PM Capital Budgeting 2

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Capital Budgeting

Namrata K
Introduction
 Capital budgeting is the process of making
investment decisions in long term assets. It is the
process of deciding whether or not to invest in a
particular project as all the investment possibilities
may not be rewarding.

 Capital budgeting is made up of two words ‘capital’


and ‘budgeting.’ In this context, capital expenditure
is the spending of funds for large expenditures like
purchasing fixed assets and equipment, repairs to
fixed assets or equipment, research and
development, expansion and the like. Budgeting is
setting targets for projects to ensure maximum
profitability & performance.
Introduction

 Capital budgeting is a process of evaluating


investments and huge expenses in order to obtain the
best returns on investment. Thus, the manager
has to choose a project that gives a rate of return
more than the cost financing such a project analysing
cost and benefit.

 An organization is often faced with the challenges of


selecting between two projects/investments or the
buy vs replace decision. Ideally, an organization
would like to invest in all profitable projects but due
to the limitation on the availability of capital an
organization has to choose between different
projects/investments.
 An organization is often faced with the challenges of
selecting between two projects/investments or
the buy vs replace decision. Ideally, an organization
would like to invest in all profitable projects but due to
the limitation on the availability of capital an
organization has to choose between different
projects/investments.

 Capital Budgeting is used for decision making of the


long term investment that whether the projects are
fruitful for the business and will provide the required
returns in the future years and it is important because
capital expenditure requires huge amount of funds
so before doing such expenditure in capital asset
management do capital budgeting to assure
themselves that the capital spending will bring profits
in the business.
Thus, it helps financial manager to:

 Make Purchase of long term assets and such


decisions may determine the future success of
the firm.
 Maximizing shareholder’s value.
 Corporate decisions like expansion/ new
products are long term financial decisions of
importance.
Where we use Capital Budgeting:
 The decision to buy new machinery
 Expansion of business in other geographical areas
 Replacement of an obsolete equipment
 New product or market development etc
 Investing in new equipment, technology and
buildings
 Upgrading and maintaining existing equipment
and technology
 Completing renovation projects on existing
buildings
 Expanding their workforce
 Developing new products
Large
Investment
Impact on
competitive
strength

Irreversible
Decision

Affect cost Features


structure of Capital
Budgeting

High Risk

Complex
Decision

Long term
impact on
Profitability
Features of Capital Budgeting

 Investment in Long Term Assets.

 Potentially large anticipated benefits

 Relatively high degree of risk.

 Relatively long time period between


initial outlay and anticipated returns.
Long Term Effect on Profitability
I
M Huge Investments in growth
P projects

O Decision cannot be
R Undone

T Control Expenditure to maximise


A wealth

N Risk and Uncertainty

C
E Helps in Complex Investment
Decisions

Long term implications


Objectives of Capital budgeting

 1. identifying & Selecting


profitable projects
 2. Capital expenditure control &
allocation of funds
 3. Finding the right sources of
funds
Investment proposal-1 Investment proposal-1I

Laptop-hp pavillion x360 Laptop- macbook

Cost: Rs 78000 Cost: Rs 1,25,000/-

Features: ....... Features: Light weight,


convenience, music, Intel
icore 7
Purpose: educational /
business Purpose: Graphic designing,
design softwares
Investment proposal – Land / Investment proposal – Land /
factory outlet – Mandideep factory outlet – VIDISHA

Cost-Rs 85 lacs COST- Rs 55 lacs

Labour availability , cost, Labour availability , cost,


power , water, sanitation, power , water, sanitation,
waste disposal, municipal corp waste disposal, municipal
charges corp charges
Types of Capital Investment
Decisions

Firm’s Decision
Situation
existence

1.Replaceme 1.Mutually
nt Exclusive
2.Modernizat 2.Accept /
ion Reject decision
3.Expansion 3. Contingent
4.Diversificat decisions
ion
Capital Budgeting Process
1. Identifying investment opportunities

 An organization needs to first identify an


investment opportunity. An investment
opportunity can be anything from a new
business line to product expansion to
purchasing a new asset. For example, a
company finds two new products that they
can add to their product line or reducing the
costs of existing product line without affecting
scale of operations.
2. Evaluating investment proposals

 Once an investment opportunity has been recognized an


organization needs to evaluate its options for investment.
That is to say, cost benefit analysis and selection of an
appropriate criterion to judge the desirability of
projects to maximize wealth.

 once it is decided that new product/products should be


added to the product line, the next step would be deciding
on how to acquire these products. There might be multiple
ways of acquiring them. Some of these products could be:
 Manufactured In-house
 Manufactured by Outsourcing manufacturing the process,
or
 Purchased from the market
3. Choosing a profitable investment

 Once the investment opportunities are identified


and all proposals are evaluated an organization
needs to decide the most profitable investment
and select it. Project selection based on
various scrutinized criteria. While selecting a
particular project an organization may have to use
the technique of capital rationing to rank the
projects as per returns and select the best option
available.

