CAPITAL BUDGETING

DECISIONS
What is capital budgeting?

 Capital Budgeting is the process of determining which real

investment projects should be accepted.

 Capital budgeting is investing in long-lived assets

 Shareholder wealth maximization should be kept in mind.

 Also called Investment Appraisal

Importance of Investment Decisions
 Involve commitment of large amount of funds

 For a long time period

 Usually not reversible

Types of Investment Decisions

Expansion of existing business

Investing in new business

Replacement of assets
Investment Evaluation Criteria

Estimation of cash flows

Estimation of the required rate of

return (the opportunity cost of capital)

Application of a decision rule for

making the choice
Evaluation Criteria

Discounted Cash Flow (DCF) Criteria Non-discounted Cash Flow Criteria

Net Present Value (NPV) Payback Period (PB)

Internal Rate of Return Accounting Rate of Return

(IRR) (ARR)

Discounted Payback Period

Profitability Index (PI)

Net Present Value Method

 NPV = PVinflows – PVoutflows

 Or NPV = PVinflows – Initial Investment

 If NPV > 0, then accept the project; otherwise reject

the project.
 If NPV=0, we may accept, or reject.
Net Present Value Method

 C1 C2 C3 Cn 
NPV       n 
 C0
 (1  k ) (1  k ) (1  k ) (1  k ) 
2 3

n
Ct
NPV    C0
t 1 (1  k )
t

C0 is the initial investment.

Calculating Net Present Value

 Assume that a new plant costs Rs 2,500 crores now

 It is expected to generate year-end cash inflows as follows:

Years 1 2 3 4 5
CFs 900 800 700 600 500
(Rs Crore)

 The opportunity cost of the capital may be assumed to be

10 per cent.
Solution

900 800 700 600 500

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

= 225.53

NPV is positive so

Accept the project

 Consider a project which has the following cash flow
stream:

 The cost of capital, k, for the firm is 10 per cent. Find

net present value of the proposal.
 = -5271.62
 Decision : reject
Evaluation of the NPV Method

 NPV is most acceptable investment rule for the following

reasons:
 Considers time value
 Cash flows used
 Maximises Shareholder value

 Limitations:
 Difficult to estimate cash flows
 Discount rate difficult to determine
Internal Rate of Return Method
 IRR is the rate of return that a project generates.

 Algebraically, IRR can be determined by setting up an NPV

equation and solving for a discount rate that makes the NPV
= 0.
 Equivalently, IRR is solved by determining the rate that
equates the PV of cash inflows to the PV of cash outflows.

 Decision Rule:
 If IRR > opportunity cost of capital (or hurdle rate), accept
the project;
 If IRR < opportunity cost of capital reject it.
 Internal Rate of Return

C1 C2 C3 Cn
C0     
(1  r ) (1  r ) 2
(1  r ) 3
(1  r ) n
n
Ct
C0  
t 1 (1  r )t
n
Ct
 t 1 (1  r ) t
 C0  0

IRR is the r in the equation

Calculation of IRR

• By Trial and Error

▫ The approach is to select any discount rate to compute the net
present value (NPV). If the calculated NPV is negative, a
lower rate should be tried.
▫ On the other hand, a higher value should be tried if the NPV
is positive. This process will be repeated till the net present
value becomes zero.
▫ For interpolation:
Example
 A project costs Rs 16000 crores and is expected to generate Rs 8000 cr, Rs
7000 cr and Rs 6000 cr at the end of each year for the next 3 years.
Evaluate the project using IRR. Cost of capital is 11%.
 Use trial and error method
 You need a starting point
 You can take any number arbitrarily
 Or
 How much time it will take to double investment?
 Ie 16000 to 32000
 Take average Cash inflows ie 7000
 32000/7000 = 4.5 years
 Rule of 72: divide 72/4.5= 16
 Start with 16%
 PV at 16% = 15942.64
 NPV at 16% = (-)57.36
 Select a lower rate, say 15%
 PV at 15% = 16194.63
 NPV at 15% = 194.63
 The IRR must lie between 15 and 16%
 Now use interpolation formula
16194.63−16000
 15+ x1
16194.63−15942.64

 = 15.77%
 16194.63−16000
 15+ x1
16194.63−15942.64

 = 15.77%

 Calculations using Excel

 = 15.77%

 Should you accept the project?

