1

CAPITAL BUDGETING
Capital budgeting refers to the process where we make

decisions concerning investments in the long-term assets of the firm. Capital budgeting is a decision situation where large funds are committed (invested) in the initial stages of the project and the returns are expected over a longer period of time usually more than one year and in case this decision goes wrong, it can not be changed which will affect the future growth of the firm.

FEATURES OF CAPITAL BUDGETING

1. Capital budgeting decisions have longterm implications.

2. These decisions involve commitment of funds.

substantial

3. These decisions are irreversible and require analysis of minute details. 4. These decisions determine and affect the future growth of the firm.
3

Decision-making Criteria in Capital Budgeting

How do we decide if a capital investment project should be accepted or rejected?

To make decisions, we need:

Initial cash investment/outflows Future cash benefits/inflows Rate of return (why)

A case study
Suppose ABC firm must decide whether to purchase a new machine for Rs. 1,00,000. This machine is expected to generate annual cash inflows of Rs. 20,000, Rs. 50,000 and Rs. 60,000 during next 3 years at 10% capitalisation rate. How do we decide?
6

Problems and constraints in cabital budgeting

Time factor Calculation of required rate of

return Calculation of future benefits

Capital budgeting process

Evaluation consists of:

1. 2. 3. 4. 5.

Estimating relevant cash outflows and cash inflows Estimating Appropriate rate of return Comparing relevant cash outflows and cash inflows by any suitable technique to take the decision: Payback period Average rate of return Net present value Profitability index Internal rate of return
9

Estimating relevant cash outflows and cash inflows

1. 2. 3.

Estimating relevant cash outflows and cash inflows depend upon the nature of investment decisions: Single/Independent decisions Replacement decisions Mutually Exclusive decisions

10

Single/Independent decisions
Calculation of CO
Cost of new plant

+ Installation expenses + Other Capital expenditure + Additional working capital

11

Single/Independent decisions
Calculation of CI for subsequent years

Cash sales revenue - Cash operating cost = Cash inflows before tax (CFBT) - Depreciation = Profits before tax/Taxable income - Tax = Profit after tax + Depreciation = Cash inflows after tax (CFAT)
12

Single/Independent decisions
Calculation of CI for TERMINAL CASH
FLOW: Cash inflows after tax (CFAT) for last year + Working capital released + Scrap value of the plant (if any).

13

Case
A cosmetic company is considering introducing a new

lotion. The manufacturing equipment will cost Rs. 5,60,000. Working capital requirement is expected to increase by Rs. 40,000. The expected life of the equipment is 8 years. The company is thinking of selling the lotion at Rs. 12 each pack. It is estimated that variable cost per pack would be Rs. 6 and annual fixed cost Rs. 3,50,000. The company expects to sell 1,00,000 packs of the lotion each year. Tax rate is 45% and straight-line depreciation is allowed for tax purpose. Calculate the cash flows assumimg: 1. Working capital requirement remains same each year. 2. Working capital requirement increases by Rs. 5,000 each year
14

ANOTHER CASE
A manufacturing department of a firm estimates that 3,000

units of a product can be sold annually at a unit cash sale price of Rs. 14. The cash variable expenses will be Rs.9 per unit. It will also involve cash fixed cost of Rs. 5,000 yearly. The machine to manufacture the product is available at Rs. 50,000. It expected useful life is 10 years. The installation cost would amount to Rs. 10,000. As a result of the acquisition of the machine, the working capital requirement will increase by Rs. 40,000. The firm uses the straight line method (SLM) of depreciation and is in the 50% tax bracket. Your are required to compute the relevant cash flows associated with the acquisition of the machine, assuming There is no salvage value The salvage value is Rs. 2,000 but for depreciation purpose: a) It is ignored b) it is considered

15

Lets try..
A firm plans to buy an asset costing Rs.

