Chapter

5
S. Maria Immanuvel
Assistant Professor,
St. Joseph’s Institute of Management
28/1 Primrose road, Off M G Road
Bangalore – 560025, India

E Mail :
[email protected]

Mobile:

+91 94876 29563, +91 87782 67637

Learning Objectives
Capital Budgeting Introduction
Techniques of Capital Budgeting
Discounted Cash flow techniques
◦ Net Present Value
◦ Internal Rate of Return
◦ Profitability Index
Non-Discounted Cash flow techniques
◦ Payback period
◦ Discounted Payback period
◦ Accounting Rate of Return
Capital Budgeting -
Introduction
Capital Budgeting - Introduction
 An efficient allocation of capital is the most important finance function in an
organization.
 It involves decisions to commit the firm’s funds to the long-term assets.
 It is considered as an important function since they tend to determine its
value by influencing its growth, profitability and risk
 The investment decision of a firm is generally is known as capital budgeting
Capital Budgeting - Meaning
 A capital budgeting decision may be defined as the form’s decision to invest its
current funds most efficiently in the long-term assets in anticipation of an
expected flow of benefits over a series of years.
 Capital budgeting is the process of evaluating and selecting long-term
investments that are consistent with the firm’s goal of maximizing owner’s
wealth
 The long-term are those that affect the firm’s operations beyond the one-year
period
 The firm’s investment decisions would generally include expansion,
acquisition, modernization and replacement of the long-term assets
Capital Budgeting - Meaning
 Sale of a division or business (disinvestment) is also as an investment decision
 Decisions like the change in the methods of sales distribution or an
advertisement campaign or research and development programs have long-
term implications for the firm’s expenditures and benefits are also evaluated
as investment decisions
 Investments in long-term assets requires large funds to be tied-up
 Expenditures and benefits of an investment should be measured in cash, as
the cash flow is more important than the accounting profit
 An investment will add value to the shareholder’s wealth, if it yields benefits
in excess of minimum benefits (Opportunity cost of capital)
Types of Investment decisions
 Expansion and diversification: add capacity to its existing product lines to
expand its operation or expand its activities in new business
 Replacement and modernization: to improve operating efficiency and reduce
costs
 Mutually exclusive investments: the purpose are same and if one is
undertaken, the other will have to be excluded
 Independent events: serve different purposes and do not compete with each
other
Process of Capital Budgeting
 Proposal generation: Proposals for new investment projects are made at all levels
within a business organization and are reviewed by finance personnel.
 Review and analysis: Financial managers perform formal review and analysis to
assess the merits of investment proposals
 Decision making: Firms typically delegate capital expenditure decision making on the
basis of dollar limits.
 Implementation: Following approval, expenditures are made and projects
implemented. Expenditures for a large project often occur in phases.
 Follow-up: Results are monitored and actual costs and benefits are compared with
those that were expected. Action may be required if actual outcomes differ from
projected ones.
Capital Budgeting Techniques
Discounted Cash flow Non-discounted cash flow
techniques techniques

Net Present Value (NPV) Payback period

Internal Rate of Return (IRR) Discounted payback period

Profitability Index (PI) Accounting Rate of Return

Non-Discounted Cash flow
techniques
Payback Period
 Payback periods are commonly used to evaluate proposed investments.
 The payback period is the amount of time required for the firm to recover its
initial investment in a project, as calculated from cash inflows.
 Constant (even) cash flows : divide cash outlay by the annual cash inflow
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐶0
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 = =
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤 𝐶
 Uneven cash flows: Payback period is found out by adding up the cash
inflows until the total is equal to the initial cash outlay
Payback Period – Decision Rule
 When the payback period is used to make accept–reject decisions, the
decision criteria are as follows:
 If the payback period is less than the maximum acceptable payback period,
accept the project.
 If the payback period is greater than the maximum acceptable payback period,
reject the project.
 Payback Period – Constant cash flows
Ex.1  A project requires an outlay of Rs.50,000 and yields annual cash flow of
Rs.12500 for 7 years. What is the payback period of the project?
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐶0
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 = =
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤 𝐶
50,000
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 =
12500
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 = 4 𝑦𝑒𝑎𝑟𝑠
 Payback Period – Uneven cash flows
Ex.2  The problem concerns Bennett Company, a medium-sized metal fabricator
that is currently contemplating two projects: Project A requires an initial
investment of $42,000, project B an initial investment of $45,000. The
projected relevant operating cash inflows for the two projects are presented in
Table Project A Project B
Initial Investment 42000 45000
Year Operating cash inflows
1 14000 28000
2 14000 12000
3 14000 10000
4 14000 10000
5 14000 10000
 Payback Period
EVEN CASH FLOWS UNEVEN CASH FLOWS

