Module 2
Capital Budgeting
Techniques
Capital Budgeting
Techniques
• Project Evaluation and Selection
• Potential Difficulties
• Capital Rationing
• Project Monitoring
• Post-Completion Audit
Project Evaluation:
Alternative Methods
• Payback Period (PBP)
• Internal Rate of Return (IRR)
• Modified Internal Rate of Return
(MIRR)
• Net Present Value (NPV)
• Profitability Index (PI)
• Accounting Rate of Return
Independent Project
• For this project, assume that it is
independent of any other potential
projects that a company may
undertake.
• Independent – A project whose
acceptance (or rejection) does not
prevent the acceptance of other
projects under consideration.
Payback Period (PBP) – Equal cash
inflow
Payback Period (PBP) – Unequal
cash inflow
0 1 2 3 4 5
–40 K 10 K 12 K 15 K 10 K 7K
PBP is the period of time
required for the cumulative
expected cash flows from an
investment project to equal the
initial cash outflow.
Payback Solution (#1)
0 1 2 3 (a) 4 5
–40 K (-b) 10 K 12 K 15 K 10 K (d) 7 K
10 K 22 K 37 K(c) 47 K 54 K
Cumulative
Inflows PBP =a+(b–c)/d
= 3 + (40 – 37) / 10
= 3 + (3) / 10
= 3.3 Years
PBP Acceptance Criterion
The management of Basket Wonders
has set a maximum PBP of 3.5
years for projects of this type.
Should this project be accepted?
Yes! The firm will receive back the
initial cash outlay in less than 3.5
years. [3.3 Years < 3.5 Year Max.]
1. An investment of Rs. 40,000 in a machine is
expected to produce constant cash flows of
Rs. 8,000 for 10 years. Calculate the payback
period
PBP 5
2. An investment of Rs. 50,00,000 in a
pension plan is expected to produce constant
cash flows of Rs. 500,000 annually for the
next 20 years. Calculate the payback period.
PBP 10
3.
If the initial cost of a project is Rs. 50,000. Calculate the Payback period. Annual inflows after
depreciation after tax is as follows:
Year Amount
1 10000
2 15000
3 20000
4 25000
PBP 3.2
4.
The following are the details of two machines A and B with uneven cash flows. Find out the
payback period for them.
Machine A B
Cash Outflow 56,125 56,125
Cash Inflows: 14,000 22,000
Year1
16,000 20,000
PBP 3.40625
2
18,000 18,000 2.7847222
3
20,000 16,000
4
25,000 17,000
5
Discounted Payback Period
• The discounted payback period is the number of periods
taken in recovering the investment outlay on the present
value basis.
Average Rate of Return Method
The ARR is obtained dividing annual average profits after
taxes by average investments.
Average investment = 1/2 (Initial cost of machine – Salvage
value) + Salvage value + net working
capital.
Annual average profits after taxes = Total expected after tax
profits/Number of years
ARR = (Average income/Average investment) × 100
Example 4
Determine the average rate of return from the following data of two
machines, A and B.
Particulars Machine A Machine B
Cost Rs 56,125 Rs 56,125
Annual estimated income
after depreciation and
income tax:
Year 1 3,375 11,375
2 5,375 9,375
3 7,375 7,375
4 9,375 5,375
5 11,375 3,375
36,875 36,875
Estimated life (years) 5 5
Estimated salvage value 3,000 3,000
Depreciation has been charged on straight line basis.
24.95%
5. The purchase price of a computer is Rs. 24000. Salvage value
is Rs. 4000. Working capital is Rs. 6000. Economic life is 5 years.
Depreciation is to be provided on SLM. Average annual profit is
Rs. 40000. Required rate of return is 15%. State whether the
project is acceptable by computing ARR.
ARR 200%
Yes
6. ZEE Ltd. provides the following information:
Purchase price – Rs.160,000
Installation charges – Rs. 40,000
Salvage value – Rs.80,000
Economic life – 4 years
Working capital required – Rs. 20,000
Annual earnings before depreciation and tax – Rs. 130000
Rate of tax – 30%
Calculate ARR if deprecation is charged using Straight Line
method
ARR 43.75%
Net Present Value (NPV)
NPV is the present value of an
investment project’s net cash
flows minus the project’s initial
cash outflow.