 ACCEPT, as the IRR>Cost of capital

Example on IRR
 Consider the cash flows of a project being
considered by Techtron Limited:

Year 0 1 2 3 4

CF -100000 30000 30000 40000 45000

 Average Cash inflows=
 (30000+30000+40000+45000)/4 = 36250
 Double the investment is 200000
 Divide 200000 by 36250 = 5.5
 Rule of 72= 72/5.5 = 13
 At 13%, PV of CIF is 105364.42
 At 15%, PV of CIF is 100800.81
 At 16%, PV of CIF is 98636.36
 Answer lies between 15 and 16%

100800.81−100000
 15+ x1
100800.81−98636.36
 = 15.37%
Evaluation of IRR Method

 IRR method has following merits:

 Time value
 Shareholder value

 IRR method may suffer from:

 Multiple rates
 Reinvestment assumption
Profitability Index
 Profitability index is the ratio of the present value of cash
inflows, at the required rate of return, to the initial cash
outflow of the investment.
 Also called BENEFIT COST RATIO

 If PI > 1, then accept the project; otherwise reject the

project
Profitability Index
 The initial cash outlay of a project is Rs 100,000 and it can
generate cash inflow of Rs 40,000, Rs 30,000, Rs 50,000
and Rs 20,000 in year 1 through 4.

 Assume a 10 per cent rate of discount. Find the Profitability

index or Benefit Cost Ratio.
 40000 30000 50000 20000
 𝑃𝑉 = + + +
1.1 1 (1.1)2 (1.1)3 (1.1)4

 = 112383.03
 PI = 112383.03/100000 = 1.12383
 Accept the project as PI is more than 1
Evaluation of PI Method

 It recognises the time value of money.

 It is consistent with the shareholder value maximisation

principle.

 It is a relative measure of a project’s profitability.

 Like NPV method, PI criterion also requires calculation of

cash flows and estimate of the discount rate. In practice,
estimation of cash flows and discount rate pose problems.
Payback

 Payback is the number of years required to recover the original cash

outlay invested in a project.
𝑅𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑡𝑜 𝑟𝑒𝑐𝑜𝑣𝑒𝑟
𝑃𝐵 = 𝑌𝑒𝑎𝑟𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑐𝑜𝑠𝑡 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 +
𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟

 The project would be accepted

 if its payback period is less than the maximum or standard payback period
set by management.

 It gives highest ranking to the project, which has the shortest payback
period and

 lowest ranking to the project with highest payback period.

Example
 Assume that a project requires an outlay of Rs 50,000 and
yields annual cash inflow of Rs 12,500 for 7 years. The
payback period for the project is:

Rs 50,000
PB   4 years
Rs 12,500
 Suppose that a project requires a cash outlay of Rs 20,000,
and generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000;
Rs 3,000 and Rs 2500 during the next 5 years. What is the
project’s payback?

1000
= 3 years + years
3000

= 3 1/3 years
Evaluation of Payback

 Certain virtues:
 Simple and easy to implement

 Serious limitations:
 Cash flows after payback ignored
 Timing of Cash flow ignored
 Standard payback period is subjective in nature
 Inconsistent with shareholder value

Can be used with NPV rule as a first step in roughly

screening the projects
Discounted Payback Period
 The discounted payback period is the number of periods taken in
recovering the investment outlay on the present value basis.
 First find the present values, then use the PVs to find the payback period.

 In the illustration below the cost of capital is 10%

Project ABC Project XYZ
0 -4000 -4000
1 3000 0
2 1000 4000
3 1000 1000
4 1000 2000
 Simple PB for ABC:
 2 years
 Simple PB for XYZ
 2 years
Discount the CFs at 10%

Project ABC PV
0 -4000
1 3000 2727.27
2 1000 826.45
3 1000 751.31
4 1000 683.01

Discounted payback period is 2.59 years

Discount the CFs at 10%

Project XYZ PV
-4000
0 0.00
4000 3305.79
1000 751.31
2000 1366.03

Discounted Pay back period is 2.92 years

Discounted Payback Period
 The discounted payback period still fails to
consider the cash flows occurring after the
payback period.
Accounting Rate of Return (ARR)

 ARR (also called Book Value Rate-of-Return) uses Net Income

and Book Value rather than cash flows to compute the return on
a capital project

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒

𝐴𝑅𝑅 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

 The ARR is the ratio of the average after-tax profit divided by

the average book value of investment.
 Accept all those projects whose ARR is higher than the
minimum rate established by the management
Example
 A project will cost Rs 40,000. It is depreciated using straight line method
during its life of 5 years. Its stream of income after taxes from first year
through five years is expected to be Rs 1,000, Rs 2,000, Rs 3,000, Rs
4,000 and Rs 6,000.