1,00,000 and expects CFBT to be Rs. 30,000 p.a. Depreciation will be charged @20% WDV. Tax rate is 30%. Estimated life is 4 years after which it will be disposed off for Rs. 45,000. Your are required to compute the relevant cash flows
16

REPLACEMENT PROJECTS
Calculation of CO Cost of new plant

+ Installation expenses + Other Capital expenditure + Additional working capital Salvage value of old plant + Tax liability on account of capital gain on sale of old plant / Tax benefit on account of capital loss on sale of old plant
17

REPLACEMENT PROJECTS
Calculation of CI for subsequent years

(incremental basis i.e., new old)

Cash sales revenue (N-O) - Cash operating cost (N-O) = Cash inflows before tax (CFBT) - Depreciation (N-O) = Profits before tax/Taxable income - Tax = Profit after tax + Depreciation (N-O) = Cash inflows after tax (CFAT) (N-O)

18

REPLACEMENT PROJECTS
Calculation of CI for TERMINAL CASH
FLOW: Cash inflows after tax (CFAT) (N-O) for last year + Working capital released + Scrap value of the plant (if any).

19

Case
A firm is currently using a machine which was purchased 2 years ago

for Rs. 70,000 and has a remaining 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 expected cash inflows before depreciation and taxes are as follows Year Existing Machine New Machine 1 30,000 50,000 2 30,000 60,000 3 30,000 70,000 4 30,000 90,000 5 30,000 1,00,000 The firm uses SLM and is in 40% tax bracket. Calculate cash flows assuming sale value of old machine is 1) 80,000 2) 60,000 3) 50,000 4) 30,000
20

Lets try..
ABC Ltd. in considering an investment proposal for which the relevant

information is as follows Purchase price of the new asset Rs.I0,00,000 Installation costs 2,00,000 increase in working capital in year zero 2,50,000 Scrap value of the new asset after 4 years 3,50,000 Revenues from new asset (Annual) 21,50,000 Cash expenses on new asset (Annual) 9,50,000 Current Book value (old asset) 4,00,000 Present scrap value (old asset) 5,00,000 Revenue from old asset (Annual) 19,25,000 Cash expenses on old asset (Annual) 11,25,000 Planning period is 4 years. Depreciation on new asset: 92% the cost is to be depreciated in the ratio of 5:8:6:4 over 4 years. Existing asset is depreciated at a rate of Rs. 1,00,000 p.a. Tax rate is 40%. Your are required to compute the relevant cash flows

21

Mutually Exclusive

22

2. DECISION CRITERIA
TECHNIQUES OF EVALUATION

Traditional or

Time-adjusted or

Non-discounting

Discounted cash flows

1. Payback period 2. Accounting Rate of Return

1. Net Present Value 2. Profitability Index 3. Internal Rate of Return

23

Case
A company is considering an investment proposal to instal new

milling controls. It will cost Rs. 50,000. The facility has a life expectancy of 5 years and no salvage value. Company tax rate is 35%. The firm uses straight line depreciation. The estimated cash flows before depreciation and tax from the proposed investment proposal are as follows: Year Cashflows 1 Rs. 10,000 2 Rs. 10,692 3 Rs. 12,769 4 Rs. 13,462 5 Rs. 20,385 Compute the following: (a) Payback period. (b) Average Rate of Return. (c) Net Present Value at 10% discount rate. (d) Profitability Index at 10% discount rate. (e) Internal Rate of Return

24

TRADITIONAL OR NON-DISCOUNTING TECHNIQUES

I . PAYBACK PERIOD:

The number of years required to recover a projects cost, or how long does it take to get the businesss money back?
25

Equal cash inflows

PB = CO/equal CI

(500) 150 150 150 150 150 150 150

How long will it take for the project to generate enough cash to pay for itself?

150

8
26

Payback period = 3.33 years.

 Is a 3.33 year payback period good? Is it acceptable? Firms that use this method will compare the payback calculation to some standard set by the firm. If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision? Accept
27

Unequal Cash inflows

PB ?
(500) 100 150 200 100 150 100 50 150

Payback period = 3.5 years.

28

TRY..
Delhi Machinery Manufacturing Company wants to replace

the manual oprations by new machine. There are two alternative models X and Y of the new machine. Using Payback period, suggest the most profitable investment. Ignore taxation. X Y Initial Investment (Rs.) 9,000 18,000 Estimated life of the machine (Years) 4 5 Estimated savings in cost (Rs.) 500 800 Estimated savings in Wages (Rs.) 6000 8000 Additional cost of maintenance (Rs.) 800 1000 Additional cost of supervision (Rs.) 1200 1800

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Critical evaluation
Strengths of Payback: 1. Easy to calculate and understand. 2. It serves the purpose of FM as it is based on cash flow analysis. 3. Provides an indication of a projects risk. Project with shorter PB will be less risky

30

Critical evaluation
Drawbacks of Payback Period: 1.The payback period does not indicate whether the project should be accepted or rejected. For example, we dont know whether 4.56 years is a good payback period, or not. 2. Cash flows that occur after the end of the payback time are ignored in the calculation of payback period. Yet, these latter cash flows may be significant in making the decision.
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Example (500) 150 150 150

0 1 2

150 150 (300) 0

This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion!

