Capital Budgeting

(NPV and other

Investments Rules)
DR. AJAYA KUMAR PANDA
 NPV and other Investments Rules
Broadly there are two types of investment decisions:

1. Expansion & Diversification

2. Replacement & Modernization
In order to carryout the above investment decisions, a wide range of
evaluation criterion has been suggested to evaluate the worthwhileness of
the investment projects.

These are broadly categorized into:

1. Discounting Criteria
2. Non-Discounting Criteria
 Investment Evaluation
Criterion

Non-Discounting
Discounting Criteria
Criteria

Benefit to Cost Accounting Rate of

NPV IRR Payback Period
Ratio Return (ARR)

Discounted Payback
MIRR
Period
Net Present Value (NPV):
Capital Budgeting is the decision making process for accepting or rejecting
the projects. NPV is the 1st method of the process which is considered to be
a classical economic method to evaluate investment proposal. It is based on
DCF technique that explicitly recognises the time value of money.

Example: 1
Suppose project X costs Rs. 2500 now and is expected to generate cash
flow at the end of each year for 5 years by 900, 800, 700, 400 and 500
respectively. If the discount rate or opportunity cost of capital is 10% p.a.,
then calculate NPV of the investment.
Net Present Value (NPV): Time line of the Project

900
800
700
500
400

0 1 2 3 4 5

-2500
 𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹4 𝐶𝐹5
𝑁𝑃𝑉 = 1
+ 2
+ 3
+ 4
+ 5
− [Initial Investment]
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖)

900 800 700 400 500

𝑁𝑃𝑉 = 1
+ 2
+ 3
+ 4
+ 5
− 2500
(1.1) (1.1) (1.1) (1.1) (1.1)

= 2725 – 2500
= Rs. 225
Case 2: Suppose Project Y has the following CFs:
3,50,000
3,00,000 3,00,000

2,00,000 2,00,000

0 1 2 3 4 5

-10,00,000
Now substituting in formula:

200000 200000 300000 300000 350000

𝑁𝑃𝑉 = 1
+ 2
+ 3
+ 4
+ 5
− 1000000
(1.1) (1.1) (1.1) (1.1) (1.1)

= 994200 – 1000000
= (-) Rs. 5800
The basic investment decision rules as follows:
1. If NPV = +ve → Accept the project
2. If NPV = -ve → Reject the project
3. If NPV = 0 → Indifference
NPV rules lead to good decision making because +ve NPV of a project adds
to the value of a firm and hence considered as the contribution of any
project to the value of the firm.

Critical Aspects of NPV:

1. First important aspects of NPV approach is to identify a correct discount
rate. It is the return of a risky asset that one expects to earn equal to a
comparable risky asset.
2. Another key attribute of NPV method is use of cash flow, instead of
earnings. Although earnings is useful from accounting prospective, still
earnings has less relevance in capital budgeting as comparison to cash
flow.

3. Again NPV approach ignores the CFs beyond a particular date, and it
may be considered as a negative aspect of NPV.
 Internal Rate of Return
IRR of the project is the discount rate that makes NPV equal to zero. In
other words, IRR is the discount rate that equates PV of the future CF of
the project with its initial investment. If IRR is considered as ‘R’, then

𝑛
𝐶𝐹 𝑡
Investment = ෍ 𝑡
𝑡=1 1+IR𝑅
Consider an investment of Rs. 100 that generates Rs. 110 after 1 yr. That is:
110
 NPV = − 100 That is R = 10%
1+𝑅

Where NPV = 0 and sum of future CF is equal to initial investment.

While calculating NPV, we assume that the discount rate is known and while
calculating IRR, we assume that NPV = 0 and try to calculate ‘R’ through trail
& error approach.

 Example : 2

Calculate IRR of a project having the following cash flows:

Initial Investment is ₹ 1,00,000 followed by 4 continuous cash inflows i.e.

₹ 30,000, ₹ 30,000, ₹ 40,000 and ₹ 45,000 subsequently.
Now the IRR is the ‘r’ that satisfies the following condition:

30,000 30,000 40,000 45,000

1,00,000 = + + +
1+𝑟 1 1+𝑟 2 1+𝑟 3 1+𝑟 4

We have to find out ‘r’ with trial and error method, that is:
If r = 15%

30,000 30,000 40,000 45,000

= + + + = 1,00,802
1.151 1.152 1.153 1.154
If r = 16%
30000 30000 40000 45000
= + + + = 98641
1.161 1.162 1.163 1.164

Hence, r is in between 15% & 16%

 At r = 15% , NPV = 802 more (+ve)

 At r = 16% , NPV = 1359 less (-ve)

802 + 1359 = 2161

802 1359
= 0.37 % or = 0.6289 %
2161 2161

→ 15% + 0.37% = 15.37 % IRR or 16% - 0.6289 % = 15.37 % IRR

Decision Rule:

1. Accept the project, if IRR is greater than discount rate.

2. Reject the project, if IRR is less than discount rate.

Problems with IRR approach:

Defining independent and mutually exclusive projects.