Average income
= (1,000 + 2,000 + 3,000 + 4,000 + 6,000)/5 = 3200

Average book value = (Beginning value + Ending value)/2

= (40000+0)/2 = 20000
(Depreciation: 40000/5 = 8000)age
ARR = 3200/20000
= 16%
Another example

Year 0 Year 1 Year 2 Year 3

Investment 300,000 200,000 100,000 0
(Book Value)
Net Income 30,000 40,000 20,000

Average Income= (30000+40000+20000)/3 = 30000

Average Investment = (300000+0)/2=150000

ARR = 30000/150000=20%
Evaluation of ARR Method

 The ARR method may claim some merits

 Simplicity

 Uses accounting data

 Shortcomings
 Cash flows ignored

 Time value ignored

 Arbitrary cut-off
 Are the book rates of returns irrelevant?
 Book rates of return don’t help at all in making
good capital investment decisions.
 Cash flows ignored

 Time value ignored

CAPITAL BUDGETING IN PRACTICE

 Over time, discounted cash flow methods have gained in

importance and internal rate of return is the most popular
evaluation method.

 Firms typically use multiple evaluation methods

 Accounting rate of return and payback period are widely

employed as supplementary evaluation methods
ESTIMATING CASH FLOWS
ELEMENTS OF THE CASH FLOW STREAM

 Initial Investment
 Operating Cash Inflows
 Terminal Cash Inflow
Cash Flow Components
 The initial investment is the after-tax cash outlay
on capital expenditure and net working capital
when the project is set up.
 The operating cash inflows are the after tax cash
inflows resulting from the operations of the project
during its economic life.
 The terminal cash inflow is the after-tax cash flow
resulting from the liquidation of the project at the
end of its economic life.
Guidelines for Cash Flow Estimation
Decisions are based on cash flows

 Non cash charges or income not to be

considered
 As PAT is calculated after reducing depreciation (non
cash charge) amount, add it back to get cash flows
Financing costs
 Financing costs should not be considered because
they will be reflected in the cost of capital figure
against which the rate of return figure will be
evaluated
 Cost of capital consists of cost of equity shares,
cost of preference shares and cost of debt
 Cost of debt is the interest
 If we subtract interest from cash flows, we would
be double counting capital costs.
Sunk Costs
 Sunk costs represent past outlays which cannot be
recovered such as R&D expenses
 Ignore sunk costs

 They are not relevant for new investment decisions.

 For example, if a company has spent, say, Rs 5 million
on some preliminary work before deciding whether it
should undertake an investment, the amount of Rs 5
million is totally irrelevant, as it represents a sunk cost,
as far as the investment decision is concerned
Post tax principle
 Cash flows should be measured on a post-tax
basis
 Taxes are cash outflows
Working Capital
 Investment will be required for Working Capital and
will be returned by the end of the project’s life
 Working Capital is Current assets – Current liabilities
 Most projects entail an investment in working capital.
Working Capital
 increases in working capital are viewed as cash outflows,
because cash tied up in working capital cannot be used
elsewhere in the business and does not earn returns.
 Each period’s change in working capital should be
recognized in your cash-flow forecasts.
 By the same token, when the project comes to an end, you
can usually recover some of the investment. This results in
a cash inflow.
 When the project comes to an end, inventories are run
down, any unpaid bills are (you hope) paid off, and you
recover your investment in working capital. This generates a
cash inflow.
Working Capital
 Change in accounts receivable The firm’s customers may
delay payment of bills which will increase receivable. Since
revenues (sales) include credit sales, it will overstate cash
inflow. Thus, increase (or decrease) in receivable should be
subtracted from (or added to) revenues for computing actual
cash receipts.

 Change in inventory The firm may pay cash for materials and
production of unsold output. The unsold output increases
inventory. Expenses do not include cash payments for unsold
inventory, and therefore, expenses understate actual cash
payments. Thus, increase (or decrease) in inventory should
be added to (or subtracted from) expenses for computing
actual cash payments.
Working Capital
 Change in accounts payable The firm may delay payment for
materials and production of sold output (sales). This will cause
accounts payable (suppliers’ credit) to increase. Since accounts
payable is included in expenses, they overstate actual cash
payments. Thus, increase (or decrease) in accounts payable should
be subtracted from (or added to) expenses for computing actual
cash payments.