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Conti
3.Calculation

of payback period ignores the time value of money. (This is a critical flaw!)

33

Discounted Payback
Discounts the cash flows at the

firms required rate of return. Payback period is calculated using these discounted net cash flows.Problems:

Discounted Payback
(500) 0
Year

250 1

250 2

250 3

250 250 4 5

Discounted
Cash Flow CF (14%)

0 1

-500 250

-500.00 219.30

Discounted Payback
(500) 0
Year

250 1

250 2

250 3

250 250 4 5

Discounted
Cash Flow CF (14%)

0 1

-500 250

-500.00 219.30 1 year 280.70

Discounted Payback
(500) 0
Year

250 1

250 2

250 3

250 250 4 5

Discounted
Cash Flow CF (14%)

0 1 2

-500 250 250

-500.00 219.30 1 year 280.70 192.38

Discounted Payback
(500) 0
Year

250 1

250 2

250 3

250 250 4 5

Discounted
Cash Flow CF (14%)

0 1 2

-500 250 250

-500.00 219.30 1 year 280.70 192.38 2 years 88.32

Discounted Payback
(500) 0
Year

250 1

250 2

250 3

250 250 4 5

Discounted
Cash Flow CF (14%)

0 1 2

-500 250 250

250

-500.00 219.30 1 year 280.70 192.38 2 years 88.32 168.75

Discounted Payback
(500) 0
Year

250 1

250 2

250 3

250 250 4 5

Discounted
Cash Flow CF (14%)

0 1 2

-500 250 250

250

-500.00 219.30 1 year 280.70 192.38 2 years 88.32 168.75 .52 years

Discounted Payback
(500) 0
Year

250 1

250 2

250 3

250 250 4 5

Discounted
Cash Flow CF (14%)

0 1 2

The -500 Discounted -500.00 250Payback 219.30 280.70 is 2.52 years

250 192.38 88.32 168.75

1 year 2 years

250

.52 years

II . ACCOUNTING RATE OF RETURN (OR) AVERAGE RATE OF RETURN (ARR)

# ARR is a measure based on accounting profits rather than the cash flows. The ARR may be defined as the annualized

net income earned on the average funds invested in a project. COMPUTATION OF ARR:

Average Annual profit (after tax)

ARR = Average Investment in the Project x 100

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Critical evaluation
Merits

1). Easy to understand. Necessary information to calculate average rate of return are available easy. 2). This method takes into account all the profits during the life time of the project, whereas pay back period ignores the profits accruing after the pay back period

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Critical evaluation
Demerits

1). Ignores the time value of money. 2). Does not use cash flow so it does not serve the purpose of FM. 3) ARR method does not consider the size of investment for each project. It may be time that the competing ARR of two projects may be the same but they may require different average investments.

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DISCOUNTED CASH FLOWS OR TIME ADJUSTED TECHNIQUES

These are based upon the fact that the cash flows occurring at different point of time are not having same economic worth i.e., TVM

45

Time Value of Money

Which would you prefer -- $10,000 today or $10,000 in 5 years? Obviously, $10,000 today. A dollar received today is worth more than a dollar received tomorrow
This is because a dollar received today can be invested to

earn interest Uncertainty Preference for present consumption

46

How can one compare amounts in different time periods?

One can adjust values from different time periods using an interest rate.
Two techniques: Compounding Technique Discounting Technique

1. 2.

47

. NET PRESENT VALUE (NPV) METHOD

The NPV of an investment proposal may be defined as

the sum of the present values of all the cash inflows less the sum of present values of all the cash outflows associated with the proposal. The decision rule is Accept the proposal if its NPV is positive and reject the proposal if the NPV is negative.

