Finance Management

Module 4: Capital Budgeting

Machhindranath Patil, PhD. IIT Bombay

An Institute Level Elective offered by Department of Computer Engineering

SEMESTER-VIII (2026)
What is Capital Budgeting?
Definition:
▶ Capital budgeting is the process of planning and evaluating long-term
investments in assets.
Key Features:
▶ Involves capital expenditures (CapEx) with large initial outlay
▶ Generates a stream of benefits over future periods
▶ Concerned with strategic asset allocation decisions
Explanation:
▶ It involves committing funds today in expectation of future cash flows
▶ The objective is to maximize returns and firm value
Examples:
▶ Investment in new plant and machinery
▶ Expansion or modernization of facilities
▶ Research and development (R&D)
▶ Automation and computerization
Importance of Capital Budgeting
Why is Capital Budgeting Important?
▶ It supports long-term planning of investment projects
▶ It has a direct impact on the growth and profitability of the firm
▶ It helps in efficient allocation of scarce financial resources
▶ It enables evaluation of project feasibility and profitability
▶ It improves decision-making through systematic analysis
▶ It ensures accountability and performance measurement
▶ It considers both:
▶ Cost reduction
▶ Revenue enhancement
▶ It is used for decisions such as:
▶ Purchase or replacement of equipment
▶ Expansion projects
Inputs to Capital Budgeting Decision

Key Inputs for Project Evaluation:

▶ Initial Cash Outflow:
▶ Includes cost of investment and net working capital (NWC)
▶ Annual Operating Cash Flows:
▶ Computed as:

Operating Cash Flow = OEAT + Depreciation − ∆NWC

▶ Project Life and Salvage Value:

▶ Project life: Duration of cash flow generation
▶ Salvage value: Expected market value at the end of project life
▶ Required Rate of Return:
▶ Typically estimated using WACC
Inputs: Parent Company Perspective

Additional Considerations (Multinational / Subsidiary Projects):

▶ Initial Investment from Parent
▶ Net Cash Flows to Parent:
▶ Cash flows repatriated from subsidiary
▶ Terminal Cash Flows:
▶ After-tax salvage value
▶ Recovery of net working capital
▶ Required Rate of Return:
▶ Based on parent company’s cost of capital
Investment Appraisal Criterion

Investment Appraisal
Criterion

Discounting Non-Discounting
Criteria Criteria

Net Present Profitability Internal Rate Modified IRR Payback Discounted Accounting Rate
Value Index (BCR/PI) of Return (MIRR) Period Payback of Return
(NPV) (IRR) Period (ARR)
Net Present Value (NPV)
Definition:
▶ Net Present Value (NPV) evaluates investment decisions involving cash flows over
multiple periods.
▶ It represents the difference between the present value of cash inflows and
initial investment.
NPV Formula:
n
X Ct
NPV = − C0
(1 + r )t
t=1

Meaning of Symbols:
▶ Ct : Cash flow at the end of year t
▶ n: Life of the project
▶ r : Discount rate (required return)
▶ C0 : Initial investment
NPV Decision Rule and Interpretation
Decision Rule:
▶ If NPV > 0 ⇒ Accept the project
▶ If NPV < 0 ⇒ Reject the project
▶ If NPV = 0 ⇒ Indifferent

Economic Interpretation:
▶ NPV measures the net addition to firm value
▶ NPV > 0:
▶ Project generates returns greater than required return
▶ Increases shareholders’ wealth
▶ NPV < 0:
▶ Project fails to meet required return
▶ Destroys firm value
▶ NPV = 0:
▶ Project earns exactly the required return
▶ No change in firm value
NPV: Numerical Example 1
Given:
▶ Initial investment (C0 ) = Rs. 1,000,000
▶ Discount rate (r ) = 10%

Year Cash Flow (Rs.)

0 -1,000,000
1 200,000
2 200,000
3 300,000
4 300,000
5 350,000
NPV Calculation:
5
X Ct
NPV = − 1,000,000
(1 + 0.10)t
t=1
Task: Compute NPV and comment on acceptability.
NPV Solution: Example 1

Given: r = 10%
Year Cash Flow (Rs.) Discount Factor (10%) Present Value (Rs.)
0 -1,000,000 1.000 -1,000,000
1 200,000 0.909 181,800
2 200,000 0.826 165,200
3 300,000 0.751 225,300
4 300,000 0.683 204,900
5 350,000 0.621 217,350
Total PV of Inflows 994,550