CF1 CF2 CFn
NPV = + +...+ - ICO
(1+k)1 (1+k)2 (1+k)n
NPV Solution
Basket Wonders has determined that the
appropriate discount rate (k) for this
project is 13%.
NPV = $10,000 +$12,000 +$15,000 +
(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
4 + 5 - $40,000
(1.13) (1.13)
NPV Solution
NPV = $10,000(0.885) + $12,000(0.783) +
$15,000(0.693) + $10,000(0.613) +
$ 7,000(0.543) – $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 – $40,000
= - $1,428
NPV Acceptance Criterion
The management of Basket Wonders
has determined that the required
rate is 13% for projects of this type.
Should this project be accepted?
No! The NPV is negative. This means
that the project is reducing shareholder
wealth. [Reject as NPV < 0 ]
Profitability Index (PI)
PI is the ratio of the present value of
a project’s future net cash flows to
the project’s initial cash outflow.
CF1 CF2 CFn
PI = + +...+ ICO
(1+k)1 (1+k)2 (1+k)n
<< OR >>
PI = 1 + [ NPV / ICO ]
PI Acceptance Criterion
PI = $38,572 / $40,000
= .9643 (Method #1, previous slide)
Should this project be accepted?
No! The PI is less than 1.00. This
means that the project is not profitable.
[Reject as PI < 1.00 ]
7. Initial investment Rs. 200,000, Net cash inflow Rs. 60,000
(Profit after tax before depre) per year, Life 6 years. Cost of
capital 8%, No Scrap value. Calculate NPV and Profitability
Index. Calculate PBP & Discounted PBP.
NPV - ₹ 77,372.78
PI - 1.386863899
PBP – 3.33
DPBP – 4.03
8. Given the following data calculate NPV and Profitability Index.
Initial investment 60000.
Life 5 years.
Cost of capital 10%.
Year Cash
Inflows
Rs.
1 14,000
2 16,000
3 18,000
4 20,000
5 25,000
NPV ₹ 8,657.38
PI 1.144289697
Internal Rate of Return (IRR)
IRR is the discount rate that equates the
present value of the future net cash
flows from an investment project with
the project’s initial cash outflow.
CF1 CF2 CFn
ICO = (1 + IRR)1 + +...+
(1 + IRR)2 (1 + IRR)n
IRR = lower rate + (higher rate– lower rate) x NPV of lower rate
(Lower rate NPV – Higher rate NPV)
IRR Solution
Basket Wonders
$40,000 = $10,000 $12,000
+ +
(1+IRR)1 (1+IRR)2
$15,000 $10,000 $7,000
+ +
(1+IRR)3 (1+IRR)4 (1+IRR)5
Find the interest rate (IRR) that causes the
discounted cash flows to equal $40,000.
IRR Solution (Try 10%)
$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +
$15,000(PVIF10%,3) + $10,000(PVIF10%,4) +
$ 7,000(PVIF10%,5)
$40,000 = $10,000(0.909) + $12,000(0.826) +
$15,000(0.751) + $10,000(0.683) +
$ 7,000(0.621)
$40,000 = $9,090 + $9,912 + $11,265 +
$6,830 + $4,347
= $41,444 [Rate is too low!!]
IRR Solution (Try 15%)
$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +
$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +
$ 7,000(PVIF15%,5)
$40,000 = $10,000(0.870) + $12,000(0.756) +
$15,000(0.658) + $10,000(0.572) +
$ 7,000(0.497)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841 [Rate is too high!!]