48

Case
XYZ Company is considering replacement of its existing

machine by a new machine, which is expected to cost Rs.1, 60,000. The new machine will have a life of 5 years and will yield annual cash revenue of Rs. 2,50,000 and incur annual cash expenses of Rs. 1,30,000. The estimated salvage value of the new machine is nil. The existing machine has a book value of Rs. 40,000 and can be sold for Rs. 20,000 today. It is good for next 5 years and is estimated to generate annual cash revenue Rs. 2,00,000 and to involve annual cash expenses of Rs. 1,40,000. Its salvage value after 5 years is zero. Corporate tax rate is 40%. Depreciation rate is 25% on WDV method. The companys opportunity cost of capital is 20%. Ignore taxes on profit or loss on sale of machine. Advice whether the company should replace the machine or not.

49

Case
A company has a machine which has been in operations for 2 years ; its remaining estimated useful life is 10 years, with no salvage value. Its current market value is Rs. 1,oo,ooo. Tile management is considering a proposal to purchase an improved model of a machine, which gives increased output. The relevant particulars are as follows:

Existing Machine New Machine Purchase price Rs. 2,40,000 Rs. 4,00,000 Estimated life 12 years 10 years Salvage value __ __ Annual operating hours 2,000 2,000 Selling price per unit Rs. 10 Rs. 10 Output per hour 15 units 30 units Material cost per unit Rs. 2 Rs. 2 Labour cost per hour 20 40 Consumable stores per year 2,000 5,000 Repairs per year 9,000 6,000 Working Capital 25,000 40,000 The company follows the straight-line method of depreciation and is subject to 50% tax. Should the existing machine be replaced ? Assume thai the companys required rate of return is 15%
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Non conventional case

Machine A costs Rs. 1,00,000 payable immediately. Machine B costs Rs. 1,20,000 half payable immediately and half payable in one years time. The cash inflows expected are as follows: Year (at end) Machine A Machine B 1 Rs. 20,000 2 60,000 Rs. 60,000 3 40,000 60,000; 4 30,000 80,000; 5 20,000 At 7% opportunity cost, which machine should be selected on the basis of NPV?

51

Try this.
ABC Ltd. is in the business of manufacturing X product. It has a plant on a piece of landwhich was purchased 10 years ago for 10 lakhs. The firm now plans to set up another plant on the same land(50% of the existing plant). Capital Expenditure for setting up new plant (incurred in the beginning of the year): Year 1 Cost of land Rs. 5,00,000 Land Development 17,00,000 Payment for purchase of Machine 20,00,000 Year 2 Final payment for Land Development 15,00,000 Final payment to Machine supplier 70,00,000 The machine has an estimated useful life of 5 years and the company follows SL method of depreciation. The information regarding sales and operational expenses is as follows Year 1 2 3 4 5 Sales (Rs. lacs) 25 30 35 40 45 Expenses (Rs. lacs) 5 7 10 12 15 If the companys rate of discount is 15% and the tax rate is 50%, should the above proposal be accepted assuming no depreciation on land.
52

Critical evaluation - merits

1 It recognizes the time value of money. 2. The NPV technique considers the entire cash flow stream and all the cash inflows and outflows. 3. It serves the purpose of FM as it is based on cash flow analysis. 4. This method is particularly useful for the selection of Mutually Exclusive projects (mostly the case with the companies) . 5. It represents the net contribution of a proposal towards the wealth of the firm and is therefore, in full conformity with the objective of maximization of the wealth of the shareholders.
53

Critical evaluation - demerits

i) It involves difficult calculations . ii) The NPV technique requires the predetermination of the required rate of return, k, which itself is a difficult job. If the value of the k is not correctly taken, then the whole exercise of the NPV may give wrong results. iii) The decision under the NPV technique is based on a value which is an absolute measure. It ignores the difference in initial outflows, size of different proposals etc. while evaluating mutually exclusive proposals.
54

II. PROFITABILITY INDEX METHOD: This technique is a variant of the NPV technique and is also known as BENEFIT - COST RATIO or PRESENT VALUE INDEX.

Total present value of cash inflows PI =

Total present value of cash outflows.

Accept the project if its PI is more than 1 and reject the proposal if the PI is less than 1.
55

III. INTERNAL RATE OF RETURN (IRR):

The IRR of a proposal is defined as the discount rate which produces a zero NPV, i.e., the IRR is the discount rate which will equate the present value of cash inflows with the present value of cash outflows. The IRR is also known as Marginal Rate of Return or Time Adjusted Rate of Return.

Logically, if IRR > the cost of capital to finance the project, the project should be accepted. If IRR < cost of capital, the project should be rejected
56

What is IRR?
The discount rate

which sets the NPV of all cash flows equal to 0. Helps to determine the YIELD on an investment.

