EL

PT
CORPORATE FINANCE

N
ABHIJEET CHANDRA
Vinod Gupta School of Management, IIT KHARAGPUR

Lecture 11: Capital Budgeting Decisions

CONCEPTS COVERED

⮚ Capital Budgeting Decision

EL
⮚ Capital Budgeting Process

PT
⮚ Types of Capital Budgeting Decisions

N
Capital Budgeting Decisions
Long-term Investment Decisions
Factors to be considered for investing decisions
• Relevant cash flows
• Effect of taxes and depreciation
• Opportunity costs: is what a resource is worth in its next-best use.
• Sunk costs: what has already been incurred and cannot be changed. E.g., R&D

EL
Accounting Terminology

PT
• Accounting profits vs. cash flows
• Working capital

N
• Depreciation
Time value of money
• A rupee (received) today is worth more than a rupee (to be received) tomorrow!
• Compounding technique: Future value of money
• Discounting technique: Present value of money
Capital Budgeting Decisions
Long-term Investment Decisions
Capital budgeting decisions as corporate strategic decisions:
• Why do firms invest in projects?
• Long-term projects vs. short-term projects
• Project types: Replacements, Expansions, New Product/Services, and mutually exclusive projects
• Capital-intensive decisions, their relevance for firm’s value and market’s reactions

EL
Various techniques of project evaluation:

PT
• Pay-back Period (PBP)
• Accounting Rate of Return (ARR)

N
• Profitability Index (PI)
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Modified IRR
Which one to go for?
Capital Budgeting Decisions
Long-term Investment Decisions: Introduction
The process of evaluating and selecting long-term investment alternatives that are consistent
with the firm’s goal of shareholders’ value maximization.
• Long-term capital expenditure: benefits expected for more than one year (typically!)
• These decisions are strategic in nature
• Capital budgeting decisions involve huge outlays of funds

EL
• These are not easily reversible
• Huge costs/impacts: financial, operational, and reputational!

PT
The Capital Budgeting Process

N
Analysing Monitoring
Generating Planning the
Individual and Post-
Ideas Capital Budget
Proposals auditing
Capital Budgeting Decisions
Basic Principles
1. Decisions are based on cash flows:
The decisions are not based on accounting concepts, such as net income. Also, intangible costs and
benefits are often ignored because, if they are real/relevant, they should result in cash flows eventually.
2. Timing of cash flows is crucial:
While analyzing for decision-making, analysts should make extra efforts to detail precisely WHEN

EL
cash flows occur.
3. Cash flows should be considered on an after-tax basis:

PT
Since taxes affect the net costs and benefits, these must be fully reflected in all capital budgeting
decisions.

N
4. Opportunity costs do matter:
Cash flows are based on opportunity costs and shall be analyzed, preferably, on an
incremental basis.
5. Financing costs are ignored:
While calculating cash flows, financing costs are ignored as they’re already reflected
in the required rate of return (e.g., the discounting rate for NPV calculation).
Capital Budgeting Decisions
Types of Capital Budgeting Decisions

EL
PT
N
Capital Budgeting Decisions
Types of Capital Budgeting Decisions: Accept-Reject Decision

EL
PT
N
Capital Budgeting Decisions
Types of Capital Budgeting Decisions: Mutually Exclusive Decisions

EL
PT
N
Capital Budgeting Decisions
Types of Capital Budgeting Decisions: Capital Rationing Decisions

EL
PT
N
Capital Budgeting Decisions
Factors to be considered in capital budgeting

EL
PT
N
CONCLUSION

• Firms often take long-term investing decisions that require substantial

EL
outlays of funds and mostly irreversible in nature.
• These decisions are to be evaluated by way of analyzing cash flows and

PT
considering opportunity costs, benefits, and other relevant factors.
• These decisions could be independent, mutually exclusive, project

N
sequencing, and capital rationing types.
• There are several approaches to analyze cash flows to evaluate capital
budgeting decisions.
REFERENCES

EL
⮚ Fundamentals of Corporate Finance, 12rd ed. (2017), Ross et al. Pearson

PT
N
N
PT
EL
 EL
PT
CORPORATE FINANCE

N
ABHIJEET CHANDRA
Vinod Gupta School of Management, IIT KHARAGPUR

Lecture 12: Capital Budgeting Decisions (cont.)