IRR Solution (Interpolate)
0.10 $41,444
X $1,444
0.05 IRR $40,000 $4,603
0.15 $36,841
X $1,444
0.05 = $4,603
IRR Solution (Interpolate)
0.10 $41,444
X $1,444
0.05 IRR $40,000 $4,603
0.15 $36,841
X $1,444
0.05 = $4,603
IRR Solution (Interpolate)
0.10 $41,444
X $1,444
0.05 IRR $40,000 $4,603
0.15 $36,841
X = ($1,444)(0.05) X = 0.0157
$4,603
IRR = 0.10 + 0.0157 = 0.1157 or 11.57%
IRR Acceptance Criterion
The management of Basket Wonders
has determined that the hurdle rate
is 13% for projects of this type.
Should this project be accepted?
No! The firm will receive 11.57% for
each dollar invested in this project at
a cost of 13%. [ IRR < Hurdle Rate ]
9. A project costs Rs. 16,000 and is expected to generate cash
inflows of Rs. 8000 and Rs. 7000 and Rs. 6000 at the end of each
year for next 3 years. Calculate IRR.
IRR 15.79
10. A project of 20 years life requires an original investment of
Rs. 100,000. The other relevant information is given below:
Average annual earnings before depreciation and tax Rs.20,000
Annual tax rate 50%
Calculate:
A) Payback period
B) Average rate of return
C) Rate of return on original Investment
a) 8
b) 15%
c) 7.5%
11. DCF limited is implementing a project with an initial capital outlay of Rs. 8000. Its cash
inflows
are as under:
Year Cash
Inflows
Rs.
1 6,000
2 2,000
3 1,000
4 5,000
The expected rate of return is 12%. Calculate the Discounted Payback
3.106
5357+1594=6951+712=7663+3178
DPBP = 3+(337/3178) = 3.106
12. Premont Systems is evaluating a capital project with the following
characteristics:
The initial outlay is Rs.150,000.
Annual after-tax operating cash flows are Rs. 28,000.
After-tax salvage value at project termination is Rs. 20,000.
Project life is 10 years.
The project beta is 1.20.
The risk-free rate is 4.2 percent and the expected market return is 9.4
percent
Required:
1 Compute the project NPV. Should the project be accepted?
2 Compute the project IRR. Should the project be accepted?
NPV ₹ 26,252.47
IRR 14.24
Multiple IRR Problem*
Let us assume the following cash flow
pattern for a project for Years 0 to 4:
–$100 +$100 +$900 –$1,000
How many potential IRRs could this
project have?
Two!! There are as many potential
IRRs as there are sign changes.
REINVESTMENT ASSUMPTION AND Modified Internal
Rate of Return (MIRR)
13.
P ltd is evaluating a project that has the following cash flow stream associated with it. The Cost of
Capital for P Ltd is 15%. Calculate MIRR. Investment in the project – Initially Rs 122 Lakhs and at
the end of the first year Rs 80 Lakhs and Inflow starts from the end of second year as given below.
Year Cash Flow (Rs lakh)
0 (122)
1 (80)
2 20
3 60
4 80
5 100
6 120
MIRR 16.0120%
14.
Mr. A is considering an investment of $250,000 in a start-up. The cost of capital for the
investment is 13%. Calculate MIRR for the proposed investment. Following cash flows are
expected:
Year $
0 (250,000)
1 50,000
2 100,000
3 200,000
MIRR 14.659%
15.
C Ltd is considering investing in a project. The expected original investment in the project
will be Rs.2,00,000. The life of project will be 5 years with no salvage value. The expected
net cash inflows after depreciation but before tax during the life of the project will be as
following.
Year 1 2 3 4 5
Rs. 85,00 100,0 80,00 80,00 40,00
(PADB 0 00 0 0 0
T)
The project will be depreciated at the rate of 20% on original cost. The company is subjected
to 30% tax rate. Cost of capital is 10%
Required:
PBP 1.9136
Calculate payback period
DPBP 2.2584
Discounted Payback Period
Calculate average of return [ARR]. ARR 0.539
Calculate net present value
Calculate Profitability Index NPV ₹ 1,61,281.80
PI 1.8064
16.
A company is considering which of two mutually exclusive projects it should undertake. The
finance director thinks that the project with the higher NPV should be chosen whereas the
managing director thinks that the one with the higher IRR should be undertaken especially as
both projects have the same initial outlay and length of line. The company anticipates a cost
of capital of 10%and the net after –tax cash flows of the projects are as follows:
Year 0 1 2 3 4 5
Project (200) 35 80 90 75 20
X (Rs.
