
2,190.08 after second year, the payback period is: 2 + 2190.08/2253.94 = 2.97 years.
Investment Decision Criteria: (3) Average Accounting Return
There are many different definitions for average accounting return. The most commonly used one is
the average net income to average book value. Note, however, that the average book value depends
on how the asset is depreciated.
Computation Method:
1.

Estimate the net incomes

2.

Estimate the book values

3.

Estimate average net incomes

4.

Estimate average book value (i.e. for straight-line depreciation, average book value is
[historical value salvage value]/2)

Decision Rule:
We accept the project if the AAR is greater than a preset rate.
Pros and Cons:
Pros

Cons

1.

Easy to calculate.

1.

It is not a true rate of return.

2.

Needed information will usually be available.

2.

Time value of money is ignored.

3.

Uses an arbitrary cut-off point.

4.

Based on accounting net income and book values, not cash flows
and market values.

Example:
Assume a company invests 400,000 in project depreciated using straight-line method over 4 years
with zero salvage value. The following table shows the revenues and operating expenses. Calculate
AAR using 40% tax rate:
Year

Revenue

200,000

250,000

300,000

320,000

Operating Expenses

90,000

100,000

120,000

90,000

Solution:
First, we find the net income where depreciation = (book value salvage value)/ useful life.
Deprecation is 400,000/4 = 100,000
Year

Revenue

200,000

250,000

300,000

320,000

Operating Expenses

90,000

100,000

120,000

90,000

Depreciation

100,000

100,000

100,000

100,000

Taxes = 0.4 (R-OE-D)

4,000

20,000

32,000

52,000

Net Income

6,000

30,000

48,000

78,000

Average net income = (6,000 + 30,000 + 48,000 + 78,000)/4= 40,500


Average book value = (400,000-0)/2= 200,000

Investment Decision Criteria:


(4) Net Present Value (NPV)
The net present value (NPV) is the present value of future after-tax cash flows minus initial
investment. It reflects the difference between the market value of the project and its cost.
Computation Method:
1.

Estimate the expected future cash flows.

2.

Estimate the required return for projects of this risk level.

3.

Find the present value of the cash flows and subtract the initial investment.

Where CFt is the cash flow at time t, r is the discount rate


for the investment and outlay is the investment cash flow at time 0.
Decision Rule:
We accept the project if the NPV is greater than zero. A positive NPV means that the project is
expected to add value to the firm and will therefore increase the wealth of the owners. Since our goal
is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.
Pros and Cons:
Pros

1.
2.

Cons

NPV gives importance to the time value of money.


In the calculation of NPV, both after cash flow and before cash
flow over the life span of the project are considered.

1.
2.

NPV is difficult to use.


NPV cant give accurate decision if the amount of investment of
mutually exclusive projects is not equal.

3.

Profitability and risk of the projects are given high priority.

3.

4.

NPV helps in maximizing the firms value.

4.

It is difficult to calculate the appropriate discount rate.


NPV may not give correct decision when the projects are of
unequal life.

Example:
Estimate the NPV at 10% discount rate for:
Year

CF

-10,000

4,500

4,500

3,000

2,000

Solution:

Investment Decision Criteria: (5) Profitability Index (PI)


The profitability index (PI) is very closely related to net present value (NPV). It is the present value of
cash flows dividend by the initial investments.
Computation Method:
1.

Estimate the expected future cash flows.

2.

Estimate the required return for projects of this risk level.

3.

Find the present value of the cash flows and divide by the initial investment.

Where CFt is the cash flow at time t, r is the discount rate for the investment
and outlay is the investment cash flow at time 0.
Decision Rule:

We accept the project if the PI is greater than one. PI greater than one means that the project is
expected to add value to the firm and will therefore increase the wealth of the owners.
Pros and Cons:
Pros

Cons

1.

PI helps in maximizing the firms value.

2.

PI is useful in cases of capital rationing.

1.

2.

PI cant give accurate decision if the amount of investment of


mutually exclusive projects is not equal.
It may not be easy to understand.