CONCEPTS COVERED

⮚ Accounting Profits versus Cashflows

EL
⮚ Effect of Depreciation

PT
⮚ Effect of Working Capital

N
Capital Budgeting Decisions
Factors to be considered in capital budgeting

EL
PT
N
Capital Budgeting Decisions: Issues and Concerns
Issues and Concerns

EL
PT
N
Capital Budgeting Decisions
Accounting profits versus cash flows

Accounting Cash Flow

Approach Approach
Revenues Rs. 1,00,000 Rs. 1,00,000
Less: Expenses

EL
Cash Expenses Rs. 50,000 Rs. 50,000

PT
Depreciation Rs. 30,000 -
Earnings Before Tax Rs. 20,000 Rs. 50,000

N
Less: Taxes @ 35% Rs. 7,000 Rs. 7,000*
Net Income/Cash Flow Rs. 13,000 Rs. 43,000
Capital Budgeting Decisions
Accounting profits versus cash flows: Depreciation

EL
PT
N
Capital Budgeting Decisions
Working Capital Requirements
Net Working Capital = Current Assets – Current Liabilities (directly related to the investment project)

• Any change in revenue brings in changes in working capital as well, mostly.

• The increased working capital: part of the initial cash outlays.
• Such working capital requirements can be at any point of time during the life of the project.

EL
Head of Expenditure Amount (Rs.)

PT
Initial Costs of the new project

N
Plus: Installation costs, etc.
Plus: Working capital requirements
Total Cash Outflows
Capital Budgeting Decisions
Determining Relevant Cashflows

EL
PT
N
Capital Budgeting Decisions
Determining Relevant Cashflows

EL
PT
N
CONCLUSION

• Firms often take long-term investing decisions that require substantial

EL
outlays of funds and mostly irreversible in nature.
• These decisions are to be evaluated by way of analyzing cash flows and

PT
considering opportunity costs, benefits, and other relevant factors.
• These decisions could be independent, mutually exclusive, project

N
sequencing, and capital rationing types.
• There are several approaches to analyze cash flows to evaluate capital
budgeting decisions.
REFERENCES

EL
⮚ Fundamentals of Corporate Finance, 12rd ed. (2017), Ross et al. Pearson

PT
N
N
PT
EL
 EL
PT
CORPORATE FINANCE

N
ABHIJEET CHANDRA
Vinod Gupta School of Management, IIT KHARAGPUR

Lecture 13: Capital Budgeting Techniques - I

CONCEPTS COVERED

⮚ Alternatives to NPV

EL
⮚ Accounting Rate of Return

PT
⮚ Payback Period and

N
⮚ Discounted Payback Period
Capital Budgeting Decisions
So far, so good!
• Firms often take long-term investing decisions, known as capital budgeting decisions.
• These decisions require substantial outlays of funds and are mostly irreversible in nature.
• We evaluate them by way of analyzing cash flows and considering opportunity costs, benefits,
and other relevant factors.
• These decisions could be independent, mutually exclusive, project sequencing, and capital

EL
rationing types.
• Net Present Value (NPV) method for investing decisions

PT
Alternative approaches

N
1. Average Accounting Rate of Return (ARR)
2. Payback Period (PBP)
3. Profitability Index (PI)
4. Internal Rate of Return (IRR)
Which one of these alternatives is the most appropriate to use?
Capital Budgeting Decisions
Alternatives to Net Present Value (NPV) Method
1. Average Accounting Rate of Return (ARR)
2. Payback Period (PBP)
3. Profitability Index (PI)
4. Internal Rate of Return (IRR)

EL
• These methods/tools have been used since long as they are simple to use, and

PT
might work well in certain situations for some individual decision makers.
• Some of these tools consider time value of money, while others don’t.

N
• For any decision that involve cash flows at different points of time in future to
make sense, it’s important to have TVM incorporated.
• The output of these tools may or may not be the same as the NPV.
• However, the NPV method provides the most sensible answer in case of
capital budgeting/investment decisions.
Alternative to Net Present Value (NPV) Method
1. Average Accounting Rate of Return (ARR)
The average Accounting Rate of Return (ARR) is calculated as:

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆

𝑨𝑹𝑹 =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑩𝒐𝒐𝒌 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝒕𝒉𝒆 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

EL
PT
• ARR is the most simple tool to use for deciding on the investment projects.
• Easy to understand and implement.