Lakhs)
Project (200) 218 10 10 4 3
Y
(Rs.
Lakhs)
Required:
[A] Calculate the NPV and IRR of each project
[B] State, the reason, which project you would recommend
[C] Explain the inconsistency in the ranking of the two projects.
[A] NPV- ₹ 29.20 & ₹ 18.55
IRR- 15.62%/ 16.06% & 18.71%/ 18.83%
[B] Since the cost of capital is 10 per cent, given the objective of the firm to
maximise wealth, project X is definitely better.
[C] Time disparity problem
Capital Rationing
Capital Rationing occurs when a
constraint (or budget ceiling) is placed
on the total size of capital expenditures
during a particular period.
Example: Julie Miller must determine what
investment opportunities to undertake for
Basket Wonders (BW). She is limited to a
maximum expenditure of $32,500 only for
this capital budgeting period.
Capital Rationing
Divisible Projects Indivisible Projects
Investment can be
Investment in full
in parts
Multiple
combinations:
Only one answer
select the best to
maximise NPV
Dependent Independent
Projects Projects
Available Projects for BW
Project ICO IRR NPV PI
A $ 500 18% $ 50 1.10
B 5,000 25 6,500 2.30
C 5,000 37 5,500 2.10
D 7,500 20 5,000 1.67
E 12,500 26 500 1.04
F 15,000 28 21,000 2.40
G 17,500 19 7,500 1.43
H 25,000 15 6,000 1.24
Choosing by IRRs for BW
Project ICO IRR NPV PI
C $ 5,000 37% $ 5,500 2.10
F 15,000 28 21,000 2.40
E 12,500 26 500 1.04
B 5,000 25 6,500 2.30
Projects C, F, and E have the
three largest IRRs.
The resulting increase in shareholder wealth
is $27,000 with a $32,500 outlay.
Choosing by NPVs for BW
Project ICO IRR NPV PI
F $15,000 28% $21,000 2.40
G 17,500 19 7,500 1.43
B 5,000 25 6,500 2.30
Projects F and G have the
two largest NPVs.
The resulting increase in shareholder wealth
is $28,500 with a $32,500 outlay.
Choosing by PIs for BW
Project ICO IRR NPV PI
F $15,000 28% $21,000 2.40
B 5,000 25 6,500 2.30
C 5,000 37 5,500 2.10
D 7,500 20 5,000 1.67
G 17,500 19 7,500 1.43
Projects F, B, C, and D have the four largest PIs.
The resulting increase in shareholder wealth is
$38,000 with a $32,500 outlay.
Summary of Comparison
Method Projects Accepted Value Added
PI F, B, C, and D $38,000
NPV F and G $28,500
IRR C, F, and E $27,000
PI generates the greatest increase in
shareholder wealth when a limited capital
budget exists for a single period.
17. Capital Rationing
The total available budget for a company is Rs.20 crores and the total cost of the projects is
Rs.25 crores. The projects listed below have been ranked in order of profitability. There is a
possibility of submitting X project where cost is assumed to be Rs.13 crores and it has the
profitability Index of 1.4.
Project Cost (Rs. Crores) Profitability Index
A 6 1.5
B 5 1.25
C 7 1.2
D 2 1.15
E 5 1.1
Which project, including X, should be acquired by the company.
X and A
18.
Project Cost (Rs.’000) NPV @ 15%
(Rs.’000)
A (50) 15.4
B (40) 18.7
C (25) 10.1
D (30) 11.2
E (35) 19.3
The company is limited to a capital spending of Rs. 1,20,000. You are required to optimize
the returns from a package of projects with the capital spending limit.
1. The projects are dependent of each other and are divisible [i.e. part project is possible]
2. If projects are independent of each other . ( Indivisible/ Mutually exclusive)
1. Projects E,B and C are to be invested in full while project D is
to be invested 2/3rd.