Project B
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐶0
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 = =
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤 𝐶 Initial 45000 Payback
Investment amount
Amount to be
45,000 Year
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑(𝑃𝑟𝑜𝑗𝑒𝑐𝑡 𝐴) = recovered in
14000 1 28000 28000 the year 3 is
2 12000 40000 5000
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 = 3 𝑦𝑒𝑎𝑟𝑠 3 10000 50000
4 10000
5 10000
Payback Period – Uneven cash flows
Project B
Actual cash inflow in the year 3 is 10000
Initial 45000 Payback
Investment amount
Balance amount to be recovered in the year 3 is 5000
Year
1 28000 28000
= (5000 / 10000) * 12
2 12000 40000 = 6 Months
3 10000 50000
4 10000 Payback period is = 2 year + 6 Months
5 10000
 Payback Period – Uneven cash flows
Ex.3  A project requires a cash outlay of Rs.20,000 and generates cash inflows of
Rs.8000, Rs.7000, Rs.4000 and Rs.3000 during the next four years. What is the
project’s payback period?

Initial 20000 Payback

Actual cash inflow in the year 4 is 3000
Investment amount
Balance amount to be recovered in the year 4 is 1000
Year
1 8000 8000
= (1000 / 3000) * 12
2 7000 15000
= 4 Months
3 4000 19000
4 3000 22000 Payback period is = 3 year + 4 Months
Discounted Payback
 Payback period does not discount the cashflows for the calculation
 Under the discounted payback, the cash inflows are discounted and then the
payback period is computed
 Discounted payback period is the number of periods taken in recovering the
investment outlay on the present value basis
 Discounted Payback
Ex.1  Example: Projects P and Q involves the same outlay of Rs.4000 each. The
opportunity cost of capital may be assumed to be as 10%. The cash flows of
the projects are given in the table. What is the discounted payback period?

Project P Project Q
Initial Investment 4000 4000
Year Operating cash inflows
1 3000 0
2 1000 4000
3 1000 1000
4 1000 2000
 Discounted Payback period
Ex.1
Project P Project Q
Initial -4000 Discount Discounted -4000 Discount Discounted
Investment rate 10% cash flow rate 10% cash flow

1 3000 .909 2727 0 .909 0

2 1000 .826 826 4000 .826 3304
3 1000 .751 751 1000 .751 751
4 1000 .683 683 2000 .683 1366

Project P = 2.6 years Project Q = 2.11 years

 Payback period and Discounted Payback period
Ex.2  Project M is under consideration for selection. Its initial cash outlay is Rs.1800
and life of 5 years. The cost of capital of the firm is 12%.
Years 0 1 2 3 4 5
Cash Flows -1800 600 300 1000 800 1100

 What is the payback period of the project?

 If the cut off payback period is three years, should the project be accepted?
 What is the discounted payback period?
 If the cut off remains same at three years even on discounted basis should the
firm accept the proposal?
 Payback period and Discounted Payback period
Ex.2
Project M Actual cash inflow in the year 3 is 1900
Initial 1800 Payback Balance amount to be recovered in the year 3 is 900
Investment amount
= (900 / 1000) * 12
Year
= 10.8 Months
1 600 600
2 300 900 Payback period is = 2 year + 10.8 Months
3 1000 1900
4 800
If the cut off period is 3 years, the project may be
5 1100
accepted, as the Payback period is less than the cut
off period
 Payback period and Discounted Payback period
Ex.2
Project M
Initial -1800 Discount Discounted Payback
= (313.3 / 508.4) * 12
Investment rate 12% cash flow = 7.40 Months