Example:
Estimate the PI at 10% discount rate for:
Year

CF

-10,000

4,500

4,500

3,000

2,000

Solution:

Investment Decision Criteria: (6) Internal


Rate of Return (IRR)
This is the most important alternative to NPV; it is often used in practice and is intuitively appealing.
It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere.
Computation Method:
1.

Estimate the expected future cash flows.

2.

Estimate using trial and error the discount rate that makes NPV = 0

Written out in an equation form,

Decision Rule:
Accept the project if the IRR if it is greater than the required return.
Pros and Cons:
Pros

Cons

1.

Knowing a return is intuitively appealing managers like to hear


returns.

2.

It is a simple way to communicate the value of a project to


someone who does not know all the estimation details.

3.

1.

Unrealistic assumption of reinvestment at IRR unlike NPV


which assumes reinvestment at WACC which is a realistic
assumption.

2.

IRR is not good for comparing two mutually exclusive


investments.

If the IRR is high enough, you may not need to estimate a


required return, which often is a difficult task.

Example:
Estimate the IRR at 10% discount rate for:
Year

CF

-10,000

4,500

4,500

3,000

2,000

Solution:
Using trial and error, if we start with discount rate of 17%
We find:

So we use a higher discount rate; lets say we apply a discount rate of18%, we find:

Therefore, the discount rate that makes NPV = 0 is between 17% and 18%. Keeping trial and error,
then IRR = 17.43%
IRR Alert
When using the IRR rule you have to be very careful from which standpoint you evaluate the
investment: investor or financier.
EXCEL FILE
This file can be used to solve problems related to capital budgeting techniques. In the first sheet, and
after entering conventional stream of cash flows for maximum of 15 periods, the file will solve for
payback period, discount payback period, NPV and IRR; it also shows the NPV profile. In the second
sheet, you can find average accounting return for a project given its estimated revenues, operating
expenses and book value.

Which investment decision criteria to use?


Whenever in conflict, always use NPV. This is because NPV (1) is based on cash flows not
accounting data, (2) assumes reinvestment rate at WACC and (3) does not require arbitrary cut-off
point. These all are improvements over the other capital budgeting techniques. It is important to note
that NPV and IRR will generally give us the same decision except when:
1.

Nonconventional cash flows cash flow signs change more than once

2.

Mutually exclusive projects

Initial investments are substantially different

Timing of cash flows is substantially different

Before showing the conflict between NPV and IRR, we must first discuss the concept of NPV profile

Capital Budgeting Solved Problems


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FINANCIAL
MANAGEME
NT
Solved
Problems
Rushi Ahuja1
SOLVED PROBLEMS CAPITAL BUDGETING
Problem 1

The cost of a plant is Rs. 5,00,000. It has an estimated


life of 5 years after which it would be disposed of (scrap
value nil). Profit before depreciation, interest and taxes
(PBIT) is estimated to be Rs. 1,75,000 p.a.Find out the
yearly cash flow from the plant. Tax rate 30%.
Solution
Annual depreciation charge (Rs. 5,00,000/5) 1,00,000Pr
ofit before depreciation, interest and taxes 1,75,000- D
epreciation 1,00,000Profit before tax 75,000Tax @ 30
% 22,500Profit after Tax 52,500+ depreciation (added
back) 1,00,000herefore, cash flow 1,52,500
Problem 2
A cosmetic company is considering to introduce a new
lotion. The manufacturing equipment will cost
Rs.5,60,000. The expected life of the equipment is 8
years. The company is thinking of selling the lotion in
asingle standard pack of 50 grams at Rs. 12 each pack.
It is estimated that variable cost per pack would beRs. 6
and annual fixed cost Rs. 4,50,000. Fixed cost includes
(straight line) depreciation of Rs. 70,000and allocated
overheads of Rs. 30,000. The company expects to sell
1,00,000 packs of the lotion eachyear. Assume that tax
is 45% and straight line depreciation is allowed for tax
purpose. Calculate the cashflows.
Solution
Initial cash outflow
Cost of equipments Rs. 5,60,000
Subsequent cash flows
Units sold 1,00,000Sales @ Rs. 12/- Rs. 12,00,000- Va
riable cost @ Rs. 6/- 6,00,000- Fixed cost (4,50,000 3