N
• Based on accounting numbers, and not based on cash flows.
• It doesn’t consider time value of money.
• No conceptually sound cutoff for distinguishing between profitable and
unprofitable projects.
Alternative to Net Present Value (NPV) Method
1. Average Accounting Rate of Return (ARR)
Example: Suppose that a company wishes to invest Rs. 20,00,000 in a 5-year long project that has a projected
sales revenue and cash operating expenses as given below. The project requires a straight-line method of
depreciation, with no salvage value at the end. Prevailing tax rate is 40%.
Year 1 Year 2 Year 3 Year 4 Year 5

Sales 10,00,000 15,00,000 24,00,000 13,00,000 8,00,000

EL
Cash 5,00,000 7,00,000 12,00,000 6,00,000 5,00,000

PT
expenses
Depreciation

N
Earnings
before taxes
Taxes @ 40%

Net income
Alternative to Net Present Value (NPV) Method
1. Average Accounting Rate of Return (ARR)
Example: Suppose that a company wishes to invest Rs. 20,00,000 in a 5-year long project that has a projected
sales revenue and cash operating expenses as given below. The project requires a straight-line method of
depreciation, with no salvage value at the end. Prevailing tax rate is 40%.
Year 1 Year 2 Year 3 Year 4 Year 5 The average net income (Y1-Y5) = Rs. 1,80,000
Sales 10,00,000 15,00,000 24,00,000 13,00,000 8,00,000 The average book value of the project

EL
(Y1-Y5) = Rs. 20,00,000 – 0
Cash 5,00,000 7,00,000 12,00,000 6,00,000 5,00,000
= Rs. 20,00,000 ÷ 2 = Rs. 10,00,000

PT
expenses
Depreciation 4,00,000 4,00,000 4,00,000 4,00,000 4,00,000 𝑹𝒔. 𝟏, 𝟖𝟎, 𝟎𝟎𝟎
𝑨𝑹𝑹 = = 𝟎. 𝟏𝟖

N
Earnings 1,00,000 4,00,000 8,00,000 3,00,000 –1,00,000 𝑹𝒔. 𝟏𝟎, 𝟎𝟎, 𝟎𝟎𝟎
before taxes
𝑨𝑹𝑹 = 𝟏𝟖%
Taxes @ 40% 40,000 1,60,000 3,20,000 1,20,000 –40,000*

Net income 60,000 2,40,000 4,80,000 1,80,000 –60,000

*Negative taxes occur in Year 5 because the EBT of –1,00,000 can be deducted against earnings
of other projects, thereby reducing the tax liability by 40,000.
Alternative to Net Present Value (NPV) Method
2. Payback Period (PBP)
The payback period of a project is defined as the number of years required to recover the
initial investment. It ignores cash flows after that time.
Y0 Y1 Y2 Y3 … Yt Yn

EL
CF1 CF2 CF3 … CFt
–CF0

PT
Payback Period is the minimum t such that
𝑪𝑭𝟏 + 𝑪𝑭𝟐 + ⋯ + 𝑪𝑭𝒕 = −𝑪𝑭𝟎

N
• Here, Payback Period t is the minimum number of years such that the sum of
cash flows from a project equals the original investment (i.e., CF0)
• Easy to understand and implement.
• Based on cash flows, yet doesn’t consider time value of money.
• Accept a project if t ≤ threshold period.
Alternative to Net Present Value (NPV) Method
2. Payback Period (PBP)
Example: Suppose that a prospective project is estimated to generate the following cash
flows. What should we do to find out the payback period of the project?
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cash flow (₹) –1,00,000 25,000 25,000 30,000 30,000 30,000

EL
PT
N
Alternative to Net Present Value (NPV) Method
2. Payback Period (PBP)
Example: Suppose that a prospective project is estimated to generate the following cash
flows. What should we do to find out the payback period of the project?
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cash flow (₹) –1,00,000 25,000 25,000 30,000 30,000 30,000

EL
Cumulative –1,00,000 –1,00,000 –70,000 + –50,000 + –20,000 + 10,000 +
cash flows (₹) + 25,000 25,000 30,000 30,000 30,000

PT
Cumulative –1,00,000 –75,000 –50,000 –20,000 10,000 40,000
cash flows (₹)

N
The project gives back the original investment sometime between Year 3
and Year 4. After Year 3, we are yet to recover Rs. 20,000 which is 2/3rd of
the cash flow in Year 4 (in order to bring the cumulative cash flow to zero).

So, the payback period of the project = 3 + 2/3rd of 4th year = 3.67 years.
Alternative to Net Present Value (NPV) Method
2. Payback Period (PBP)
We see that the Payback Period calculation ignored Time Value of Money. If we discount the
cash flows and use the same, we get the Discounted Payback Period.
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cash flow (₹) –1,00,000 25,000 25,000 30,000 30,000 30,000

EL
Cumulative cash –1,00,000 –1,00,000 –70,000 + –50,000 + –20,000 + 10,000 +
flows (₹) + 25,000 25,000 30,000 30,000 30,000

PT
Cumulative cash –1,00,000 –75,000 –50,000 –20,000 10,000 40,000
flows (₹)

N
Discounted CF* (₹) –1,00,000 22,727 20,661 22,539 20,490 18,628

Cumulative –1,00,000 –77,273 –56,612 –34,073 –13,583 5,045

discounted CF (₹)

The discounted payback period = 4 years + (13,583÷18,628 = 0.73 of the 5th

year) = 4.73 years
CONCLUSION

• We know that the Net Present Value (NPV) considers the present value of

EL
the expected cash flows associated with a project to decide whether to
accept the project or not.

