Capital Budgeting Techniques

Investment decisions are generally called capital budgeting decisions

1. Net Present Value (NPV)

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

What is a Non-Discounted Cash Flow (NDCF)

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Future Value, Present Value & Net Present Value
Net present value considers the "Time value of money"
Money grows over time, when it earns interest.
Therefore a dollar in hand today is worth more than a dollar in future.

FV = PV (1 + k)n
FV = Future Value
PV = Present Value
K = Discounted Rate
n = Number of Years

⮚ NPV realistically predicts the future cash flows

⮚ NPV discounts future cash flows at an appropriate industry discount rate, the appropriate discount rate is the
project’s opportunity cost of capital.
⮚ NPV is the sum of all discounted cash flows
⮚ IF NPV > 0 (positive), The project can be accepted, The greater the NPV, the better the project financial
benefits.
⮚ Net present value = “Present value of cash Inflows” – “Present value of cash Outflows”.
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Future Value
Example
If $ 100 dollars is invested in a bank today may earn 8% per year.
what is the future value of the $ 100 dollars for 1st, 5th and 15th year?

FV = PV (1 + k)n

After one year: FV = $100*(1+(8/100))1 = 100(1.08)1

After five years: $ 100 (1.08)5 = $ 146.93
After fifteen years: $ 100 (1.08)15 = $ 317.22

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Present Value
Example
If $ 100 dollars is to be received after 1 year, what is the present value of $100 dollars today?
If $ 100 dollars is to be received after 5 years, what is the present value of $100 dollars today?
If $ 100 dollars is to be received after 15 years, what is the present value of $100 dollars today?
Note: Discounted rate is 8% per year.

The Present value of $ 100 to be received after 1 year is $93 dollars today.
The Present value of $ 100 to be received after 5 years is $68 dollars today.
The Present value of $ 100 to be received after 1 year is $32 dollars today.

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Net Present Value
Example: Calculating NPV
A sum of $ 400,000 dollars invested today in an IT project may give a series of below cash inflows in future:
$ 70,000 in year 1
$ 120,000 in year 2
$ 140,000 in year 3
$ 140,000 in year 4
$ 40,000 in year 5
If Opportunity cost of capital is 8% per annum, then should we accept or reject the project?

Solution: Calculating NPV

Step 1: Calculate the PV value of year 1, year2, year3, year4, and year5
Step 2: Sum the PV of all years
Step3: NPV = Present value of all cash inflows – Present value of all cash outflow.
Step 4: If NPV is positive, Accept the project, if not Reject the project.

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Cash Inflow of all Present Values is : $ 408,959
Present value of Cash outflow is : $400,000
Net Present Value = PV of Cash inflows – PV of Cash Outflows = ($408959 – $400000) = $8959 dollars.
Since NPV is positive, (i.e., $8959, This project can be accepted)

Same example: Calculating NPV however with Discount rate or Opportunity cost of capital at 15%
A sum of $ 400,000 dollars invested today in an IT project may give a series of below cash inflows in future:
$ 70,000 in year 1
$ 120,000 in year 2
$ 140,000 in year 3
$ 140,000 in year 4
$ 40,000 in year 5
If Opportunity cost of capital is 15% per annum, then should we accept or reject the project?
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Solution: Calculating NPV
Step 1: Calculate the PV value of year 1, year2, year3, year4, and year5
Step 2: Sum the PV of all years
Step3: NPV = Present value of all cash inflows – Present value of all cash outflow.
Step 4: If NPV is positive, Accept the project, if not Reject the project.

Cash Inflow of all Present Values is : $ 343591

Present value of Cash outflow is : $400,000
Net Present Value = PV of Cash inflows – PV of Cash Outflows = ($343591– $400000) = $ -56408 dollars.
Since NPV is Negative, (i.e., -$56408, This project should be rejected)

N.B: Though we have the same inflow of cash in the previous example and this example, The NPV value changed
with the change in the Discount rate of interest. Therefore, NPV is very much dependent on the Discount rate of
interest value or in other words the opportunity cost of the capital value.
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IRR - Internal Rate of Return
IRR (Internal Rate of Return) is a discount rate at which NPV (Net Present Value) becomes Zero.
In other words, IRR is the opportunity cost at which the NPV becomes Zero.
IRR as the name suggests, it tells how much rate of return are we getting from the project.
Why IRR, what is the use of calculating IRR?
⮚ IRR is used to rank different projects.
⮚ The higher a project's internal rate of return, the more desirable it is to undertake the project.
⮚ If all the other factors are same for different projects then the project with the Highest Internal rate of
return value should be considered.

Note:
For Constant rate of Cash inflow for every year, Internal Rate of Return can be calculated with the help of a
formula
For Uneven rate of Cash inflows for every year, IRR can be calculated by little trail & error adjustments.

Accept the project when Internal rate of return > Discount rate or Opportunity cost of capital.
Reject the project when Internal rate of return < Discount rate or Opportunity cost of capital.
May accept the project when Internal rate of return = Discount rate or Opportunity cost of capital.

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Relationship between IRR, Discount rate and NPV
If IRR > Discount rate or Opportunity cost of capital 🡪 The NPV is always Positive.
If IRR < Discount rate or Opportunity cost of capital 🡪 The NPV is always Negative.
If IRR = Discount rate or Opportunity cost of capital 🡪 The NPV is Zero.

Note: As long as the NPV is Positive, the project is financially viable.

The moment that NPV becomes Negative, the Project is NOT financially viable.

The cost of a project is $1000. It has a time horizon of 5 years and the expected year wise incremental cash
flows are:
Year 1 : $200 Year 2: $300
Year 3 : $300 Year 4: $400
Year 5 : $500
Compute IRR of the project. If opportunity cost of Capital is 12%,
Should we accept the project?

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 At Discount Rate of 12%, the NPV is 169 (positive)

At Discount Rate of 17.7%, the NPV is 0 (Zero), there fore the IRR is 17.7%, Since IRR > Discount rate,
Project can be accepted

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PI – Profitability Index
Present Value of all future cash inflows divided by Initial cash outflows

Project acceptance criteria using Profitability Index method.

Accept the project when PI > 1

Reject the project when PI < 1
May accept the project when PI = 1
Higher the profitability Index of the project, the better.

Note:
For a project with NPV > 0, PI is always greater than 1.
For a project with NPV < 0, PI is always less than 1

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A sum of $ 25,000 invested today in a project may give a series of cash inflows in future as described below:
$ 5000 in year 1
$ 9000 in year 2
$ 10,000 in each of year 3
$ 10,000 in each of year 4
$ 3000 in year 5
If the required rate of return is 12% pa, what is the Profitability Index?

Profitability Index is 1.07

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