0,000 70,000) 3,50,000- Depreciation 70,000Profit be


fore tax 1,80,000Tax @ 45% 81,000Profit after tax 99,0
00Depreciation (added back) 70,000Cash flow 1,69,00
0There is no terminal cash inflow. It may be noted that
the allocated overheads of Rs. 30,000 gave beenignored
as they are irrelevant.
Problem 3

FINANCIAL MANAGEMENT
Solved Problems
Rushi Ahuja 2
ABC and Co. is considering a proposal to replace one of
its plants costing Rs. 60,000 and having awritten down
value of Rs. 24,000. The remaining economic life of the
plant is 4 years after which it willhave no salvage value.
However, if sold today, it has a salvage value of Rs.
20,000. The new machinecosting Rs. 1,30,000 is also
expected to have a life of 4 years with a scrap value of
Rs. 18,000. The newmachine, due to its technological
superiority, is expected to contribute additional annual
benefit (beforedepreciation and tax) of Rs. 60,000. Find
out the cash flows associated with this decision given
that thetax rate applicable to the firm is 40%. (The
capital gain or loss may be taken as not subject to tax).
Solution
(Amount in Rs.)
1. Initial cash outflow: 1,30,000Cost of new machine 2
0,000- Scrap value of old machine 1,10,0002. Subsequ
ent cash inflows (annual)Incremental benefit 60,000-

Incremental
depreciationDep. On new machine 28,000Dep. On old
machine 6,000 22,000Profit before tax 38,000- Tax
@ 40% 15,200Profit after tax 22,800+ Depreciation (
added back) 22,000Annual cash inflow 44,800The
amount of depreciation of Rs. 28,000 on the new
machine is ascertained as follows: (Rs. 1,30,000-Rs.
18,000)/4 = Rs. 28,000. It may be noted that in the
given situation, the benefits are given in theincremental
form i.e., the additional benefits contributed by the
proposal. Therefore, only the incrementaldepreciation
of Rs. 22,000 has been deduced to find out the
taxable profits. The same amount of depreciation
has been added back to find out the incremental annual
cash inflows.
Terminal cash inflow:
There will be an additional cash inflow of Rs. 18,000 at
the end of 4
th
year whenthe new machine will be scrapped away.
Therefore, total inflow of the last year would be Rs.
62,800 (i.e.Rs. 44,800 + Rs. 18,000).
Problem 4
XYZ is interested in assessing the cash flows associated
with the replacement of an old machine by a
newmachine. The old machine bought a few years ago
has a book value of Rs. 90,000 and it can be sold forRs.
90,000. It has a remaining life of five years after which
its salvage value is expected to be nil. It isbeing
depreciated annually at the rate of 20 per cent (written

down value methd).The new machine costs Rs.


4,00,000. It is expected to fetch Rs. 2,50,000 after five
years when it will nolonger be required. It will be
depreciated annually at the rate of 33 1/3 per cent
(written down valuemethod). The new machine is
expected to bring a saving of Rs. 1,00,000 in
manufacturing costs.Investment in working capital
would remain unafected. The tax rate applicable
to the firm is 50 percent.Find out the relevant cash
flow for this replacement decision. (Tax on capital gain /
loss to be ignored).