1 600 .8929 535.74 534.74

Payback period is = 3 year
2 300 .7972 239.16 774.9 + 7.40 Months
3 1000 .7118 711.8 1486.7
4 800 .6355 508.4 1995.1
5 1100 .5674 624.14

If the cut off period is 3 years, the project may be rejected, as the discounted
Payback period is more than the cut off period
Payback period – Limitations
 The payback period rule ignores all cash flows after the cutoff date. If the
payback period is two years, the payback rule rejects project A regardless of
the size of the cash inflow in year 3
 The payback period rule gives equal weight to all cash flows before the cutoff
date. Payback rule says that Project A and C are equally attractive, but because
Cs cash inflows occur earlier, C has the higher NPV at any discount rate.
 Accounting rate of Return
 Accounting Rate of Return (ARR) also known as Return on Investment
 This method uses accounting information as revealed by Financial Statements
to measure the profitability of an investment
 ARR is the ratio of the average after tax profit divided by the average
investment
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑐𝑜𝑚𝑒
Accounting Rate of Return (ARR) =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
σ𝑛𝑡=1 𝐸𝐵𝐼𝑇(1 − 𝑇) /𝑛
Accounting Rate of Return (ARR) =
𝐼0 + 𝐼𝑛 /2
Average Income: Earnings after tax without adjustment for interest OR Net operating income after tax (EBIT (1-T)),
I0:Book value of investment at the beginning, I1: Book value of the investment at the end of n number of years
Accounting rate of Return – Acceptance Rule
 This method will accept all those projects whose ARR is higher than the
minimum rate established by the management and reject those projects
which have ARR less than the minimum rate.
 This method would rank a project as number one if it has highest ARR and
lowest rank would be assigned to the project with lowest ARR
 Accounting rate of Return
Ex.1  A Company wants to invest in new set of vehicles for the business. The
vehicles cost £350,000 and would increase the company’s annual revenue by
£100,000, as well as the company’s annual expenses by £10,000. The vehicles
are estimated to have a useful shelf life of 20 years, with no salvage value.
Compute the ARR.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑐𝑜𝑚𝑒
Accounting Rate of Return (ARR) =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
σ𝑛𝑡=1 𝐸𝐵𝐼𝑇(1 − 𝑇) /𝑛
Accounting Rate of Return (ARR) =
𝐼0 + 𝐼𝑛 /2
Accounting rate of Return
Average annual profit = £100,000 - £10,000 = £90,000
Depreciation expense = £350,000 / 20 = £17,500

True average annual profit = £90,000 - £17,500 = £72,500

ARR = £72,500 / 350,000 = 0.2071 = 20.71%

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑐𝑜𝑚𝑒 σ𝑛
𝑡=1 𝐸𝐵𝐼𝑇(1−𝑇) /𝑛
Accounting Rate of Return (ARR) = =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐼0+𝐼𝑛 /2
 Accounting rate of Return
Ex.2  A project will cost Rs.40,000. Its streak of earnings before depreciation,
interest and taxes (EBDIT) during the first year through five years is expected
to be Rs.10,000, Rs.12,000, Rs.14,000, Rs.16,000 and Rs.20,000. Assume a 50%
per cent tax rate and depreciation on straight-line basis. Compute the
project’s ARR.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑐𝑜𝑚𝑒
Accounting Rate of Return (ARR) =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
σ𝑛𝑡=1 𝐸𝐵𝐼𝑇(1 − 𝑇) /𝑛
Accounting Rate of Return (ARR) =
𝐼0 + 𝐼𝑛 /2
Average Income: Earnings after tax without adjustment for interest OR Net operating income after tax (EBIT (1-T)),
I0:Book value of investment at the beginning, I1: Book value of the investment at the end of n number of years
Accounting rate of Return
Period 1 2 3 4 5 Average
EBIDT 10,000 12,000 14,000 16,000 20,000 14,400
Depreciation 8,000 8,000 8,000 8,000 8,000 8,000
EBIT 2,000 4,000 6,000 8,000 12,000 6,400
Taxes (50%) 1,000 2,000 3,000 4,000 6,000 3,200
EBIT(1-T) 1,000 2,000 3,000 4,000 6,000 3,200