57

Calculation of IRR
1) When CI are equal 2) When CI are unequal

58

IRR- When CI are equal

A firm is evaluating a proposal

costing Rs. 1,00,000 and having annual inflows of Rs. 25,000 occurring at the end of each of next six years. Calculate the IRR of the proposal

59

Step 1
Calculate PB period = CO / Equal CI
The payback period in the given case is 4 years.

60

Step 2
Now, search for a value nearest to PB for the year equal to the life of the project in the PVAF

table. Out of the closest figures, one will be bigger and other smaller than PB. Corresponding to these , find two interest rates. In our case, search for a value nearest to 4 in the 6th year row of the PVAF table. The closest figures are given in rate 12% (4.111) and the rate 13% (3.998). This means that the IRR of the proposal is expected to lie between 12% and 13%.
61

Step 3 In order to make a

precise estimate of the IRR, find out the NPV of the project for both these rates. One NPV will be positive and other will be negative.

At 12%, NPV=

25,000X 4.111 1,00,000 = Rs. +2,775. At 13%, NPV= 25,000X 3.998 1,00,000 = Rs. -50.

62

Step 4 Calculate IRR by using

interpolation technique IRR = L+ A x (H - L) A-B where, L= Lower discount rate, at which NPV is positive H= Higher discount rate, at which NPV is negative.. A=NPV at Lower discount rate, L. B= NPV at Higher discount rate, H.
IRR= 12% + 2,775 x (1312) 2,775 (50) = 12.98%

63

Try this.
A project costs Rs. 36,000 and is expected to generate cash

inflows of Rs. 11,200 annually for 5 years. Calculate IRR

64

IRR- When CI are unequal

A firm is evaluating a proposal costing Rs. 50,000 and having

annual inflows of Rs. 10,000; 10,450; 11,800; 12,250; 16,750 occurring at the end of each of next 5 years. Calculate the IRR of the proposal
65

Self assessment
A company is considering as to which of two mutually exclusive

projects it should undertake. The Finance Director thinks that the project with the higher NPV should be chosen whereas the Managing Director thinks that the one with the higher IRR should be~ undertaken especially as both projects have the same initial outlay and length of life. The company anticipates a cost of capital of 10% and the net after-tax cash flows of the projects are as follows: (Figures in Rs. 000) Year 0 1 2 3 4 5 Project X (200) 35 80 90 75 20 Project Y (200) 218 10 10 4 3 Required: a) Calculate the NPV and IRR of each project. b) State, with reasons, which project you would recommended.

66

Typical case
A share of the face value of Rs. 100 has current market price of Rs. 480. Annual expected dividend

is 30%. During the fifth year, the shareholder is expecting a bonus in the ratio of 1:5. Dividend rate is expected to be maintained on the expanded capital base. The shareholder intends to retain the share till the end of the eighth year. At that time the value of share is expected to be Rs. 1,000. Additional expenses at the time of purchase and sale are estimated at 5% on the market price. There is no tax on dividend income and capital gain. The shareholder expects a minimum return of 15% per annum. Should he buy the share
67

Mind Teaser
Following are the data on a capital project being

evaluated by the management of X Ltd. Particulars Project M Annual cost saving Rs.40,000 Useful life 4 years Internal rate of return 15% Profitability index 1.064 Net present value ? Cost of capital ? Cost of project ?
Payback period Salvage value Find the missing figures ? 0

68

Drawbacks of IRR
Tedious calculations
Reinvestment rate assumption

Multiple IRR

69

2.

Reinvestment rate assumption

The IRR criterion implicitly assumes that the cash flow

generated by the projects will be reinvested at the internal rate of return, that is, the same rate as the proposal itself offers. With the NPV method, the assumption is that the funds released can be reinvested at a rate equal to the cost of capital, that is, the required rate of return.

70

The crucial factor is which assumption is correct?

The assumption of the NPV method is considered to be superior theoretically because it has the virtue of having a rate which can consistently be applied to all investment proposals.
In contrast to the NPV method, the IRR method assumes a high reinvestment rate for investment proposals having a high IRR and a low investment

rate for investment proposals having a low IRR

71

Therefore it becomes important to incorporate consistent reinvestment rate in IRR. But HOW ?????