 In our example, the company here has to decide


what is more profitable for them. Manufacturing or
purchasing one or both of the products or scrapping
4. Capital Budgeting and Apportionment

 After the project is selected an organization


needs to fund this project. To fund the project
it needs to identify the sources of funds and
allocate it accordingly.

 The sources of these funds could be reserves,


investments, loans or any other available
channel.
Gratuity – Rs 20 lacs Gratuity – Rs 20 Gratuity – Rs 20
lacs lacs
Option A
Option B Option C
Fixed Deposit
Investment Plan Gold / Real Estate
@6% (Equity +Debt)
Rates , inflation,
Bank/ RBI @ 10-18% market condition-
boom / stable,
Market indices depression
RATE OF INTEREST-
QUARTERLY / YEARLY Gold –long term
3 YRS LOCKIN appreciate
INCREMENTAL GROWTH
IN INTEREST – STABLE INTEREST / Real estate –
DIVODEND- profitable or rates
ANNUALLY AS are increasing when
COMPANY market is
DECLARES performing good

LONG TERM >5 YRS


5. Performance Review
 The last step in the process of capital budgeting is
reviewing the investment. Initially, the
organization had selected a particular investment
for a predicted return. So now, they will
compare the investments expected performance to
the actual performance.

 In our example, when the screening for the most


profitable investment happened, an expected
return would have been worked out. Once the
investment is made, the products are released in
the market, the profits earned from its sales should
be compared to the set expected returns. This will
help in the performance review.
Capital
Budgeting
Process
Capital Budgeting Techniques
Non Discounted Methods
Discounted Methods
Present Value (PV)= 100
DISCOUNT RATE =10%

YR 1=1-10/100=.909
YR 2=(1-10/100)^2=.826
YR 3= (1-10/100)^3=.755

FV 1= 100*.909=90.9
FV 2 = 100*.826=82.6
FV 3 = 100*.755=75.5
Non Discounting Methods

 1. Payback period method


 In this technique, the entity calculates the
time period required to earn the initial
investment of the project or investment. The
project or investment with the shortest
duration is opted for.

 Payback period = Cash outlay


(investment) / Annual cash inflow
Payback period method
 It refers to the period in which the proposal will
generate cash to recover the initial investment made.
 It purely emphasizes on the cash inflows, economic
life of the project and the investment made in the
project, with no consideration to time value of money.
 Through this method selection of a proposal is based
on the earning capacity of the project.
 With simple calculations, selection or rejection of the
project can be done, with results that will help gauge
the risks involved. However, as the method is based
on thumb rule, it does not consider the importance of
time value of money and so the relevant dimensions
of profitability.
Machine A Machine B

Cost of Project 1,20,000 90,000

Cash flows 1 50,000 40,000 annually

Cash flows 2 40,000

Cash flows 3 30,000

Calculate Payback Period ?


Example
Machine A Machine B
Cost of Project 1,20,000 90,000
Cash flows 1 50,000 40,000 annually
Cash flows 2 40,000
Cash flows 3 30,000

Solution:
Total Cash inflows 1,20,000 1,20,000
(in 3 Yrs)
Cash investment/ 3 yrs 2 yrs + 10,000/
annual cash inflow 40,000*12
2 yrs 3 months

Machine B is preferred than Machine A.


Example
Year A B C
0/ -110 -110 -100
C.Y.
1 20 20 0
2 30 30 0
3 40 40 90
4 30 30 30
5 20 20 20
6 20 10 20
Solution A B C
Total Cash 160 150 160
Inflows
3+ 3+20/30*
20/30*12 12
Payback 3 Yrs 8 3 Yrs 8 3 Yrs 8
Period months months months
Advantages:

 1. A company can have more favourable short-run


effects on earnings per share by setting up a
shorter payback period.