FINANCIAL MANAGEMENT
Solved Problems
Rushi Ahuja 3Solution
Initial cash flows: Amt. (Rs.)
Cost of new machine 4,00,000- Salvage value of old m
achine 90,0003,10,000
Subsequent annual cash flows:(Amount Rs.
000)
Yr.1 Yr.2 Yr.3 Yr.4 Yr.5
Savings in costs (A) 100 100 100 100 100Depreciat
ion on new machine 133.3 88.9 59.3 39.5 26.3- De
preciation on old machine 18.0 14.4 11.5 9.2 7.4Th
erefore, incremental depreciation (B) 115.3 74.5 47
.8 30.3 18.9Net incremental saving (A B) -15.3 25
.5 52.2 69.7 81.1Less: Incremental Tax @ 50% -7.6
12.8 26.1 34.8 40.6Incremental Profit -7.7 12.7 26.
1 34.9 40.5Depreciation (added back) 115.3 74.5 4

7.8 30.3 18.9Net cash flow 107.6 87.2 73.9 65.2 59


.4
Terminal cash flow:
There will be a cash inflow of Rs. 2,50,000 at the end of
5
th
year when the newmachine will be scrapped away. So,
in the last year the total cash inflow will be Rs. 3,09,400
(i.e. Rs.2,50,000 + Rs. 59,400).
Problem 5
A firm is currently using a machine which was purchased
two years ago for Rs. 70,000 and has aremaining useful
life of 5 years.It is considering to replace the machine
with a new one which will cost Rs. 1,40,000. The cost
of installation will amount to Rs. 10,,000. The increase in
working capital will be Rs. 20,000. The expectedcash
inflows before depreciation and taxes for both the
machines are as follows:
Year Existing Machine New Machine
1 Rs. 30,000 Rs. 50,0002 30,000 60,0003 30,000 70,
0004 30,000 90,0005 30,000 1,00,000The firm use
Straight Line Method of depreciation. The average tax
on income as well as on capital gains / losses is
40%.Calculate the incremental cash flows assuming sale
value of existing machine: (i) Rs. 80,000, (ii) Rs.60,000,
(iii) Rs. 50,000, and (iv) Rs. 30,000.

FINANCIAL MANAGEMENT
Solved Problems

Rushi Ahuja 4Solution


(Figures in Rs.)
Different Scrap Values
Cost of new machine 1,40,000 1,40,000 1,40,000 1
,40,000+ Installation cost 10,000 10,000 10,000 10
,000+ Additional working capital 20,000 20,000 20,
000 20,000- Scrap value 80,000 60,000 50,000 30,
00090,000 1,10,000 1,20,000
1,40,000Tax liability / saving 12,000 4,000
-8,000Cash outflow 1,02,000 1,14,000 1,02,000 1,3
2,000
Calculate of tax paid / saved:
Book value of old plant 50,000 50,000 50,000 50,0
00- Scrap value 80,000 60,000 50,000 30,000Profit
/ Loss 30,000 10,000 (20,000)Tax @ 40% on capit
al gain / loss 12,000 4,000 -8,000
Subsequent Cash inflows (Annual)(Amount
Rs. 000)
Yr.1 Yr.2 Yr.3 Yr.4 Yr.5
Cash
inflowsOn new machine 50,000 60,000 70,000 90,0
00 1,00,000On old machine 30,000 30,000 30,000
30,000 30,000Incremental cash inflow 20,000 30,0
00 40,000 60,000 70,000- Incremental depreciation
20,000 20,000 20,000 20,000 20,000Profit before t
ax - 10,000 20,000 40,000 50,000- Tax at 40% - 4,0
00 8,000 16,000 20,000Profit after tax - 6,000 12,0
00 24,000 30,000Depreciation (added back) 20,00
0 20,000 20,000 20,000 20,000Net cash inflow 20,
000 26,000 32,000 44,000 50,000

The amount of incremental depreciation has been


calculated as
follows:Depreciation of new machine = (Rs. 1,40,000
+ Rs. 10,000)/5= Rs. 30,000Depreciation on old machi
ne = Rs. 70,000/7= Rs. 10,000Therefore, incremental
depreciation = Rs. 20,000
Terminal cash flow:
There will be a terminal cash flow of Rs. 20,00 at the end
of 5
th
year in the form of working capital released.
Problem 6
A firm whose cost of capital is 10% is considering two
mutually exclusive projects X and Y, the details of which
are:
Year Project X Project Y
Cost 0 Rs. 70,000 Rs. 70,000

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