2. Projects E,B and D
19.
National electronics Ltd. An electronic goods manufacturing company, is producing a large
range of electronic goods. It has under consideration two projects ‘X’& ‘Y’, each costing
Rs.120 lakh. The projects are mutually exclusive and the company is considering the question
of selecting one of the two. Profit Before Depreciation & Taxes have been worked out for both
the projects and the details are given below. ‘X’ has a life of 8 years and ‘Y’ has a life of 6
years. Both will have zero salvage value at the end of their operational lives. The company is
already making profits and its tax rate is 50%. The cost of capital of the company is 15%
Year Project X (Rs. Lakhs) Project Y (Rs.
(PBDT) Lakhs)(PBDT)
1 25 40
2 35 60
3 45 80
4 65 50
5 65 30
6 55 20
7 35 -
8 15 -
The company follows straight line method of deprecating assets. Advise the company
regarding the selection of the project.
NPV(X)-8.211,IRR(X)–17.13%;
NPV(Y)-10.296, IRR(Y)–18.4412%
Project Y is recommended.
20.
A Ltd is considering the question of taking up a new project which requires an investment of
Rs.200 lakhs on machinery and other assets. The project is expected to yield the following
gross profits [before depreciation and tax] over the next five years.
Year 1 2 3 4 5
Gross Profit 80 80 90 90 75
(Rs.
Lakhs)(PBDT)
The cost of raising the additional capital is 12% and the assets have to be depreciated at 20%
on written down value basis. The scrap value at the end of the five-year period may be taken
as zero. Income tax applicable to the company is 50%.
Calculate the net present value of the project and advise the management whether the project
has to be implemented. Also calculate the internal rate of return of the project .
NPV = 18.9764, accept
IRR = 15.96%
21.
ITC Ltd. have decided to purchase a machine to augment the company’s installed capacity to
meet the growing demand for its products. There are three machines under consideration of
the management. The relevant details including estimated yearly expenditure and sales are
given below. All sales are on cash. Corporate income-tax rate is 40%. Cost of capital may be
assumed to be 10%.
Particulars Machine Machine Machine
1 (Rs.) 2 (Rs.) 3 (Rs.)
Initial investment required 3,00,000 3,00,000 3,00,000
Estimated annual sales 5,00,000 4,00,000 4,50,000
Cost of production [estimated]: -
Direct materials 40,000 50,000 48,000
Direct labour 50,000 30,000 36,000
Factory overheads 60,000 50,000 58,000
Administration costs 20,000 10,000 15,000
Selling and distribution costs 10,000 10,000 10,000
The economic life of machine 1 is 2 years, while it is 3 years for the other two. The scrap
values are Rs.40,000, Rs 25,000 and Rs 30,000 respectively. You are required to find out the
most profitable investment based on ‘Payback Method’
Machine 1- 1.23 Years Accept
Machine 2- 1.61 Years
Machine 3- 1.46 Years
22.
An oil company proposes to install a pipeline for transport of crude from wells to refinery.
Investments and operating costs of the pipeline vary for different sizes of pipeline
[diameter]. The following details have been conducted;
Pipeline Diameter (inches) 3 5 5 6 7
Investment required (in Rs. 16 24 36 64 150
Lakhs)
Annual Savings before 5 8 15 30 50
Depreciation (in Rs. Lakhs)
The estimated life of the installation is 10 year. The tax rate is 50% there is no salvage value
and straight-line rate of depreciation is followed;
Calculate the net savings after tax and cash flow generation and recommend therefrom, the
largest pipeline to be installed, if the company desires a 15% post tax return. Also, indicate
which pipeline will have the shortest payback.
NPV (3)- 0.56, PBP- 4.84
NPV (4)- 2.10, PBP- 4.62
NPV (5)- 10.67, PBP- 3.87
NPV (6)- 27.34, PBP- 3.52 Accept
NPV (7)- 18.11, PBP- 4.62
23.