Book Value of Investment

Beginning 40,000 32,000 24,000 16,000 8,000

Ending 32,000 24,000 16,000 8,000 0
Average 36,000 28,000 20,000 12,000 4,000 20,000
Accounting rate of Return
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑐𝑜𝑚𝑒 σ𝑛
𝑡=1 𝐸𝐵𝐼𝑇(1−𝑇) /𝑛
Accounting Rate of Return (ARR) = =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐼0+𝐼𝑛 /2

3,200
Accounting Rate of Return (ARR) =
20,000

Accounting Rate of Return (ARR) = 16 %

 Accounting rate of Return
Ex.3  Compute the Accounting Rate of Return for the given information: Initial
Investment $60 million, Salvage Value $20 million, Useful life: 5 years, Tax rate
may be exempted. The project is expected to produce EBDIT of $5 million, $10
million, $15 million, $20 million and $25 million respectively for next five
years.
Period 1 2 3 4 5 Average
EBIDT (Millions) 5 10 15 20 25 15
Depreciation 8 8 8 8 8 8
EBIT -3 2 7 12 17 7

Annual Depreciation = ($60 million – $20 million) ÷ 5 Years = $8 million

Accounting rate of Return
Book Value of Investment (in millions)

Year 1 2 3 4 5 Average
Beginning 60 52 44 36 28
Ending 52 44 36 28 20
Average 57 48 40 32 24 40.2
7
Accounting Rate of Return (ARR) =
40.2

Accounting Rate of Return (ARR) = 17.41 %

Accounting rate of Return - Limitations
 Cash flows and book income are often very different.
 Accountant labels some cash outflows as capital investment and others as
operating expense.
 Operating expenses deducted from the income statement, capital expenses
are converted into depreciation and adjusted both in the income statement as
well as in balance sheet.
 Hence, Accounting rate of return depends on which items the accountants
treat as capital and how rapidly they are depreciated
 The average profitability of past investments is not usually the right hurdle for
new investments
Discounted Cash flow
techniques
Net Present Value (NPV)
 Net Present Value (NPV) gives explicit consideration to the time value of
money, hence, it is considered a sophisticated capital budgeting technique.
 All such techniques in one way or another discount the firm’s cash flows at a
specified rate.
 This rate—often called the discount rate, required return, cost of capital, or
opportunity cost—is the minimum return that must be earned on a project to
leave the firm’s market value unchanged.
 NPV = Present value of cash inflows – Initial Investment
Net Present Value (NPV) - Rule
 Net Present Value (NPV) rule recognizes that a rupee today is worth more than
a rupee tomorrow because the rupee today can be invested to start earning
interest immediately. Any investment rule that does not recognize the time
value of money can not be sensible
 NPV depends only solely on the forecasted cash flows from the project and
the opportunity cost of capital
 Because present values are all measured in today’s rupees, you can add them
up. (NPV A+B = NPV(A) + NPV(B))
Net Present Value (NPV) - Steps
 Cash flows of the investment project should be forecasted based on realistic
assumptions
 Appropriate discount rate should be identified to discount the forecasted cash flows.
The appropriate discount rate is the Project’s opportunity cost of capital which is
equal to the required rate of return expected by the investors on investments
equivalent risk
 Present value of cash flows should be calculated using the opportunity cost of capital
as the discount rate
 Net present value should be found out by subtracting the present value of cash
outflows from the present value of cash inflows. The project should be accepted, if
NPV is positive (i.e NPV > 0). If the NPV is less than 0, reject the project
Net Present Value (NPV) - Steps
 If the NPV is greater than $0, the firm will earn a return greater than its cost of
capital. Such action should increase the market value of the firm, and
therefore the wealth of its owners by an amount equal to the NPV
𝐶1 𝐶2 𝐶𝑛
NPV = + 2 +⋯. 𝑛 −C0
(1+𝑟) 1+𝑟 1+𝑟

𝐶𝑡
NPV = σ𝑛𝑡=1 𝑡 −C0
1+𝑟

C1, C2 and Cn represents cash inflows, r: opportunity cost of capital /

discounting rate, C0 is initial cost of investment, n is the expected life of the
investment
 𝐶1 𝐶2 𝐶𝑛
NPV = + 2 +⋯. 𝑛 −C0
(1+𝑟) 1+𝑟 1+𝑟
Net Present Value (NPV)
Ex.1  Assume that Project X costs Rs. 2500 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. Compute the NPV of Project X.