 2. The riskiness of the project can be tackled by


having a shorter payback period as it may ensure
guarantee against loss.

 3. As the emphasis in pay back is on the early


recovery of investment, it gives an insight to the
liquidity of the project.

 4. Simple and easy to understand / calculate.


Limitations:

 1. It fails to take account of the cash inflows earned after the


payback period.

 2. It is not an appropriate method of measuring the profitability


of an investment project, as it does not consider the entire cash
inflows yielded by the project.

 3. It doesn’t consider time value of money and ignores cost of


capital.

 3. It fails to consider the pattern of cash inflows, i.e., magnitude


and timing of cash inflows and no consideration for risk.

 4. Administrative difficulties may be faced in determining the


maximum acceptable payback period as ignores working
capital, salvage and depreciation.
2. Accounting Rate of Return

 In this technique, the total net income of the investment


is divided by the initial or average investment to derive
at the most profitable investment.

 ARR= Average income/Average Investment


 Average Investment=Initial investment +
installation charges- scrap value/2 +scrap value

 This method helps to overcome the disadvantages of


the payback period method as it considers cash inflows
after payback period and working capital and salvage
too. The rate of return is expressed as a percentage of
the earnings of the investment in a particular project.
2. Accounting Rate of Return

 It works on the criteria that any project having


ARR higher than the minimum rate established by
the management will be considered and those
below the predetermined rate are rejected.

 This method takes into account the entire


economic life of a project providing a better
means of comparison. It also ensures
compensation of expected profitability of projects
through the concept of net earnings. However,
this method also ignores time value of money and
doesn’t consider the length of life of the projects.
Also it is not consistent with the firm’s objective of
maximizing the market value of shares.
Example
 Yr Profit after Tax and depreciation
 1 Rs. 50,000
 2 Rs. 75,000
 3 Rs.1,25,000
 4 Rs. 1,30,000
 5 Rs. 80,000
 Total Rs. 4,60,000
 Cost of Project Rs.9,80,000 installation Rs. 20,000
 ARR= Average PAT/ Average Investment*100
 ARR= 92,000/5,00,000*100=18.4%
 Average PAT=4,60,000/5= Rs. 92,000/-
 Average Investment=9,80,000+20,000/2=Rs.
5,00,000/-
Advantages: Limitations:

 1. It is very simple to
 1. It uses accounting
understand and use. profits, not cash flows in
appraising the projects.
 2. It can be readily  2. It ignores the time
calculated using the
value of money and cost
accounting data. of capital.
 3. It uses the entire  3. It does not consider the
stream of incomes in lengths of projects lives,
calculating the profits occurring in
accounting rate. different periods are
valued equally.
 4. It does not allow for the
fact that the profit can be
reinvested.
Example
 Yr Profit after Tax and depreciation
 0 - Rs.14(million)
 1 Rs. 3
 2 Rs. 4
 3 Rs.5
 4 Rs. 6
 5 Rs. 10
 Total Rs. 28
 Average Return = 28/5=5.6
 Average Investment=-14/2=-7
 ARR= 5.6/7*100=80%
Initial Investment= $2,00,000
Cash inflow A Cum. Cash Cash inflow Cum. Cash
inflow B inflow
1 $ 70,000 $ 70,000 $ 45,000 $ 45,000
2 60,000 1,30,000 60,000 1,05,000
3 55,000 1,85,000 50,000 1,55,000
4 40,000 2,25,000 1,00,000 2,55,000
5 30,000 2,55,000 1,05,000 3,60,000
6 25,000 2,80,000 75,000 4,35,000

PAYBACK PERIOD (A) = 3 Yrs+15000/40000*12= 3 yrs 4.5


months
(B)= 3 Yrs +45000/1,00,000*12= 3 yrs
5.4 months

Average Return = 2,80,000/6= 46,667/-


=4,35,000/6= 72,500/
Average Investment = 2,00,000/2=1,00,000/-
=2,00,000/2=1,00,000/
Discounted Payback method:

 The discounted cash flow technique calculates


the cash inflow and outflow through the life of
an asset. These are then discounted through a
discounting factor. The discounted cash
inflows and outflows are then compared. This
technique takes into account the interest
factor and the return after the payback period.
Net present Value (NPV) Method:

 This is one of the widely used methods for evaluating


capital investment proposals. In this technique the
cash inflow that is expected at different periods of
time is discounted at a particular rate.
 This method considers the time value of money and is
consistent with the objective of maximizing profits for
the owners. However, understanding the concept of
cost of capital is not an easy task.
 The NPV is calculated by taking the difference
between the present value of cash inflows and
the present value of cash outflows or original
investment over a period of time. The investment
with a positive NPV will be accepted. In case there are
multiple projects, the project with a higher NPV is
more likely to be selected.
Where A1, A2…. represent cash inflows, K is the firm’s
cost of capital, C is the cost of the investment proposal
and n is the expected life of the proposal. It should be
noted that the cost of capital, K, is assumed to be
known, otherwise the net present, value cannot be
known.

NPV = PVB – PVC


where,
PVB = Present value of benefits/ cash inflows
PVC = Present value of Costs/ cash outflows
Calculating Present Values:
Discountin Present
g factor value
(10%)
(1/1.10)1 = .9090 1/(1.12) 0.892
(
1/1+df/100)
n
(1/1.10)2 .826 1/(1.12)2 0.7972

(1/1.10)3 .751 1/(1.12)3 0.7117

(1/1.0)4 .683 0.6355

(1.10)5 .621 0.5674


Example
 Cost of Project : Rs 50,000/-
Yr Project 1 Project 2
1 25000 10000
2 15000 12000
3 10000 18000
4 Nil 25000
5 12000 8000
6 6000 4000

Cost of capital @10% using discounted cash inflows


method, which is most preferred project?
Solution
Yr PVF@10 Project 1 Present Project 2 Present value
% value Cash cash inflow(p
inflow(p 1) 2)

1 .909 25000 22725 10000 9090


2 .826 15000 12390 12000 9912
3 .751 10000 7510 18000 13518
4 .683 Nil NIL 25000 17075
5 .621 12000 7452 8000 4968
6 .564 6000 3384 4000 2256
Total PV 53461 56819
cash
inflows
- PV of 50000 50000
Cash
outflow
NPV 3461 6819
Project 2 P.V > Project 1 P.V , so accept Project
PVF=2
(1/1+df/100))n
PI = 53,461/50,000 = 1.0692
Example

Yr Project Project Project C PVF@12%


A B

0 -20,000 -60,000 -36,000 1

1 5600 12,000 13,000 .893


(1/1.12)1=

2 6000 20,000 13,000 .797(1/1.12)


2=

3 8000 24,000 13,000 .712(1/1.12)


3=

4 8000 32,000 13,000 .636


SOLUTION

Yr PV of Project A PV of Project B PV of Project C


0 -20,000*1=-20,000 -60,000*1=-60,000 -36,000*1=-36,000
1 5600*.893=5000.8 12,000*.893=10,71 13,000*.893=1160
6 9
2 6000*.797=4782 20,000*.797=15,94 13,000*.797=1036
0 1
3 8000*.712=5696 24,000*.712=17088 13,000*.712=9256
4 8000*.636=5088 32,000*.636=20352 13,000*.636=8268
Total PV = Total PV Total PV
20,566.8 =64096 =39494
NPV 20566.8- 64096- 39494-36000=
 PI=20566.8/20000=1.283
20000=566.8 60,000=4096 3494
64096/60000= 1.0082
39494/36000= 1.097
Advantages: Limitations:

 1. It recognizes the  1. It is difficult to use


time value of money  2. It presupposes that the
discount rate which is
 2. It considers all cash
usually the firm’s cost of
flows over the entire capital is known. But in
life of the project in its practice, to understand
calculations. cost of capital is quite a
 3. It is consistent with difficult concept.
the objective of  3. It may not give
maximizing the satisfactory answer when
the projects being
welfare of the owners.
compared involve
different amounts of
investment.
Profitability Index (PI):

 It is the ratio of the present value of future cash benefits,


at the required rate of return to the initial cash outflow of
the investment. It may be gross or net, net being simply
gross minus one. The formula to calculate profitability
index (PI) or benefit cost (BC) ratio is as follows.

 Simply, ratio of sum of cash inflows to the sum of cash


outflow during a project. A higher ratio depicts high
profitability and preferred. Feasible condition PI >One (1).

