CAPITAL BUDGETING

DECISIONS

Kinshuk Saurabh
Types of Investment Decisions
• A useful way to classify investments is as follows:

o Mutually exclusive investments

• Serve the same purpose and compete with
each other
 RANK all alternatives, and select the best one.
o Independent investments
• Serve different purposes and do not compete
with each other.
• A company can undertake both investments
o Must exceed a MINIMUM acceptance criteria
 Evaluation Criteria

1. Discounted Cash Flow (DCF) Criteria

o Net Present Value (NPV)
o Internal Rate of Return (IRR)
o Profitability Index (PI)
o Discounted payback period (DPB)

2. Non-discounted Cash Flow Criteria

o Payback Period (PB)
 Net Present Value Method
• Net present value can be written as follows:
 C1 C2 C3 Cn 
NPV        C0
 (1  k ) (1  k ) (1  k ) (1  k ) 
2 3 n

n
Ct
NPV    C0
t 1 (1  k )
t

All C𝒕 future cash flows are reinvested at the discount rate k

Using NPV function in Excel:

• The first item is the required return entered as a decimal.
• The second is the range of cash flows beginning with year 1.
• Add the initial investment after computing the NPV.
NPV(rate,value1,[value2],...)
 Calculating Net Present Value
• Assume that Project X costs Rs 2,500 now and is
expected to generate year-end cash inflows of Rs
900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1
through 5. The opportunity cost of the capital may
be assumed to be 10 per cent.
 Acceptance Rule
• Accept the project when NPV is positive
• NPV > 0
• Reject the project when NPV is negative
• NPV < 0
• May accept the project when NPV is zero
• NPV = 0

The NPV method can be used to select between mutually exclusive

projects; the one with the higher NPV should be selected.
 Evaluation of the NPV Method
• Merits of NPV:
o Time value
o Measure of true profitability
o Value-additivity
o Shareholder value

• Limitations:
o Involved cash flow estimation
o Discount rate difficult to determine
o Mutually exclusive projects
 IRR Method
• The internal rate of return (IRR) is the rate that
equates the investment outlay with the present
value of cash inflows. This is the discount rate which
makes NPV = 0. (Example- YTM)
• All C𝒕 future cash flows are reinvested at IRR

• No outside factor: only project cash flows are considered

• All negative cash flows precede its positive cash flows.
 Calculation of IRR
• Level Cash Flows
o Assume that an investment would cost Rs 20,000
and provide annual cash inflow of Rs 5,430 for 6
years
o What is the IRR of the investment?

NPV   Rs 20,000 + Rs 5,430(PVAF6,r ) = 0

Rs 20,000  Rs 5,430(PVAF6,r )
Rs 20,000
PVAF6,r   3.683
Rs 5,430
 NPV Profile and IRR
NPV Profile
 Acceptance Rule
• When k is opportunity cost of capital:

o Accept the project when IRR > k

o Reject the project when IRR < k

o May accept the project when IRR = k

• Select project with the highest IRR

• For independent projects,

o IRR and NPV rules will give the same results if the firm has no
shortage of funds
 Evaluation of IRR Method

• IRR method has following merits:

 Time value
 Profitability measure
 Acceptance rule
 Shareholder value

• IRR method may suffer from

 Multiple rates means no IRR
 Does not distinguish between lending or borrowing type
projects
 Creates problem in mutually exclusive projects
 No value-additivity like NPV
 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.
• The formula for calculating benefit-cost ratio or
profitability index is as follows:

Total PV of Future Cash Flows

• PI 
Initial Investent


 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 percent rate of discount. The PV of cash inflows
at 10 percent discount rate is:
 Acceptance Rule

• The following are PI acceptance rules for projects:

o Accept the project when PI > 1
o Reject the project when PI < 1
o May accept the project when PI = 1

• The project with positive NPV will have PI > 1. If PI is

less than one it means that NPV is negative.
 PAYBACK
• Payback is the number of years required to recover
the original cash outlay invested in a project.
• If the project generates constant annual cash inflows,
the payback period can be computed by dividing
cash outlay by the annual cash inflow. That is:

Initial Investment C0
Payback = 
Annual Cash Inflow C
 Example – equal cash flows
• 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 12,000
PAYBACK – unequal cash flows
• In case of unequal cash inflows, the payback period
can be found out by adding up the cash inflows until
the total is equal to the initial cash outlay.