900 800 700 600 500

NPV of Project X = + 2
+ 3
+ 4
+ 5
− 2500
(1.10) 1.10 1.10 1.10 1.10

NPV of Project X = 2725 - 2500

NPV of Project X = 225

 𝐶1 𝐶2 𝐶𝑛
NPV = + 2 +⋯. 𝑛 −C0
(1+𝑟) 1+𝑟 1+𝑟
Net Present Value (NPV)
Ex.1  Assume that Project X costs Rs. 2500 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. Compute the NPV of Project X.
Year 1 Cash inflow PVIF @10% DCF
0 -2500 -2500
1 900 0.9091 818.19
2 800 0.8264 661.12
3 700 0.7513 525.91
4 600 0.6830 409.80
5 500 0.6209 310.45
NPV of Project X 225.47
 𝐶1 𝐶2 𝐶𝑛
NPV = + 2 +⋯. 𝑛 −C0
(1+𝑟) 1+𝑟 1+𝑟
Net Present Value (NPV)
Ex.2  Bennett Company, a medium sized metal fabricator that is currently
contemplating two projects Project A requires an initial investment of
Rs.42000, Project B an initial investment of Rs.45000. The projected relevant
operating cash inflows for the two projects are presented below table.
Compute the NPV of Project A and B and conclude which project may be
accepted. Assume that the cost of capital is 10%

Year 1 2 3 4 5
Project A 14,000 14,000 14,000 14,000 14,000

Project B 28,000 12,000 10,000 10,000 10,000

 𝐶1 𝐶2 𝐶𝑛
NPV = + 2 + ⋯. 𝑛 −C0
(1+𝑟) 1+𝑟 1+𝑟

Net Present Value (NPV)

Year Cash inflow Cash Inflow PVIF DCF DCF Both projects are
Project A Project B @10% Project A Project B acceptable, because
the net present value
0 -42000 -45000 -42000 -45000 of each is greater
than $0. If the
1 14000 28000 0.9091 12727.4 25454.8 projects were being
2 14000 12000 0.8264 11569.6 9916.8 ranked, however,
3 14000 10000 0.7513 10518.2 7513.00 project A would be
considered superior
4 14000 10000 0.6830 9562.00 6830.00 to B, because it has a
5 14000 10000 0.6209 8692.6 6209.00 higher net present
NPV of Projects 11069.8 10923.6 value
 𝐶1 𝐶2 𝐶𝑛
NPV = + 2 +⋯. 𝑛 −C0
(1+𝑟) 1+𝑟 1+𝑟
Net Present Value (NPV)
Ex.3  Mr halcyon is considering the purchase of a new bulk carrier for Rs.80 million.
The forecasted revenues are Rs.50 million per year and operating costs are
Rs.35 million. A major refit costing Rs.20 million will be required after both the
fifth and tenth years. After 15 years the ship is expected to be sold for scrap at
Rs.15 million. If the discounted rate is 8%, what is the ship's NPV?
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
80 50 50 50 50 50 50 50 50 50 50 50 50 50 50 50
Cost 35 35 35 35 35 35 35 35 35 35 35 35 35 35 35 35

Refi 20 20
ting
Salv 15
age
 𝐶1 𝐶2 𝐶𝑛
NPV = + 2 +⋯. 𝑛 −C0
(1+𝑟) 1+𝑟 1+𝑟
Net Present Value (NPV)
Ex.3 Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
80 50 50 50 50 50 50 50 50 50 50 50 50 50 50 50
Cost 35 35 35 35 35 35 35 35 35 35 35 35 35 35 35 35