72

The Modified Internal Rate of Return

Modified Internal Rate of Return or MIRR is the

investor's required rate of return which equates the Initial Cost Outlay with the present value of future value of cash inflows

73

Conti
The modified IRR

(MIRR) is the average annual rate of return that will be earned on an investment if the cash flows are reinvested at the specified rate of return (usually, the WACC) To calculate the MIRR, first find the total future value of the cash flows at the reinvestment rate, and then apply the formula:

FVCF MIRR 1 IO
N

74

The MIRR: An Example Assume that your company is investigating a new

labor-saving machine that will cost $10,000. The machine is expected to provide cost savings each year as shown in the following timeline:
-10,000 2000 0 1 2500 2 3000 3 3500 4 4000 5

75

To calculate the MIRR for our example, first find the FV of the cash flows at 12% (the WACC):
FVCF20 1. 2 250 1. 2 30 1. 2 350 1. 2 40 18,342.56
4 3 2 1

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Conclusion
This is the amount that

you will have accumulated by the end of the life of the investment Now, find the average annual rate of return Since the MIRR is greater than the WACC, this project is acceptable

1834256 . MIRR 1 12899% . 10000

5

77

3. Multiple Rates of Return

If a project has more than one rate of return, how

would you make an accept/reject decision?

78

Investment Classification
Simple Investment Def: Initial cash flows are negative, and only one sign change occurs in the net cash flows series. Example: -$100, $250, $300 (-, +, +) ROR: A unique ROR Non simple Investment Def: Initial cash flows are negative, but more than one sign changes in the remaining cash flow series. Example: -$100, $300, $120 (-, +, -)
ROR: A possibility of

multiple RORs

79

Multiple Rates of Return Problem

CI $2,300

CO $1,000 Find the rate(s) of return:

CO $1,320

$2,300 $1,320 PW (i ) $1, 000 1 i (1 i ) 2 0

80

1 Let x . Then, 1 i $2,300 $1,320 PW (i ) $1,000 (1 i ) (1 i ) 2 $1,000 $2,300 x $1,320 x 2 0 Solving for x yields, x 10 / 11 or x 10 / 12 Solving for i yields i 10% or 20%
81

Plot for Investment with Multiple Rates of Return

82

Why use MIRR versus IRR?

MIRR correctly assumes reinvestment at opportunity cost = WACC and also avoids the problem of multiple IRRs. Managers like rate of return comparisons, so when there are non normal CFs and more than one IRR, MIRR is better than IRR

83

Net Present Value(NPV)

Snapshot

The Net Present Value (NPV) or Net Present Worth (NPW) of a investment proposal, is defined as the sum of the present values (PVs) of the individual cash Inflows less the sum of present value of all the cash outflows associated with the proposal
The decision rule is Accept the proposal if its

NPV is positive and reject the proposal if the NPV is negative.

Internal Rate of Return(IRR)

A Snapshot
The IRR of a proposal is defined as the discount rate which produces a zero NPV, i.e., the IRR is the discount rate which will equate the present value of cash inflows with the present value of cash outflows
It is also known as Marginal Rate of Return or Time Adjusted Rate of Return

If IRR > Cost of Capital, then the project is accepted, If IRR < Cost of Capital, then project is Rejected

Similarities between NPV and IRR

 Both NPV and IRR will gave the same result (i.e.

acceptance and rejection) regarding an investment proposal in the following cases:

When project involving conventional cash flows Independent Investment Proposals, i.e. , acceptance of

which does not preclude the acceptance of the others (Single Machine)

Reason for the same results is, NPV will be positive

only when the actual return on investment is more than the cut-off rate (required rate of return/ cost of capital), whereas IRR support projects in whose case the IRR is more than the cut-off rate

Consider the following case (Already discussed) Following information regarding Machine A is available

and suggest that machine will be purchased or not on the basis of NPV method and IRR method: Cash Outflow Rs. 50,000 Cost of Capital 10% Year CFAT PVF@10 % 1 Rs. 10,000 .909 2 Rs. 10,450 .826 3 Rs. 11,800 .751 4 Rs. 12,250 .683 5 Rs. 16,750 .621
NPV (-4648) Reject the proposal IRR (6.58%) Reject the proposal

The big Q? Will the two methods always give the same answer? No, unfortunately not

Dissimilarities between NPV and IRR

 In certain situations NPV and IRR gives contradictory

results such that if NPV methods find one proposal acceptable, while IRR favors the other This sort of problems will be faced in mutually exclusive projects The problem of the conflicting results can be classified due to the following differences in the projects
Size Disparity problem Time Disparity problem Unequal expected lives