 PI = PV or sum of cash inflows/Initial cash outlay ,


 PI = NPV (CASH INFLOWS) / NPV (CASH OUTFLOW)
 Net profitability index=profitability index-1.
 All projects with PI > 1.0 is accepted.
 Profitability Index is the ratio of the present
value of future cash flows of the project to the
initial investment required for the project.
 1. It gives due consideration to the time value of money.
 2. It requires more computation than the traditional
method but less than the IRR method.
 3. It can also be used to choose between mutually
exclusive projects by calculating the incremental benefit
cost ratio.
 4. It considers all cash flows and allows expected
change in cost of capital.
5. Computes contribution towards wealth creation
however require pre-determined discounting factor.
Example
Yr PVF@12% Project PV of Project PV of
A cash B cash
0 1 -20,000 -36,000
1 .893 5,600 .893*560 5001 13,000 11,609
0
2 .797 6,000 .797*600 4782 13,000 10,361
0
3 .712 8,000 .712*800 5696 13,000 9,256
0
4 .636 8,000 .636*800 5088 13,000 8,268
0
Total PV Cash 20,567 39,494
inflows
PV Cash 20,000 36,000
Outflow
NPV 567 3494
Profitability Total PV 20,567 39,494
Index Cash / 20,000 / 36,000
inflows = 1.028 = 1.097
Yr Discount Cash Flow (A) Cash flow (B)
Factor@8
%
0 1 -48000 -85000
1 .926 8000 18,000
2 .857 10,000 25,000
3 .794 15,000 30,000
4 .735 22,000 40,000
5 .681 30,000 20,000
PV Cash inflow A PV Cash inflow B
0 -48,000*1=-48,000 -85,000*1= - 85,000
1 8,000*.926=7408 18,000*.926=16,668
2 10,000*.857=8570 25,000*.857=21425
3 15,000*.794=11,910 30,000*.794=23,820
4 22,000*.735=16170 40,000*.735=29,400
5 30,000*.681=20430 20,000*.681=13,620
Pv of cash inflow=64,488 Pv of cash
inflow=1,04,933
NPV=16,488 (64,488-48,000) NPV=19,933(1,04,933-
85,000)
Example
Yr PVF@9% Project A PV of Project B PV of
cash cash
0 1 - -
10,00,00 12,00,00
0 0
1 1,00,000 1,30,000
2 2,50,000 1,30,000
3 3,50,000 1,00,000
4 2,65,000 1,00,000
5 4,15,000 1,70,000
Total PV Cash
inflows
PV Cash
Outflow
NPV
Profitability Total PV
Index Cash
inflows
/ PV Cash
Yr PVF@9% Project A PV of cash Project B PV of cash
flow A FLOW B

0 1 - 0-12,00,000 0
10,00,00
0
1 0.91741,00,000 917401,30,000 119262
2 0.84162,50,000 2104001,30,000 109408
3 0.77213,50,000 2702351,00,000 77210
4 0.70842,65,000 1877261,00,000 70840
5 0.64994,15,000 269708.51,70,000 110483
PV OF CASH 1029809.5 487203
INFLOWS

PV CASH
OUTFLOW 1000000 1200000
NPV 29809.5
Example
Yr PVF@18% Project PV of Project PV of
A cash B cash
0 1 -8320 -24,300
1 0.8475 3,411 5,000
2 0.7182 4070 5,000
3 0.6086 5824 5,000
4 0.5158 2965 5,000
5 salvage 900 100
Total PV Cash
inflows
PV Cash
Outflow
NPV
Profitability Total PV
Index Cash
inflows
/ PV Cash
Outflow
Yr Discount Cash Flow (A) Cash flow (B)
Factor@10%

0 1 -50,000 -78,000

1 (installation) 0.909 -6000 -10000


1 0.909 18000 12000
2 0.826 27500 18000
3 0.751 18000 15000
4 0.683 18000 17800
5 0.621 16500 18700
5- Scrap 0.621 3500 15000
Yr Discount Cash Cash flow pv cash PV Cash
Factor@1 Flow (A) (B) flows A flows B
0%
0 1 -50,000 -78,000 -50000 -78000
1
(installati
on) 0.909 -6000 -10000 -5454 -9090

Yr Discount Cash Flow Cash flow (B) pv cash flows A PV Cash flows
Factor@10% (A) B

1 0.909 18000 12000 16362 10908


2 0.826 27500 18000 22715 14868
3 0.751 18000 15000 13518 11265
4 0.683 18000 17800 12294 12157.4
5 0.621 16500 18700 10246.5 11612.7
5- Scrap 0.621 3500 15000 2173.5 9315
PV CASH INFLOW 77309 70126.1
Total PV CASH
INFLOW 77309 70126.1

Total PV cash outflow 55454 87090

NPV (PV cash inflow-


PV cash outflow) 21855 -16963.9

PI (PV cash inflow/ PV


of cash outflow) 1.394110434 0.805214146
Internal Rate of Return (IRR):

 This is defined as the rate at which the net present


value of the investment is zero. The discounted
cash inflow is equal to the discounted cash outflow.
This method also considers time value of money.