 It is, thus, clear that changes in working capital items should be taken
into account while computing net cash inflow from the profit and loss
account.
 Instead of adjusting each item of working capital, we can simply
adjust the change in net working capital, viz. the difference between
change in current assets (e.g., receivables and inventory) and
change in current liabilities (e.g., accounts payable) to profit.
Increase in net working capital should be subtracted from and
decrease added to after-tax operating profit.
Incremental cash flows
 To ascertain a project’s incremental cash flows you have
to look at what happens to the cash flows of the firm with
the project and without the project
 Include All Incidental Effects:
 It is important to consider a project’s effects on the
remainder of the firm’s business.
 For example, suppose Sony proposes to launch
PlayStation X, a new version of its videogame console.
 Demand for the new product will almost certainly cut into
sales of Sony’s existing consoles. This incidental effect
needs to be factored into the incremental cash flows.
Opportunity Costs

 Opportunity costs are considered

 A plant space could be leased out for Rs 5,00,000 a year.

Accepting the project means we will not receive the rentals.
This is an opportunity cost and it should be charged to the
project.
Salvage Value

 When the project comes to an end, you may be

able to sell the plant and equipment
 If the equipment is sold, you must pay tax on the
difference between the sale price and the book
value of the asset.
 The salvage value (net of any taxes) represents a
positive cash flow to the firm.
Illustration

 Following information is available for a project:

 Initial investment outlay is 100m i.e. 80m on Plant and
Machinery and 20m on working capital
 Project will be financed with 45m of equity capital, 5m of
preference capital, 50m of debt capital.
 Preference capital has a cost of 15%, debt has after-tax cost
of 8.4%
 For Equity Capital we have the following information: Beta of
the company and the project is 1.2; the market risk premium is
12% and the return on government securities is 8%.
 Expected life of the project is 5 years
 At the end of 5 years, fixed assets will fetch a value of 30m
and Working Capital will be liquidated at book value
 Project is expected to receive revenues of 120 million per year
and incur costs of 80 million per year. The costs do not include
depreciation, interest and tax
 Effective tax rate will be 30%
 Plant and Machinery will be depreciated by 25% per year on
Written Down Value method
 Estimate the project cash flows, calculate cost of capital and
find out its NPV and IRR. Should the project be accepted?
 0 1 2 3 4 5
A. FIXED ASSETS -80
B. NET WORKING CAPITAL -20
C. REVENUES 120.00 120.00 120.00 120.00 120.00
D. COST (OTHER THAN DEPR’N AND INT) 80.00 80.00 80.00 80.00 80.00
E. DEPRECIATION 20.00 15.00 11.25 8.44 6.33
F. PROFIT BEFORE TAX 20.00 25.00 28.75 31.56 33.67
G. TAX 6.00 7.50 8.63 9.47 10.10
H. PROFIT AFTER TAX 14.00 17.50 20.13 22.09 23.57
I. NET SALVAGE VALUE OF FIXED ASSETS 26.70
J. RECOVERY OF NET WORKING CAPITAL 20.00
K. INITIAL OUTLAY -100
L. OPERATING CASH FLOW (H+E) 34.00 32.50 31.38 30.53 29.90
M. TERMINAL CASH FLOW (I+J) 46.69
N. NET CASH FLOW (K+L+M) -100 34.00 32.50 31.37 30.53 76.59

Working notes for Depreciation and Net Salvage Value in the next slide
 Depreciation Schedule
Net Salvage Value Calculation

Year Depreciation Schedule Rs

Beginning Balance 80 Sale price of asset 30.00
Depreciation 20 Book Value of asset 18.98
1
Ending Balance 60 Profit on sale of asset 11.02
Depreciation 15 Tax on profit 3.31
2
Ending Balance 45
Depreciation 11.25 Sale Price received 30.00
3
Ending Balance 33.75 Less tax paid 3.30
Depreciation 8.44 Net Salvage Value 26.70
4
Ending Balance 25.31
Depreciation 6.33
5
Ending Balance 18.98
 Cost of Equity capital
 .08+(1.2*0.12) =0.224 = 22.4%

 Cost of capital
 0.224*0.45 + 0.084*0.5 + 0.15*0.05 = 15.03%

 NPV
 Rs 30.20 million
 NPV is positive so Accept

 IRR
 25.72%
 IRR is more than cost of capital so Accept