• 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; and Rs 3,000 during the next 4 years.
What is the project’s payback?
3 years + 12 × (1,000/3,000) months
3 years + 4 months
 Acceptance Rule
• The project would be accepted if its payback
period is less than the maximum or standard
payback period set by management.

• Highest ranking to the shortest payback period and

lowest ranking to the project with highest payback
period.
 Discounted Payback Period
• The discounted payback period is the number of
periods taken in recovering the investment outlay on
the present value basis.
• The discounted payback period still fails to consider
the cash flows occurring after the payback period.

Discounted Payback Illustrated

NPV Profile
 NPV vs. IRR Conflict
• Conventional Cash Flows
o – + + ++++
o IRR rule agrees with NPV
• If the firm is not constrained for funds in accepting all profitable projects.

• Exceptions
• Non-conventional Cash Flows
o – + + + – ++ – + - -+
o more than one change in the signs of cash flows
o Lending and Borrowing Types together
• Mutually exclusive projects
o Initial scale of investments differ substantially
o Timing of cash flows (initial to later) differ substantially
• Multiple IRRs
• Nonexistent IRR
 Applying The IRR Rule
• Delayed Investments
500,000 500,000 500,000
NPV  1,000,000   2
 3
  $243,426
1.1 1.1 1.1
o The Cash flow above is called as Financing type.
o Should you accept the deal?
• Since the NPV is negative, the NPV rule indicates you
should reject the deal when K =10%.
o Calculate the rate at which NPV is zero. IRR = 23.38%
• It means IRR 23.38% > K 10%
o IRR rules means you should accept the deal.
o Will you accept the project when K = 30%?
NPV of Star’s $1 Million Book Deal

• When the benefits of an investment occur before the costs,

the NPV is an increasing function of the discount rate
 Lending and Borrowing Type
Project X with initial outflow followed by inflows (- +) is a
lending type project
Project Y with initial inflow followed by outflows (+ -) is a
borrowing or financing type project.
Both are conventional projects (- +) or (+ -).
In the example below 10% is our opportunity cost of capital. For
project Y we can be well off only if we could borrow at a rate
less than our opportunity cost of capital 10%. Have we
underestimated the cost of capital?

Lending
Borrowing
 Conflicting Ranking: NPV vs IRR
• The NPV and IRR rules give conflicting ranking to the
projects under the following conditions:

o Timing/Pattern of Cash Flows:

• The cash flow pattern of the projects may differ over time.
o cash flows of one project may increase over time,
while those of others may decrease

o Scale of Investment:
• The cash outlays of the projects may differ.

o Project Life Span:

• The projects may have different expected lives.
 Conflicting Ranking
NPV vs. IRR: Timing of cash flows
The most commonly found condition for the conflict between the
NPV and IRR is the difference in the timing of cash flows.

For both projects M &N discount rate is 9%.

Project M : Larger Cash flows upfront

Project N : Larger Cash flows later
Example
 Conflicting Ranking - example

While the IRR Rule works for project A, it fails for each of the other projects.
 Salvaging IRR: Incremental
approach
• IRR method can still be used to choose between
mutually exclusive projects if we adapt it to
calculate rate of return on incremental cash flows.
• The incremental approach may salvage IRR rule.
o But incremental cash flows series may result in a mix of
negative and positive cash flows.
o This would result in multiple rates of return and ultimately
the NPV method will have to be used.
NPV vs. IRR: Scale of investment
NPV vs. IRR: Project life span
NPV vs. IRR: which one to choose?

• High IRR ⇒ “bigger bang for the buck” and more

margin for error

• High NPV ⇒ creates more “dollar value”

The reasons for these differences

Reinvestment Assumption
• IRR method assumes that the cash flows generated by
the project can be reinvested at its IRR (assumes infinite
stream of projects all yielding IRR)
whereas
• NPV method assumes that the cash flows are reinvested
at the opportunity cost of capital (based upon what
projects of comparable risk should earn)

The solution?
• Compute a modified internal rate of return (MIRR), explicitly
incorporating the desired reinvestment rate assumption.
 Modified IRR (MIRR)
• The MIRR is the compound average annual rate
calculated with a reinvestment rate different than the IRR

NPV @ 10% IRR

0 1 2 3
Project X -115.74 100 0 56 17.24 20%
Project Y -115.74 0 0 200 34.52 20%