NPV = 994,550 − 1,000,000 = −5,450

Decision:
▶ NPV < 0 ⇒ Reject the project
NPV: Numerical Example 2
Given: Initial investment (C0 ) = Rs. 500,000, Project life = 4 years, Discount rate (r )
= 12%.
Year Cash Flow (Rs.)
0 -500,000
1 150,000
2 180,000
3 200,000
4 220,000
NPV Calculation:
4
X Ct
NPV = − 500,000
(1 + 0.12)t
t=1

Task:
▶ Compute NPV
▶ State whether the project should be accepted
NPV Solution: Example 2

Given: r = 12%
Year Cash Flow (Rs.) Discount Factor (12%) Present Value (Rs.)
0 -500,000 1.000 -500,000
1 150,000 0.893 133,950
2 180,000 0.797 143,460
3 200,000 0.712 142,400
4 220,000 0.636 139,920
Total PV of Inflows 559,730

NPV = 559,730 − 500,000 = 59,730

Decision:
▶ NPV > 0 ⇒ Accept the project
Profitability Index (PI)
Definition:
▶ Profitability Index (PI) is a relative measure of project profitability.
▶ It is defined as the ratio of the present value of future cash inflows to the
initial investment.

Formula:
Pn Ct
t=1 (1+r )t
PI =
C0

Meaning of Symbols:
▶ Ct : Cash flow at time t
▶ r : Discount rate
▶ n: Project life
▶ C0 : Initial investment
Profitability Index (PI): Decision Rule

Decision Rule:
▶ If PI > 1 ⇒ Accept the project
▶ If PI < 1 ⇒ Reject the project
▶ If PI = 1 ⇒ Indifferent

Economic Interpretation:
▶ PI measures value created per unit of investment
▶ PI > 1: Project generates more value than cost
▶ PI < 1: Project destroys value
▶ PI = 1: Break-even investment

Relation with NPV:

PI > 1 ⇐⇒ NPV > 0
Limitations of Net Present Value (NPV)

▶ Although NPV is consistent with the objective of value maximization, it has

certain limitations.
▶ Scale Problem:
▶ NPV is an absolute measure and does not consider the size of investment.
▶ Example:
▶ Project A: NPV = Rs. 5,000, Investment = Rs. 50,000
▶ Project B: NPV = Rs. 2,500, Investment = Rs. 10,000
▶ Project B may be more efficient despite lower NPV.
▶ Project Life Problem:
▶ NPV does not account for differences in project life.
▶ May bias decisions in favour of longer duration projects.
PI: Numerical Example 1

Given:
▶ Initial investment = Rs. 1,000,000
▶ Discount rate = 10%

Year Cash Flow (Rs.)

1 200,000
2 200,000
3 300,000
4 300,000
5 350,000

Task: Compute PI and comment on the decision.

PI Solution: Example 1

From NPV calculation:

PV of inflows = 994,550

994,550
PI = = 0.995
1,000,000

Decision:
▶ PI < 1 ⇒ Reject the project
PI: Numerical Example 2

Given:
▶ Initial investment = Rs. 500,000
▶ Discount rate = 12%

Year Cash Flow (Rs.)

1 150,000
2 180,000
3 200,000
4 220,000

Task: Compute PI and interpret the result.

PI Solution: Example 2

From NPV calculation:

PV of inflows = 559,730

559,730
PI = = 1.12
500,000

Decision:
▶ PI > 1 ⇒ Accept the project
Benefit-Cost Ratio (BCR)
Definition:
▶ Benefit-Cost Ratio (BCR) measures the present value of benefits per unit of
investment.
Formula:

Present Value of Benefits (PVB)

BCR =
I
Net Benefit-Cost Ratio (NBCR):

PVB − I
NBCR = = BCR − 1
I
Decision Rule:
▶ If BCR > 1 (or NBCR > 0) ⇒ Accept
▶ If BCR < 1 ⇒ Reject
Note:
▶ BCR is equivalent to Profitability Index (PI)
BCR: Numerical Example

Given:
▶ Initial investment (I ) = Rs. 100,000
▶ Discount rate = 12%

Year Cash Flow (Rs.)

1 25,000
2 40,000
3 40,000
4 50,000

Task: Compute BCR and comment on the project.

BCR Solution

Discount rate = 12%

Year Cash Flow Discount Factor Present Value
1 25,000 0.893 22,325
2 40,000 0.797 31,880
3 40,000 0.712 28,480
4 50,000 0.636 31,800
Total PVB 114,485

114,485
BCR = = 1.145
100,000
Decision:
▶ BCR > 1 ⇒ Accept the project
Advantage of BCR over NPV

▶ BCR is a relative measure (per rupee of investment), unlike NPV which is

absolute.
▶ It is useful when:
▶ Comparing projects of different sizes
▶ Capital is rationed
▶ It helps in selecting projects that provide maximum value per unit of
investment.