Refi 20 20
ting
Salv 15
age
-80 15 15 15 15 -5 15 15 15 15 -5 15 15 15 15 30

NPV : 110.25
Internal Rate of Return (IRR)
 The internal rate of return (IRR) is probably the most widely used
sophisticated capital budgeting technique.
 The internal rate of return (IRR) is the discount rate that equates the NPV of an
investment opportunity with $0 (because the present value of cash inflows
equals the initial investment).
 It is the compound annual rate of return that the firm will earn if it invests in
the project and receives the given cash inflows.
 IRR is also called as yield on an investment, marginal efficiency of capital, rate
of return over cost, time adjusted rate of internal return
 Internal Rate of Return (IRR)
 The true rate of return on an investment of Rs10,000 made in bank with the
interest rate of 8% investment would be Rs.10800.
 The amount that you would obtain in the future (10800) would consist of your
investment (10000) plus return on your investment (10000*.08)
 The rate of return (8%) of your investment makes the discounted (present)
value of your cash inflow (10800) equal to your investment (10000)
𝐶1
10000 0.08 = 10800 𝐶1 𝐶0 =
=1+𝑟 (1 + 𝑟)
10800 𝐶0
10000 = r : Rate of return on an investment
1.08
𝐶1 − 𝐶0 𝐶1 𝐶1 C0: Investment
𝑟= = −1 =1+𝑟
𝐶0 𝐶0 𝐶0 C1: Cash inflow after one period
 Internal Rate of Return (IRR)
 IRR can be computed using the following equation:
𝑛 𝑛
𝐶1 𝐶2 𝐶𝑛 𝐶𝑡 𝐶𝑡
C0= + + ⋯. C0= ෍ 𝑡 ෍ −C0 = 0
(1 + 𝑟) 1+𝑟 2 1+𝑟 𝑛 1+𝑟 1+𝑟 𝑡
𝑡=1 𝑡=1
 IRR equation is the same as NPV equation
 In the NPV method, required rate of return (r) is known and NPV is found
 In the IRR method, the value of r has to be determined at which the NPV
becomes 0
 Accept the project if its IRR is higher than the opportunity cost of capital,
reject if IRR is less than lower than the opportunity cost of capital
 Internal Rate of Return (IRR)
Ex.1  A project costs Rs.16,000 and is expected to generate cash inflows of Rs.8,000,
Rs.7,000 and Rs.6,000 at the end of each year for next years. Compute the IRR
of the project. (Trial and Error Method)
Year Cash PVIF DCF PVIF DCF PVIF DCF
inflow @20% @20% @16% @16% @15% @15%

0 -16000 -16000 -16000 -16000 The true rate of

1 8,000 0.8333 6666.4 0.8621 6896.8 0.8696 6956.8 return should lie
between 15-16
2 7,000 0.6944 4860.8 0.7432 5202.4 0.7561 5292.7
3 6,000 0.5787 3472.2 0.6407 3844.2 0.6575 3945
Total 14999.4 Total 15943.4 Total 16194.5
Diff -1000.6 Diff -56.6 Diff 194.5
 Internal Rate of Return (IRR)
Ex.1

Cash inflow Difference

PV Required 16000
PV at lower rate 15% 16194.5 16194.5 -16000 194.5

PV at lower rate 16% 15943.4 16194.5 - 15943.4 251.1

r = 15% + (16%-15%) 194.5 / 251.1 r = 15% + 0.77% r = 15.77%

 Internal Rate of Return (IRR)
Ex.2  Bennett Company, a medium sized metal fabricator that is currently
contemplating two projects Project A requires an initial investment of
Rs.42000, Project B an initial investment of Rs.45000. The projected relevant
operating cash inflows for the two projects are presented below table.
Compute the IRR of Project A and B. If cost of capital is 10%, which project
may be accepted.