Size Disparity Problem It arises when the initial investment in mutually

exclusive projects are different

Particulars Cash Outlays Cash Inflow at the end of year Cost of Capital NPV @10% IRR

Project A (Rs. 5000) 6250

Project B (Rs 7500) 9150

10%
681.25 25% 817.35 22%

Time Disparity Problem

This problem arises when the cash

flow pattern of mutually exclusive projects is different. i.e., most of the cash flows from one project come in the early years, while most of the cash flows from the other project come in the later years

Example already discussed

A company is considering as to which of two mutually

exclusive projects it should undertake. The Finance Director thinks that the project with the higher NPV should be chosen whereas the Managing Director thinks that the one with the higher IRR should be undertaken especially as both projects have the same initial outlay and length of life. The company anticipates a cost of capital of 10% and the net aftertax cash flows of the projects are as follows:
1 35 218 2 80 10 3 90 10 4 75 4 5 20 3

(Figures in Rs. 000) Year 0 Project X (200) Project Y (200)

95

Proposals having unequal lives

If a firm is evaluating two mutually exclusive proposals

having unequal lives, then the decision may be taken in normal course on the basis of NPV of the two proposals. The proposal with the higher NPV will be selected. The difference in economic lives may not be of much importance, unless they can be repeated indefinitely.

96

Example
A firm is evaluating the following two proposals @ 15% discount

rate

Year 0 1 2 3 4 5

X 24,000 14,000 14,000 14,000

Y 44,000 16,000 16,000 16,000 16,000 16,000

Evaluate the proposal if: 1) They are one off investment 2) They can be repeated indefinitely.

97

 This is done by Equivalent Annuity Method (EAM). The equivalent annuity is defined as the amount of

annuity for n years, which has a present values discounted at r percent per annum equivalent to the given amount.

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In our case,
The project X has the NPV of Rs. 7,962. Considering this to be the present value of annuity of three years at discount rate of 15%, the annuity amount can be calculated as X/1.15+ X/(1.15)(1.15)+ X/(1.15)(1.15)(1.15)=7962 Annuity Amount (X) = Rs.7,962/2.283 = Rs.3,488. Similarly, for project Y, Annuity Amount (Y) = Rs.9,632/3.352 = Rs.2,873.
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Interpretation
Project X Project X is giving NPV of Rs. 7,962 after a period of every three years. This can also be

considered as an annuity of Rs. 3,488 for three years; and with replacement every three years, this can be considered as a perpetuity of Rs.3,488 forever. Project Y: Project Y is giving NPV of Rs. 9,632 after a period of every five years. This can also be considered as an annuity of Rs. 2,873 for five years; and with replacement every five years, this can be considered as a perpetuity of Rs. 2,873 forever.
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Question is
To select between the NPV of Rs. 7,962 (Project X)

every three years or the NPV of Rs. 9,632 (Project Y) every five years. Now, in the light of the above, the same can be expressed as a choice between a perpetuity of Rs. 3,488 (Project X) and Rs. 2,873 (Project Y). The choice now, is obvious and the firm will like to select project X only.

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Conclusion
To conclude, the two methods would give similar accept-

reject decisions in the case of independent conventional investments. They would, however, rank mutually exclusive projects differently in the case of the (i) size-disparity problem, (ii) time-disparity problem, and (iii) unequal service life of projects. The ranking by the NPV decision criterion would be theoretically correct as it is consistent with the goal of maximization of shareholders wealth. Further, the reinvestment rate of funds released by the project is based on assumptions which can be consistently applied. The IRR can, of course, be modified by adopting the incremental approach to resolve the conflict in ranking. But it involves additional computation. Another deficiency of the IRR is that it may be indeterminate and give multiple rates in the case of a non-conventional cash flow pattern. In sum, therefore, the NPV emerges as a superior evaluation technique.
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CAPITAL BUDGETING PRACTICES IN INDIA

1. Capital budgeting decisions are undertaken at the top management level and are planned in advance. The Corporates follow mostly top-down approach in this regard.
2. Discounted cash flow techniques are more popular now.

3. High growth firms use IRR more frequently whereas Payback period is more widely used by small firms. 4. PI technique is used more by public sector units than by private sector units.
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