The Basics of Capital Budgeting:

Evaluating Cash Flows

Should we
build this
plant?

By: Dr Pawan
Gupta

Indian School of Petroleum

 Capital Budgeting: the process of
planning for purchases of long-
term assets.
■ example:

Suppose our firm must decide whether to

purchase a new plastic molding machine
for Rs125,000. How do we decide?
■ Will the machine be profitable?
■ Will our firm earn a high rate of return
on the investment?
Indian School of Petroleum
Decision-making Criteria in
Capital Budgeting

How do we decide
if a capital
investment
project should
be accepted or
rejected?
Indian School of Petroleum
 Decision-making Criteria in
Capital Budgeting
■ The Ideal Evaluation Method should:

a) include all cash flows that occur

during the life of the project,
b) consider the time value of money,
c) incorporate the required rate of
return on the project.
Indian School of Petroleum
 Future value

FVn = PV(1 + i) .
n

What’s the FV of an initial Rs 100

after 3 years if i = 10%?

Indian School of Petroleum

After 3 years:

FV3 = PV(1 + i)3

= Rs 100(1.10)3
= Rs 133.10.

Indian School of Petroleum

 Present value

■ What’s the PV of Rs 100 due in 3 years if i =

10%?

n
FVn  1 
PV = = FVn  
(1+ i)n 1+ i
3
 1 
PV = 100  
 1.10 
= Rs 75.13.
Indian School of Petroleum
 Payback Period
■ The number of years needed to
recover the initial cash outlay.
■ How long will it take for the project
to generate enough cash to pay for
itself?

Indian School of Petroleum

 Payback Period
■ How long will it take for the project
to generate enough cash to pay for
itself?
(500) 150 150 150 150 150 150 150 150

0 1 2 3 4 5 6 7 8

Indian School of Petroleum

 Payback Period
■ How long will it take for the project
to generate enough cash to pay for
itself?
(500) 150 150 150 150 150 150 150 150

0 1 2 3 4 5 6 7 8

Payback period = 3.33 years.

Indian School of Petroleum
■ 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 the project.

Indian School of Petroleum

 Drawbacks of Payback Period:

■ Firm cutoffs are subjective.

■ Does not consider time value of money.
■ Does not consider any required rate of
return.
■ Does not consider all of the project’s
cash flows.

Indian School of Petroleum

 Drawbacks of Payback Period:

■ Does not consider all of the project’s

cash flows.
(500) 150 150 150 150 150 (300) 0 0

0 1 2 3 4 5 6 7 8

Consider this cash flow stream!

Indian School of Petroleum
 Drawbacks of Payback Period:

■ Does not consider all of the project’s

cash flows.
(500) 150 150 150 150 150 (300) 0 0

0 1 2 3 4 5 6 7 8
This project is clearly unprofitable, but we
would accept it based on a 4-year payback
criterion! Indian School of Petroleum
 Discounted Payback

■ Discounts the cash flows at the firm’s

required rate of return.
■ Payback period is calculated using
these discounted net cash flows.
■ Problems:
■ Cutoffs are still subjective.
■ Still does not examine all cash flows.

Indian School of Petroleum

 Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30

Indian School of Petroleum

 Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70

Indian School of Petroleum

 Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38

Indian School of Petroleum

 Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
Indian School of Petroleum
 Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
3 250Indian School of Petroleum
168.75
 Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
3 250Indian School of Petroleum
168.75 .52 years
 Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
The Discounted
0 -500 -500.00
Payback
1 250 219.30 1 year
is 2.52 years
280.70 280.70
2 250 192.38 2 years
88.32
3 250Indian School of Petroleum
168.75 .52 years
 Other Methods

1) Net Present Value (NPV)

2) Profitability Index (PI)
3) Internal Rate of Return (IRR)

Each of these decision-making criteria:

■ Examines all net cash flows,
■ Considers the time value of money, and
■ Considers the required rate of return.
Indian School of Petroleum
 Net Present Value

• NPV = the total PV of the annual net

cash flows - the initial outlay.

