Capital Budgeting
Session 11
Question 2
• From the following data, compute the number of dollars returned for
every dollar invested. Recommend which is the best investment
proposal.
Solution
Question 3
• Using the following information compute the PI of each project, identify
the best project to pursue and give reasons for your answer
Solution
Year Project A Project B
0 -10000 -7000
1 5000 9000
2 7000 5000
3 9000 2000
NPV @ 10% $ 7,092.41 $ 6,816.68
• PI(A) = (NPV + Cost)/Cost = $ 17,092.41/ 10,000 = 1.71
• PI(B) = (NPV + Cost)/Cost = $ 13,816.68/ 7,000 = 1.97
• Project B may be chosen since it has a higher PI compared to Project A.
Question 4
• What is the profitability index for the following set of cashflows at a discount
rate of 10%. What would the PI be at 15% and 22% discount rate? At which
discount rate would the company be advised to proceed with the proposal?
Year Cash flow (in $)
0 -27,500
1 15,800
2 13,600
3 8,300
Solution
• Calculating PI at 10%
Year Cash inflow PVF at 10% Discounted CF
1 15800 0.909 14362
2 13600 0.826 11233
3 8300 0.751 6233
Total 31,829
PI = PV of discounted cash flow/ PV of cash inflow
Profitability index = 31829/27500 = 1.16
Solution contd..
• Calculating PI at 15% • Calculating PI at 22%
Question 5
• Geremy Company invests in a new project. Their initial investment is US
$10000. Calculate their PI at 10% discount rate. Given below is the cash inflow
for the next 5 years –
Solution
Year Cash flow PV of cash inflow ($)
1 4000 3636
2 4000 3304
3 4000 3004
4 2000 1366
5 2000 1242
Total 12552
PI Formula = PV of Future Cash Flows / Initial Investment Required
PV of cash inflow 12,552
Initial Investment 10000
PI 1.26
Question 6
• Paint & Co. wishes to Invest in a new painting technology. Using the PI
method advice them about the decision to accept/reject the proposals. The
company provides the following cash flows, to be estimated at a 10%
discount rate for project A and at 12% discount rate for project B.
Year Cash flows (Project A) Cashflows (Project B)
0 (20,00,000) (30,00,000)
1 3,00,000 6,00,000
2 6,00,000 8,00,000
3 9,00,000 9,00,000
4 7,00,000 10,00,000
5 6,00,000 12,00,000
Solution
Year Cash flows (A) PV of Cashflows Cash flows (B) PV of Cashflows
at 10% (A) at 12% (B)
1 3,00,000 2,72,700 6,00,000 5,35,800
2 6,00,000 4,95,600 8,00,000 6,37,600
3 9,00,000 6,75,900 9,00,000 6,40,800
4 7,00,000 4,78,100 10,00,000 6,36,000
5 6,00,000 3,72,600 12,00,000 680,400
Total 22,94,900 3,130,600
Profitability Index of Project A = 22,94,900 / 20,00,000 = 1.15
Profitability Index of Project B = 31,30,600 / 30,00,000 = 1.04
Using the formula of profitability index, it can be seen that Project A will create an additional value of
Re. 0.15 for every Re.1 invested in the project compared to Project B, which will create an additional
value of Re. 0.04 for every Re. 1 invested in the project. Therefore, Paint & Co. should select Project
A over Project B.
Method #3
Pay Back Period Analysis
Payback Period Analysis
• Payback analysis is the simplest form of capital budgeting
analysis, but it's also the least accurate.
• It's still widely used because it can give managers a quick
understanding of the real value of a proposed project.
• Usually used when companies have only a limited amount of
funds (or liquidity) to invest in a project.
• Payback analysis calculates how long it will take to recoup the
costs of an investment.
Interpreting PBP
• Payback period is a quick and easy way to assess
investment opportunities and risk, but instead of a
break-even analysis’s units, payback period is
expressed in years.
• The shorter the payback period, the more attractive the
investment would be, because this means it would take
less time to break even.
Computation of PBP
• The payback period is identified by dividing the initial investment in
the project by the average yearly cash inflow that the project will
generate.
Example:
• If it costs $400,000 for the initial cash outlay, and the project
generates $100,000 per year in revenue, how many years would it
take to recoup the investment?
• PBP = Initial Cash outlay/Revenue per year
• PBP = 4,00,000/1,00,000 = 4 years
The Pros and Cons of PBP Analysis
The payback period formula is easy
Though it shows the length of
to understand.
time it takes for a return on
Helps to know how quickly companies
investment, it doesn’t show the
can get back their investment.
specific profitability.
It facilitates side-by-side analysis of
It doesn’t take the time value of
two or more competing projects
money.
Payback analysis is thus, not considered a true measure of how profitable a project
is but instead, provides a rough estimate of how quickly an initial investment can be
recouped.