Project M
Annual Cash inflow: Rs. 40,000
Life: 4 years
IRR: 15%
Profitability index [PI]: 1.064
Salvage Value: 0
Find: NPV, Cost of Capital, Payback period, Initial Investment
Given below is the table of Discounting factors:
15% 14% 13% 12%
Discount
factor
1 Year 0.869 0.877 0.885 0.893
2 Year 0.756 0.769 0.783 0.797
3 Year 0.658 0.675 0.693 0.712
4 Year 0.572 0.592 0.613 0.636
2.855 2.913 2.974 3.038
ICO=114200
NPV=7309
k=12%
PBP=2.855
24. A housewife is looking at ways of producing domestic hot
water and considers two possibilities –an electric immersion
heater having an installation of cost of Rs.160 and estimated
annual electric charges of Rs.200, and a gas boiler with an
installation cost of Rs.760 with annual fuel bills of Rs.80.
Assuming yourself as a consultant to this cost-conscious
housewife advise her suitably by comparing two systems on the
basis of [1] total expenditure and [2] present value over 5 years of
period. Take Cost of Capital at 9%.
What will be your recommendation if you consider both the
equipment for 8 years period?
(i) PV of total expense (heater)- Rs 937.94 Accept
PV of total expense (gas boiler)- Rs 1071.18
(ii) PV of total expense (heater)- Rs 1266.96
PV of total expense (gas boiler)- Rs 1202.79 Accept
26. Jupiter Inc. is considering a project that requires an initial investment of
$500,000. Sales will amount to $300,000 in the first year, and are expected to
increase by 3% every year. Variable cash operating expenses are expected to equal
50% of sales each year, while fixed cash operating expenses will be $25,000 a year.
The project will be depreciated on a straight‐line basis to zero over its 5‐year useful
life. The company’s marginal tax rate and the required rate of return are 40% and
10%, respectively. Compute NPV and advise on selection of the project.
NPV -45,007 is negative, reject.
27. Trytonic Ltd. is considering a new project for manufacture of project video games involving
a capital expenditure of Rs. 600 Lakhs and working capital of Rs.150 lakhs. The capacity of
the plants for an annual production of 12 lakh units and capacity utilization during 6-year
life of the project is expected to be as indicated below:
Year 1 2 3 4-6
Capacity Utilization (%) 33.33 66.67 90 100
The average price per unit of product is expected to Rs. 200 netting a contribution of 40
percent. The annual fixed costs, excluding depreciation, are estimated to be Rs.480 Lakh per
annum from the third year onwards for the first and second year, it would be Rs. 240 lakh
and Rs. 360 lakhs respectively. The average rate of depreciation for tax purpose is 33.33%
on the capital assets as per WDV. The rate of income tax may be taken at 35%. The cost of
capital is 15%
At end of the third year an additional investment of Rs. 100 lakhs would be required for
working capital. Terminal value for the fixed assets may be taken at 10% and for the current
assets at 100% for the purpose of your calculations, the recent amendments to tax laws with
regard to balancing charge may be ignored. As a financial consultant what recommendation
on the financial viability of the project would you make to the Trytonic Ltd.
NPV 271.78 is positive, accept.
28.
6.
Modern Electronic wants to take up a new project of the manufacture if an electronic device which
has good market further details are given below:
1. Cost (in Rs. lakhs) of the project as estimated:
- Land: 2.00 [will be incurred at the beginning of year 1] Means 0
- Building: 3.00 [will incurred at the end of year 1]
- Machinery: 10.00 [will be incurred at the end of year 2]
- Working capital: 5.00 [will incurred at the Beginning of year 3] End of year 2
2. The project will go into production from the beginning of years 3 and will be operational for
a period of 5 years. The annual working results (in Rs. lakhs) are estimated as follows:
Sales: 20.00
Variable cost: 8.00
Fixed cost [excluding depreciation]: 4.00
3. Depreciation of assets: 2.00
1. At the end of the operational period, it is expected that the fixed assets can be sold for Rs. 5
Lakhs [ without any profit]
2. Cost of capital of the firm is 10 % Applicable tax rate is 50%
You are required to evaluate the proposal by working out the net present value and advise the firm.
NPV- 3.61732