 It tries to arrive to a rate of interest at which funds


invested in the project could be repaid out of the
cash inflows. However, computation of IRR is a
tedious task. It is true interest yield from an
investment.

 It is called internal rate because it depends solely


on the outlay and proceeds associated with the
project and not any rate determined outside
 NPV=PV CASH INFLOW- PV CASH OUTFLOW

 NPV=0

 PV CASH INFLOW=PV CASH OUTFLOW=NPV=0

 Discounted cash inflow = Discounted cash


outflow = NPV=0
If IRR > WACC then the project is
profitable.

If IRR > k(cost of capital) = accept

If IRR < k (cost of capital) = reject

WACC-Weighted Average Cost of Capital


What is the Significance of IRR?
 Internal Rate of Return is much more useful when it is used to carry
out a comparative analysis rather than in isolation as one single
value. The higher a project’s Internal Rate of the Return value, the
more desirable it is to undertake that project as the best available
investment option. IRR is uniform for investments of varied sorts
and, as such, IRR values are often used to rank multiple prospective
investment options that a firm is considering on a comparatively
even basis. Assuming the amount of investment is equal among the
different available options of investment, the project with the
highest IRR value is considered as the best, and that particular
option is (theoretically) taken up first by an investor.

 The IRR of any project is calculated with three assumptions in mind:


 The investments made will be held until their maturity dates.
 The intermediate cash flows will be reinvested in IRR itself.
 All the cash flows are periodic, or the time gaps between different
cash flows are equal.
What is the Significance of IRR?

 The IRR value provides the organization with a rate of


growth that can be expected to be obtained by
making an investment in the project considered.
While the actual Internal Rate of Return obtained may vary
from the theoretical value that we have calculated, the
highest value will surely provide the best growth rate
among all.

 The most common use of the Internal Rate of Return is


seen when an organization uses it to consider
investing in a new project or increase the
investment in a currently ongoing project. As an
example, we can take the case of an energy company that
opts to start a new plant or to expand the working of a
current working plant. The decision, in this case, can be
taken by calculating IRR and thus finding out which of the
 The hurdle rate or required rate of return is a
minimum return expected by an organization on the
investment they are making. Most organizations keep
a hurdle rate, and any project with an Internal Rate of
Return exceeding the hurdle rate is considered
profitable. Although this is not the only basis of
considering a project for investment, the Hurdle rate is
an effective mechanism in screening out projects which
will not be profitable or profitable enough. Usually, a
project with the highest difference between the Hurdle
rate and IRR is considered the best project to invest.

 Independent Projects: IRR > Cost of Capital (hurdle


rate), Accept the project.