▪ An independent project is one whose acceptance or rejection is independent of the

acceptance or rejection of other projects.
▪ Two projects A and B are mutually exclusive when you can accept A or can
accept B or can reject both A & B. But you cannot accept both A & B at the same
time. Hence A is mutually exclusive to B and vice versa.
 The Profitability Index (PI)

Another method used to evaluate project is Profitability Index (or) Benefits to Cost
ratio.

𝑃𝑉 𝑜𝑓 𝐶𝐹𝑠 𝑠𝑢𝑏𝑠𝑒𝑞𝑢𝑒𝑛𝑡 𝑡𝑜 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

PI =
𝐼𝑛𝑖𝑡𝑎𝑖𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Example:
Suppose a project has following CFs. If discount rate (r) is 12% then calculate the PI
& NPV
Project CF1 CF2 CF3 PV of CFs PI NPV @ 12%
1 -20 70 10 70.5 3.53 50.5
2 -10 15 40 45.3 4.53 35.3
PV of CFs after subsequent initial investment =
70 10
70.5 = +
1.12 1.122

70.5
PI = = 3.53
20

Decision Rule:

1. Accept the independent project if PI > 1

2. Reject the independent project if PI < 1

PI is equally suffered with time and scale factor.

 Benefits-Cost Ratio (BCR)
BCR is otherwise called as Profitability Index (PI). It is defined as two ways

𝑃𝑉𝐵
BCR =
𝐼

NBCR = BCR – 1

PVB = PV of Benefits
I = Initial Investment
NBCR = Net Benefits to Cost Ratio
Example
Consider a project with opportunity cost of 12%. It requires initial
investment of Rs. 1,00,000 and generates CFs for 4 years i.e. Rs. 25,000,
Rs. 40,000, Rs. 40,000 and Rs. 50,000 respectively. Evaluate the project
using BCR technique.
Ans:
𝑃𝑉𝐵
BCR =
𝐼

25000 40000 40000 50000

PVB = + + + = Rs. 114500
1.12 1.122 1.123 1.124

Initial Investment (I) = Rs. 100000

114500
 BCR = = 1.145 or NBCR = BCR – 1 = 0.145
100000

 Decision Rule:
1. BCR > 1 or NBCR > 0 → Accept the project
2. BCR < 1 or NBCR < 0 → Reject the project
3. BCR = 1 or NBCR = 0 → Indifference
 Payback Period

1. Non-discounting criteria 2. Discounting criteria

Payback Period (Non-discounting)

 The payback period is the number of years required to recover the
original cash invested in the project. If the project generates constant
annual cash inflows, then the payback period can be calculated easily.

Example (Even Cashflow)

Suppose a project requires Rs. 50,000 initial investment and yields annual
cash inflow of Rs. 12,500 for 7 years. Then calculate the payback period of
the project?
 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 (𝐶0 )
Payback period (PB) =
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤 (𝑒)

50,000
PB = = 4 𝑦𝑒𝑎𝑟𝑠
12,500

Example 2 (Uneven Cash flow)

 Suppose a project requires initial investment of Rs. 20,000 and
generates cash flows of Rs. 8000, 7000, 4000 and 3000 respectively for
4 consecutive years. What is the project’s payback period?
Ans:
By adding CFs of first 3 years, we get (8000 + 7000 + 4000) Rs. 1900 and now it
requires Rs. 1000 from 4th year’s cash flow to cover its initial investment. If the 4th year
cash flow of Rs. 3000 is evenly distributed over the year then,

1000
× 12 = 4 𝑚𝑜𝑛𝑡ℎ𝑠
3000
Hence Payback period is 3 years and 4 months of the above project.
Or
1000
 × 365 = 121.666 𝑑𝑎𝑦𝑠
3000

121.666
 = 4.05 𝑚𝑜𝑛𝑡ℎ𝑠
30
Limitation of Payback period

1. In some projects, there will be high CFs at early time of the project or there
may be more CFs at latter timeline. The non-discounting approach considers all
the CFs equally. Hence it doesn’t consider the timing of the CFs within the
payback period.

2. This approach is silent about payments after the payback period.

Discounting Payback Period:
Take the example of the following CFs: (-100, 50, 50, 20)
If discount rate is 10%, then the discounted CFs are:

50 50 20
-100, , ,
(1.1) (1.1)2 (1.1)3

= -100, 45.45, 41.32, 15.03

In this case (45.45+41.32+15.03 = 101.8) i.e. payback period is slightly less than 3 years.

The difference appeared because CFs are discounted at their respective discounting rate.
Thank You