Key Insight:
▶ NPV → Absolute value creation
▶ BCR (PI) → Efficiency of investment
Internal Rate of Return (IRR)
Definition:
▶ Internal Rate of Return (IRR) is the discount rate at which the Net Present
Value (NPV) of a project becomes zero.
▶ It represents the rate of return generated by the project.
Mathematical Condition:
n
X Ct
NPV = − C0 = 0
(1 + r )t
t=1
Equivalent Form:
n
X Ct
C0 =
(1 + IRR)t
t=1
Meaning of Symbols:
▶ Ct : Cash flow at time t
▶ C0 : Initial investment
▶ n: Project life and, r : Discount rate (IRR)
IRR Decision Rule and Interpretation

Decision Rule:
▶ If IRR > r (cost of capital) ⇒ Accept
▶ If IRR < r ⇒ Reject
▶ If IRR = r ⇒ Indifferent

Economic Interpretation:
▶ IRR is the maximum return the project can generate
▶ It is the break-even discount rate
▶ At IRR:
▶ Present value of inflows = Initial investment
▶ NPV = 0
IRR: Numerical Example

Given:
▶ Initial investment = Rs. 100,000

Year Cash Flow (Rs.)

0 -100,000
1 30,000
2 30,000
3 40,000
4 45,000

Task:
▶ Find IRR using trial-and-error (or interpolation)
IRR Solution (Trial Method)

Step 1: Try r = 10%

▶ Compute NPV ⇒ Positive
Step 2: Try r = 15%
▶ Compute NPV ⇒ Slightly Positive
Step 3: Try r = 18%
▶ Compute NPV ⇒ Negative

Conclusion:
▶ IRR lies between 15% and 18%
▶ Approximate IRR ≈ 16% − 17%
Limitations of Internal Rate of Return (IRR)
▶ Multiple IRR Problem:
▶ Projects with non-conventional cash flows (multiple sign changes) may yield
multiple IRRs.
▶ This creates ambiguity in decision-making.
▶ Reinvestment Assumption:
▶ IRR assumes that intermediate cash flows are reinvested at the same IRR.
▶ This is often unrealistic, especially for high IRR values.
▶ Conflict with NPV:
▶ For mutually exclusive projects, IRR may give conflicting rankings compared to
NPV.
▶ Scale Problem:
▶ IRR does not consider the size of investment.

Key Insight:
▶ Due to these limitations, IRR may lead to incorrect decisions.
Modified Internal Rate of Return (MIRR)
Purpose: MIRR is developed to overcome the limitations of IRR. It assumes
reinvestment at the cost of capital (more realistic). Concept:
▶ Separate treatment of:
▶ Cash outflows → discounted to present value
▶ Cash inflows → compounded to terminal value

MIRR Formula:
 1
TV n
MIRR = −1
PVC
Where:
P Cash Outflowt
▶ PVC = (1+r )t (Present Value of costs)
▶ TV = Cash Inflowt (1 + r )n−t (Terminal Value of inflows)
P
▶ r : Cost of capital
▶ n: Project life
Decision Rule:
▶ If MIRR > r ⇒ Accept. If MIRR < r ⇒ Reject
MIRR: Numerical Example
Given:
▶ Cost of capital (r ) = 15%

Year Cash Flow (Rs.)

0 -120
1 -80
2 20
3 60
4 80
5 100
6 120

Steps:
▶ Compute Present Value of Costs (PVC)
▶ Compute Terminal Value of Inflows (TV)
▶ Calculate MIRR
MIRR Solution
Step 1: Present Value of Costs
80
PVC = 120 + = 189.6
(1.15)
Step 2: Terminal Value of Inflows

TV = 20(1.15)4 + 60(1.15)3 + 80(1.15)2 + 100(1.15) + 120

TV = 34.98 + 91.26 + 105.76 + 115 + 120 = 467

Step 3: MIRR Calculation
 1  1
TV n 467 6
MIRR = −1= −1
PVC 189.6

MIRR = 1.162 − 1 = 0.162 = 16.2%

Decision:
▶ MIRR > 15% ⇒ Accept the project.
NPV vs IRR vs MIRR
Comparison of Investment Criteria:
▶ Internal Rate of Return (IRR):
▶ Measures the rate of return of a project
▶ May give multiple or misleading results for non-conventional cash flows
▶ Assumes reinvestment at IRR (often unrealistic)
▶ Modified Internal Rate of Return (MIRR):
▶ Provides a unique and more realistic return
▶ Assumes reinvestment at cost of capital
▶ Eliminates multiple IRR problem
▶ ⇒ Better than IRR for measuring true return
▶ Net Present Value (NPV):
▶ Measures absolute increase in firm value
▶ Consistent with shareholder wealth maximization
▶ Preferred for mutually exclusive projects

Key Insight:
▶ MIRR ⇒ Best for measuring rate of return
▶ NPV ⇒ Best for measuring value creation
Payback Period
Definition:
▶ Payback Period is the time required to recover the initial investment from
cash inflows.