• Decision Rule:

• If NPV is positive, ACCEPT.

• If NPV is negative, REJECT.
Indian School of Petroleum
 NPV Example
■ Suppose we are considering a capital
investment that costs Rs276,400 and provides
annual net cash flows of Rs 83,000 for four
years and Rs116,000 at the end of the fifth year.
The firm’s required rate of return is 15%.

83,000 83,000 83,000 83,000 116,000

(276,400)

0 1 2 3 4 5
Indian School of Petroleum
 Profitability Index

Σ
ACFt
NPV = t - IO
(1 + k)
t=1

Indian School of Petroleum

 Profitability Index

Σ
ACFt
NPV = t - IO
(1 + k)
t=1

Σ
ACFt
PI = IO
(1 + k) t
t=1
Indian School of Petroleum
 Profitability Index

• Decision Rule:

• If PI is greater than or equal

to 1, ACCEPT.
• If PI is less than 1, REJECT.
Indian School of Petroleum
Internal Rate of Return (IRR)

■ IRR: the return on the firm’s

invested capital. IRR is simply the
rate of return that the firm earns
on its capital budgeting projects.

Indian School of Petroleum

 Internal Rate of Return (IRR)

Σ
ACFt
NPV = - IO
(1 + k) t
t=1

Indian School of Petroleum

 Internal Rate of Return (IRR)

Σ
ACFt
NPV = - IO
(1 + k) t
t=1

n
ACFt
IRR:
Σ
t=1
(1 + IRR) t = IO

Indian School of Petroleum

 Internal Rate of Return (IRR)
n
ACFt
IRR:
Σt=1
(1 + IRR) t = IO

■ IRR is the rate of return that makes the

PV of the cash flows equal to the initial
outlay.

Indian School of Petroleum

 Calculating IRR
■ Looking again at our problem:
■ The IRR is the discount rate that
makes the PV of the projected cash
flows equal to the initial outlay.

83,000 83,000 83,000 83,000 116,000

(276,400)

0 1 2 3 4 5
Indian School of Petroleum
 83,000 83,000 83,000 83,000 116,000
(276,400)

0 1 2 3 4 5
■ This is what we are actually doing:

83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR)

= 276,400

Indian School of Petroleum

 83,000 83,000 83,000 83,000 116,000
(276,400)

0 1 2 3 4 5
■ This is what we are actually doing:

83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR)

= 276,400
You should get IRR = 17.63%!
■ This way, we have to solve for IRR by trial
and error. Indian School of Petroleum
 IRR
• Decision Rule:

• If IRR is greater than or equal

to the required rate of return,
ACCEPT.
• If IRR is less than the required
rate of return, REJECT.
Indian School of Petroleum
 Capital Rationing

■ Capital rationing occurs when a company

chooses not to fund all positive NPV projects.
■ The company typically sets an upper limit on
the total amount of capital expenditures that it
will make in the upcoming year.

Indian School of Petroleum

Reason: Companies want to avoid the direct
costs (i.e., flotation costs) and the indirect costs
of issuing new capital.
Solution: Increase the cost of capital by enough
to reflect all of these costs, and then accept all
projects that still have a positive NPV with the
higher cost of capital.

Indian School of Petroleum

Reason: Companies don’t have enough
managerial, marketing, or engineering staff to
implement all positive NPV projects.

Solution: Use linear programming to maximize

NPV subject to not exceeding the constraints on
staffing.

Indian School of Petroleum

Reason: Companies believe that the project’s
managers forecast unreasonably high cash flow
estimates, so companies “filter” out the worst
projects by limiting the total amount of projects
that can be accepted.
Solution: Implement a post-audit process and tie
the managers’ compensation to the subsequent
performance of the project.

Indian School of Petroleum

Thanks

Indian School of Petroleum