Year 1 2 3 4 5
Project A 14,000 14,000 14,000 14,000 14,000 IRR (A) = 19.9%
Accept B
Project B 28,000 12,000 10,000 10,000 10,000 IRR (B) = 21.7%
NPV and IRR
When discounted at the opportunity cost of capital:
 If the opportunity cost of capital is less than IRR, then the project has a
positive NPV
 If the opportunity cost of capital is equal to IRR, then the NPV is Zero
 If the opportunity cost of capital is greater then IRR, then the project has a
negative NPV
 Therefore, when we compare the opportunity cost of capital with the IRR, we
are effectively asking whether our project has a positive NPV
NPV and IRR – Pitfall 1 - Lending or Borrowing?
 Not all cash-flow streams have NPVs that decline as the discount rate
increases. This is contrary to the normal relationship between NPV and
discount rates.
Co C1 C2 C3 IRR NPV @ 10%
+1000 -3600 +4320 -1728 +20% -0.75
 With some cash flows (as noted below) the IRR of both the projects are
equal. However, they are not equally attractive. (When we lend money we want high
rate of return. When we borrow money, we want a low rate of return)

Project C0 C1 IRR NPV @ 10%

A -1000 1500 +50% +364
B +1000 -1500 +50% -364
NPV and IRR – Pitfall 2 - Multiples Rates of Return?
 Certain cash flows can generate NPV=0 at two different discount rates. (Cleaning up the site
cost at the end of the life of the project)
 The following cash flow generates NPV=0 at both (3.50%) and 19.54%.
C0 -30
C1 10
C2 10
C3 10
C4 10
C5 10
C6 10
C7 10
C8 10
C9 10
C10 -65
NPV and IRR – Pitfall 3 – Mutually Exclusive Projects
 Firms often have to choose between several alternatives ways of doing the
same job or using the same facility. They need to choose Mutually Exclusive
Projects. Here IRR tool may be misleading
 Example:
 Project D: Manually controlled machine tool (NPV is less, IRR is high),
 Project E: Controlled by the computers (NPV is High and IRR is less)

Project C0 C1 IRR % NPV @ 10%

D -10000 20000 100 +8182
E -20000 35000 75 +11818
NPV and IRR – Pitfall 4 – More than one opportunity cost of capital
 All the discussion are based on the assumption of having opportunity cost of
capital at one level for all the cash flows (C1, C2, C3….etc)
 The differences between short and long term discount rates can be important
when the term structure of interest rates is not flat.
Profitability Index (PI)
 Profitability Index (PI) is the ratio of the present value of cash inflows, at the
required rate of return, to the initial cash outflows of the investment.
 It is also called as benefit – cost (B/C) ratio
𝑛
𝑃𝑉 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 𝑃𝑉(𝐶𝑡) 𝐶𝑡
Profitability Index (PI) = = ෍ ÷ C0
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑙𝑎𝑦 𝐶0 1+𝑟 𝑡
𝑡=1
 Accept the project when PI is greater than 1 (PI>1)
 Reject the project when PI is less than 1 (PI<1)
 The project with positive NPV will have PI greater than 1. PI is less than 1
when NPV is negative
 𝑃𝑉 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 𝑃𝑉(𝐶𝑡)
Profitability Index (PI) = =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑙𝑎𝑦 𝐶0
Profitability Index (PI)
Ex.1  The initial cash outlay of a project X 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% rate of discount. Determine the Profitability Index of the
project.
Year 1 Cash inflow PVIF @10% DCF
1 40,000 0.9091 36364
2 30,000 0.8264 24792 112381
PI = = 1.12
100000
3 50,000 0.7513 37565
4 20,000 0.6830 13660
PV of Project X 112381
 Profitability Index (PI)
Ex.2  Bennett Company, a medium sized metal fabricator that is currently
contemplating two projects Project A requires an initial investment of
Rs.42000, Project B an initial investment of Rs.45000. The projected relevant
operating cash inflows for the two projects are presented below table.
Compute the Profitability Index of Project A and B and conclude which project
may be accepted. Assume that the cost of capital is 10%

Year 1 2 3 4 5
Project A 14,000 14,000 14,000 14,000 14,000

Project B 28,000 12,000 10,000 10,000 10,000

 𝑃𝑉 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 𝑃𝑉(𝐶𝑡)
Profitability Index (PI) = =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑙𝑎𝑦 𝐶0
Profitability Index (PI)