Formula (Uniform Cash Flows):

Initial Investment
Payback Period =
Annual Cash Inflow

For Uneven Cash Flows:

▶ Compute cumulative cash flows year by year
▶ Identify the year in which investment is recovered

Decision Rule:
▶ Accept if Payback Period ≤ Desired (cut-off) period
▶ Reject if Payback Period > Cut-off period
Payback Period: Example (Uniform Cash Flow)

Given:
▶ Initial Investment = Rs. 100,000
▶ Annual Cash Inflow = Rs. 25,000

Calculation:
100,000
Payback Period = = 4 years
25,000

Decision:
▶ If cut-off period = 5 years ⇒ Accept
▶ If cut-off period = 3 years ⇒ Reject
Payback Period: Example (Uneven Cash Flows)

Given:
▶ Initial Investment = Rs. 100,000

Year Cash Flow (Rs.) Cumulative CF (Rs.)

1 20,000 20,000
2 30,000 50,000
3 40,000 90,000
4 50,000 140,000

Observation:
▶ Investment recovered between Year 3 and Year 4
Working Capital: Meaning
Definition:
▶ Working Capital refers to the funds required for day-to-day operations of a
firm.

Types of Working Capital:

▶ Gross Working Capital: Total current assets
▶ Net Working Capital:

NWC = Current Assets − Current Liabilities

Example:
▶ Current Assets = Rs. 500,000
▶ Current Liabilities = Rs. 300,000

NWC = 500,000 − 300,000 = 200,000

Importance of Working Capital Management

▶ Ensures smooth day-to-day operations

▶ Maintains liquidity and solvency
▶ Helps in timely payment of expenses and obligations
▶ Improves profitability by efficient resource use
▶ Enhances creditworthiness of the firm
▶ Prevents overtrading and financial distress

Key Insight:
▶ Too little WC ⇒ Liquidity problems
▶ Too much WC ⇒ Idle funds (low return)
Factors Affecting Working Capital Needs

▶ Nature of Business: Manufacturing firms require more WC than service firms

▶ Business Cycle: Expansion requires higher WC
▶ Production Cycle: Longer cycle ⇒ Higher WC
▶ Credit Policy: Liberal credit ⇒ Higher receivables
▶ Inventory Policy: Higher inventory ⇒ More WC
▶ Seasonality: Seasonal demand increases WC requirement
▶ Operating Efficiency: Efficient firms require less WC
Estimation of Working Capital Requirements
Concept:
▶ Based on operating cycle of the firm

Operating Cycle:

OC = Inventory Period + Receivables Period − Payables Period

Example:
▶ Inventory Period = 60 days
▶ Receivables Period = 30 days
▶ Payables Period = 20 days

OC = 60 + 30 − 20 = 70 days
Interpretation:
▶ Firm needs funds for 70 days of operations
Management of Inventories
Objective:
▶ Minimize total cost (ordering + holding cost)

Economic Order Quantity (EOQ):

r
2DS
EOQ =
H

Where:
▶ D: Annual demand
▶ S: Ordering cost per order
▶ H: Holding cost per unit

Example: r
2 × 1000 × 50 p
EOQ = = 50,000 = 224 units
2
Management of Receivables
Objective:
▶ Balance between sales growth and credit risk

Key Concepts:
▶ Credit policy
▶ Credit period
▶ Collection policy

Example:
▶ Average daily sales = Rs. 10,000
▶ Average collection period = 30 days

Receivables = 10,000 × 30 = 300,000

Management of Cash and Marketable Securities
Objective:
▶ Maintain optimal cash balance

Motives for Holding Cash:

▶ Transaction motive
▶ Precautionary motive
▶ Speculative motive

Example:
▶ Daily cash requirement = Rs. 5,000
▶ Safety buffer = Rs. 20,000

Total Cash Needed = 5,000 × 30 + 20,000 = 170,000

Working Capital Management: Key Insight

▶ Working capital ensures liquidity and operational efficiency

▶ Efficient management improves:
▶ Profitability
▶ Cash flow stability
▶ Trade-off:
▶ High WC ⇒ Safety but low returns
▶ Low WC ⇒ Risk but higher returns
End of Module 4