Session 6 Capital Budgeting

P R O J E C T A N A LY S I S
CAPITAL BUDGETING DECISIONS

PROJECT CASH FLOWS
• Capital budgeting is concerned primarily with the after-tax net (operating) cash flows
(NCF) of a particular project, or change in cash inflows minus change in cash outflows.
C A P I T A L I N V E S T M E N T:
I M P O R TA N C E
• Long term Effects
• Irreversibility
• Substantial Outlay
I S S U E S W I T H C A P I TA L
BUDGETING
• Measurement Problems
• Uncertainty
• Temporal spread
P R O J E C T C L A S S I F I C AT I O N
• Mandatory Investments
• Replacement Projects
• Expansion Projects
• Diversification Projects
• Research and Development Projects
• Miscellaneous Projects
P R O C E S S O F C A P I TA L
BUDGETING
F A C E T S O F P R O J E C T A N A LY S I S
INVESTMENT CRITERIA
USE OF TECHNIQUES
N E T P R E S E N T VA L U E ( N P V )
Advantage of NPV
1. Net Present Values Are Additive
2. Intermediate Cash Flows Are Invested at the Cost of

Capital
3. NPV Calculation Permits Time Varying Discount
Rates
EXAMPLE
SOLUTION
N P V- D I S A D VA N TA G E
• The NPV is expressed in absolute terms rather than relative terms and hence does not factor in the scale of
investment.
project A project B
NPV ₹ 5,000 ₹ 2,500
Investment ₹ 50,000 ₹ 10,000
• The NPV rule does not consider the life of the project
EXERCISE
SOLUTION
B E N E F I T C O S T R AT I O
( P R O F I TA B I L I T Y I N D E X )
Decision Rules
SOLUTION
I N T E R N A L R AT E O F R E T U R N ( I R R )
• The internal rate of return (IRR) of a project is the discount rate which makes its NPV
equal to zero.
• The discount rate that makes NPV = 0 is also the rate of return.
EXAMPLE
Acceptance Rule
The firm should accept an
investment project if the
opportunity cost of capital is less
than the internal rate of return
EXERCISE
Consider the cash flows of a project being evaluated by Techtron Limited:
Year Cash Flow 15.000% 12.000% 15.365%

0 1,00,000
1 30,000 26086.957 26785.71 26004.421
2 30,000 22684.31 23915.82 22540.997
3 40,000 26300.649 28471.21 26051.803
4 45,000 25728.896 28598.31 25404.826
NPV 801 7,771 2

I N T E R P O L AT I O N
Interpolation IRR NPV
1 15.000% 801
2 x 0 Using (2-1) 15- x 801- 0'
3 15.500% -291 Using (3-1) 15.50' - 15.0' _-291 - 801
0.15- x 801
0.005 -1,092
0.15-x = -0.00366758
x= 0.153667582
15.3668%
ISSUES WITH IRR?
• Not all cash-flow streams have NPVs that decline as the discount rate increases.
ISSUES WITH IRR?
• Multiple Rates of Return
• A mining firm involves an initial investment of A$30 billion and is expected to produce a
cash inflow of A$10 billion a year for the next nine years. At the end of that time, the
company will incur A$65 billion of cleanup costs.
M U LT I P L E I R R
ANOTHER EXAMPLE
ANOTHER EXAMPLE
M U T U AL LY EXCLUSIVE PROJECTS
A situation in which taking one investment prevents the taking of another.

N P V P R O F I L E S F O R M U T U A L LY
EXCLUSIVE INVESTMENTS
ANOTHER EXAMPLE
M E T H O D U N D E R C A P I TA L
R AT I O N I N G
When money is limited, we must pick the projects that offer the
highest net present value per dollar of initial outlay. This ratio is
known as the profitability index:
NPV VS IRR
PROS AND CONS: IRR
M I R R : M O D I F I E D I N T E R N A L R AT E
OF RETURN
EXAMPLE
FLOW DIAGRAM
B O O K ( A C C O U N T I N G ) R AT E O F
RETURN
• Ratio of book income from the investment and the book value of the assets that the firm
is proposing to acquire:
EXAMPLE
accounting rate of return equal to or greater than a pre-specified cut-off

SHORTCOMINGS
P AY B A C K P E R I O D
• The payback period is the length of time required to recover the initial cash outlay on the
project.
• For example, if a project involves a cash outlay of Rs.600,000 and generates cash
inflows of Rs.100,000, Rs.150,000, Rs.150,000, and Rs.200,000, in the first, second,
third, and fourth years, respectively, its payback period is 4 years because the sum of
cash inflows during 4 years is equal to the initial outlay.
A D VA N TA G E A N D D I S A D VA N TA G E
• It is simple, both in concept and • It fails to consider the time value of money.
application. Cash inflows, in the payback calculation,
• It favours projects which generate are simply added without suitable
substantial cash inflows in earlier years discounting.
and discriminates against projects • It ignores cash flows beyond the payback
which bring substantial cash inflows in period. This leads to discrimination against
later years but not in earlier years.
projects which generate substantial cash
• Since it emphasises earlier cash inflows in later years.
inflows, it may be a sensible criterion
when the firm is pressed with problems
of liquidity.
EXAMPLE
The payback criterion prefers A,
which has a payback period of 3
years in comparison to B which has a
payback period of 4 years, even
though B has very substantial cash
inflows in years 5 and 6.
D I S C O U N T E D PAY B A C K P E R I O D
The discounted
payback period is the
length of time until the
sum of the discounted
cash flows is equal to
the initial investment.
ANOTHER EXAMPLE
SUMMARY
EXERCISE
The cost of capital is 12 percent. Calculate the
following:
(a) net present value,
(b) benefit-cost ratio,
(c) internal rate of return,
(d) modified internal rate of return,
(e) payback period, and
(f) discounted payback period.
NPV
SOLUTION
M I R R A N D PAY B A C K
PROBLEM 1
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P R O J E C T A N A LY S I S

CAPITAL BUDGETING DECISIONS

2. Intermediate Cash Flows Are Invested at the Cost of

Year Cash Flow 15.000% 12.000% 15.365%

NPV 801 7,771 2

A situation in which taking one investment prevents the taking of another.

accounting rate of return equal to or greater than a pre-specified cut-off

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