Year Cash inflow Cash Inflow PVIF DCF DCF

Project A Project B @10% Project A Project B 53069.8
PI (A) = = 1.26
42000
1 14000 28000 0.9091 12727.4 25454.8
2 14000 12000 0.8264 11569.6 9916.8
66847.2
3 14000 10000 0.7513 10518.2 7513.00 PI (B) = = 1.24
45000
4 14000 10000 0.6830 9562.00 6830.00
5 14000 10000 0.6209 8692.6 6209.00
PV of Projects 53069.8 55923.6
Capital Rationing and Profitability Index (PI)
 When company’s are facing a situation of selecting multiple projects, they may
encounter the problem of limitation on the investment. In such cases, they
may not be able to select all the projects. This is called capital rationing.
 When capital is rationed, then we may use the Profitability Index method for
selecting the package of projects that is within the company’s resources that
gives the highest possible net present value
Project C0 C1 C2 NPV at 10%
Project A (in Millions) -10 +30 +5 21
Project B (in Millions) -5 +5 +20 15
Project C (in Millions) -5 +5 +15 12
Capital Rationing and Profitability Index (PI)
 Suppose the company is limited to spending 10 million.
 It can invest either in Project A or Projects B and C. Not in all three
 Pick the projects that offer the highest net present value per rupee of initial
outlay

Projects Investment in Millions NPV at 10% Profitability Index

Project A -10 +30 +5
Project B -5 +5 +20
Project C -5 +5 +15
Estimating Net Cash Flows
Cash flow principle
 Companies spend money today in the expectation that it will generate a
stream of future profits.
 When discounting the cash flows, the firm should apply the same criteria for
all capital investments regardless whether they involve a tangible or intangible
asset. When discounting consider the following:
1. Only cash flow is relevant
2. Always estimate cash flows on an incremental basis
3. Be consistent and financing decisions
4. Separate investment and financing decisions
Cash flow principle – Relevant cash flows
 Do not confuse accounting with cash flows. Accounting income is to measure
how well the company has performed.
 Cash flow should be considered after tax basis
 Effect of non-cash charges to be considered appropriately – depreciation, prov
for bad debts
 Tax benefit on depreciation to be considered
Cash flow principle –

₹ Lakhs
Proj A Proj A
1 Profit before Depreciation 100 100
2 Depreciation 20 50
3 Profit after depreciation 80 50
4 Tax @ 30% 24 15
5 PAT 56 35
6 Operating cash (2+5) 76 85
Cash flow principle –
2. Estimate cash flows on an incremental basis
 Remember to include taxes and consider the cash flow after tax basis
 Do not confuse average with incremental payoffs
 Include all incidental effects
 Forecast sales today and recognize after-sales cash flows to come later
 Include opportunity costs
 Forget sunk costs
 Beware of allocated overhead costs
Cash flow principle –
3. Treat inflation consistently
 If the discount rate is stated in nominal terms, then consistency requires that
cash flows should also be estimated in nominal term, taking account of trends
in selling price, labor and material costs
 Tax savings from depreciation do not increase with inflation
 They are constant in nominal terms because tax law in India allows only the
original cost of assets to be depreciated
Cash flow principle –
4. Separate Investment and Financing Decisions
 Focus exclusively on the project cash flows, not the cash flows associated with
alternative financing schemes
 Regardless of actual financing, view the project as if it were all equity financed
and treating all cash outflows required for the project as coming from
stockholders and all cash inflows are going to them
 You should neither subtract the debt proceeds from the required investment
nor recognize the interest and principal payment on the debt as cash outflows
Using NPV rule to choose among projects
 Taking higher NPV in evaluating the project will the correct procedure as long
as the choice between two projects does not affect any future decisions that
you might wish to make.
 Sometimes the choices you make today will have an impact on future
opportunities. If these situations, choosing between competing projects is
trickier and consider the following:
 The investment timing problem: Should you invest now or wait and think
about it again next year?. Here, today’s investment is competing with possible
future investments
Using NPV rule to choose among projects
 The choice between long and short lived equipment. Should the company
save money today by installing cheaper machinery that will not last long?
Here, Today’s decision would accelerate a later investment in machine
replacement
 The replacement problem: When should existing machinery be replaced?
Using it another year could delay investment in more modern equipment
 The cost of excess capacity: What is the cost of using equipment that is
temporarily not needed? Increasing the use of equipment may bring forward
the date at which additional capacity is required
Chapter End