 Independent Projects: IRR < Cost of Capital (hurdle


rate), Reject the project
Example

Y DF PV Cash DF PV DF PV Cash DF@ PV Cash


r @1 InFlow @1 Cash @1 InFlow 18% InFlow (A)
2 % (A) 4% InFlow 7% (A)
(A)
0 1 -48000 1 -48000 1 -48000 1 -48000
1 .89 8000*0.8 .877 8000*.8 .855 8000*0.85 .847 8000*.847=677
3 93= 77=701 5=6840 6
7144 6
2 .79 10,000*.7 .769 10,000* .730 10,000*.7 .718 10,000*.718=7
7 97=7970 .769=7 30=7300 180
690
3 .71 15,000*.7 .674 15,000* .624 15,000*.6 .608 15000*.608=91
2 12=1068 .674=1 24=9360 20
0 0110
4 .63 22,000*.6 .591 22,000* .534 22,000*.5 .516 22,000*.516=1
6 36=1399 .591=1 34=11748 1352
2 3002
5 .56 30,000*.5 .519 30,000* .456 30,000*.4 .437 30,000*.437=1
Initial Investment = Rs48,000
7 67=1701 .519=1 56=13680 3110
PVF= (1/ 1+df/100)n
IRR=
0 17%+ 928/
557048928 -
47538*1%
=56796 =5338 =48928 =47538
Example
 Initial Investment Rs 60,000
 Life of asset: 4 Yrs
 Net annual cash inflows are:
Yr Annual PVF PV of PVF@ PV of PVF@ PV of
Cash @10 cash 14% cash 15% cash
Inflow % inflows inflow inflow
s s
1 15,000 .909 13635 .877 13,155 .869 13,035
2 20,000 .826 16520 .769 15,380 .756 15,120
3 30,000 .751 22530 .674 20,220 .657 19,710
4 20,000 .683 13660 .592 11,840 .571 11,420
Total value 66,345 60,595 59,285
As Initial investment Rs 60,000, so IRR is between 14% and
15% ( Rs 60,595 and Rs 59,285 = Rs 1310 difference)
Exact IRR= 14% + 595/ 1310* 1% =14.45%
Example
Year Cash PVF@18 P PVF@17 PV @17%
inflow % V@18% % cash inflow
cash
inflow
0 -160 1 -160 1 -160
1 30 .847 25.42 .855 25.64
2 40 .718 28.73 .731 29.22
3 50 .609 30.43 .624 31.22
4 60 .516 30.95 .534 32.02
5 100 .437 43.71 .456 45.61
Total PV of Cash 159.24 163.71
Inflows
Difference between -0.76 3.71
PV cash outflow
and PV of cash
inflow
IRR=17%+3.71/((3.71+ (-.76)) *1% =
17.84%
Advantages: Limitations:
 1. Like the NPV method, it
 1. It involves complicated
considers the time value of computation problems.
money.  2. It may not give unique
 2. It considers cash flows answer in all situations. It
over the entire life of the may yield negative rate or
project. multiple rates under certain
 3. It satisfies the users in circumstances.
terms of the rate of return  3.It implies that the
on capital. intermediate cash inflows
 4. Unlike the NPV method, generated by the project
the calculation of the cost of are reinvested at the
capital is not a precondition. internal rate unlike at the
 5. It is compatible with the firm’s cost of capital under
firm’s maximising owners’ NPV method. The latter
welfare. assumption seems to be
more appropriate.
Disadvantages
 The need for the use of NPV in conjunction is
considered to be a big drawback of IRR. Although
considered an important metric, it can’t be useful
when used alone. The problem arises in situations
where the initial investment gives a small IRR value
but a greater NPV value. It happens on projects which
give profits at a slower pace, but these projects may
benefit in enhancing the overall value of the
organization.

 A similar problem is when a project gives a faster-


paced result for a short period of time. A small project
may seem like giving a large profit in a short time,
giving a greater IRR value but a lower NPV value. The
project length has a greater significance in this case.
Disadvantages
 Another problem with the Internal Rate of Return, which is not strictly
inherent to the metric itself, but related to a typical misuse of IRR. Individuals
might assume that once positive cash flows are generated throughout the
course of a project (not at the end), the money will be reinvested at the
project’s rate of return. It may seldom be the case. Instead, once positive
cash flows are reinvested, it’ll be at a rate that represents the value of the
total capital employed. Misreading and misusing IRR in this way could
result in the conclusion that a project is a lot more profitable than it truly is.

 Another common drawback is termed as multiple IRR. Multiple IRR drawbacks


occur in cases where the cash flows in the course of the project’s lifespan are
negative (i.e., the project operates at a loss or the organization needs to
contribute additional capital). It is referred to as a “non-normal cash flow”
situation, and such cash flows can provide multiple Internal Rate of Return.

 These drawbacks of multiple Internal Rate of Return occurrences and the


inability to handle multiple duration projects have brought up the need for a
better procedure to find out the best project to invest. And so, a new modified
metric known as the modified internal rate of return or in short MIRR is
designed.
SIGNIFICANCE OF CAPITAL BUDGETING

 Capital budgeting is an essential tool in financial


management.
 Capital budgeting provides a wide scope for
financial managers to evaluate different projects in
terms of their viability to be taken up for
investments.
 It helps in exposing the risk and uncertainty of
different projects.
 It helps in keeping a check on over or under
investments.
 The management is provided with an effective
control on cost of capital expenditure projects.
 Ultimately the fate of a business is decided on how
optimally the available resources are used.

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