PT
• There are simpler methods, such as Accounting Rate of Return (ARR),

N
Payback Period (PBP), and discounted PBP.
• However, these methods are not as superior as NPV, because either they
do not consider time value of money, or they do not capture the entire
stream of cash flows.
REFERENCES

EL
⮚ Fundamentals of Corporate Finance, 12rd ed. (2017), Ross et al. Pearson

PT
N
N
PT
EL
 EL
PT
CORPORATE FINANCE

N
ABHIJEET CHANDRA
Vinod Gupta School of Management, IIT KHARAGPUR

Lecture 14: Capital Budgeting Techniques - II

CONCEPTS COVERED

⮚ Profitability Index (PI)

EL
⮚ Internal Rate of Return (IRR)

PT
N
Capital Budgeting Techniques
Alternatives to NPV Method
• Accounting Rate of Return (ARR): A method that does not consider time value of money, but
just the absolute income and investment related to a project.
• Payback Period (PBP): Does not consider time value of money as well as entire cash flows.
• Discounted Payback Period: Considers TVM but not the entire cash flows.

EL
Now, we will see other alternatives to the Net Present Value (NPV) method.
1. Average Accounting Rate of Return (ARR)

PT
2. Payback Period (PBP)
3. Profitability Index (PI)

N
4. Internal Rate of Return (IRR)
 Alternative to Net Present Value (NPV) Method
3. Profitability Index (PI)
The profitability index is defined as the present value of a project’s future cash flows divided
by the original investment.
Y0 Y1 Y2 Y3 … … Yn

EL
CF1 CF2 CF3 … … CFn
–CF0

Profitability index of project is:

PT
𝑷𝑽 𝒐𝒇 𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘𝒔 𝑵𝑷𝑽
𝑷𝑰 = =𝟏+

N
𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

• Consider time value of money; closely related to NPV method.

• Whenever NPV will be positive, the PI will be greater than 1.
• Decision criteria: Accept a project if PI > 1, otherwise do not accept.
• Might not be helpful in comparison of projects with varying initial investments.
 Alternative to Net Present Value (NPV) Method
3. Profitability Index (PI)
Example: Suppose that a firm considers investing in a project that requires an initial
investment of $10,000. The project is expected to yield a cash flow of $5,000 each year for
next three years. If the discounting rate is 12%, we can calculate the PI as follows:
Y0 Y1 Y2 Y3

EL
CF0 = –$10,000 CF1 = $5,000 CF2 = $5,000 CF3 = $5,000

PT
N
$𝟓, 𝟎𝟎𝟎 $𝟓, 𝟎𝟎𝟎 $𝟓, 𝟎𝟎𝟎
Present value of the cash flows from the project = 𝑷𝑽 = + +
(𝟏. 𝟏𝟐) (𝟏. 𝟏𝟐)𝟐 (𝟏. 𝟏𝟐)𝟑
= $𝟏𝟐, 𝟎𝟎𝟗

$𝟏𝟐, 𝟎𝟎𝟗
Profitability index of project is: = 𝟏. 𝟐𝟎𝟏
$𝟏𝟎, 𝟎𝟎𝟎

Or, PI = 1 + (NPV ÷ Initial Investment) = 1 + (2,009/10,000) = 1+0.2009 = 1.201

Alternative to Net Present Value (NPV) Method
3. Profitability Index (PI)
• The PI indicates the value that we expect to receive in return for one unit of money
invested in the project.
• It is used more often as a capital rationing tool; less popular than NPV.
• Also, known as “benefit-to-cost ratio” in the context of government and non-profit
organizations.

EL
Profitability index scales projects by their original investments, sometimes leading to

PT
confusing conclusions while comparing projects:

N
Initial Investment (CF0) CF1 CF2 PV @ 10% PI

Project A – Rs. 10,000 Rs. 9,000 Rs. 14,000 Rs. 19,752 1.975

Project B – Rs. 50,000 Rs. 45,000 Rs. 32,000 Rs. 76,355 1.347

Even though the NPV of Project B is clearly much higher, the PI suggests that the
Project A should better be preferred. Hence, → NPV
 Alternative to Net Present Value (NPV) Method
4. Internal Rate of Return (IRR)
As one of the most commonly used tool in capital budgeting, IRR indicates the discount rate that
makes the PV of the future cash flows equal to the initial investment (i.e., r, where NPV = 0).
Y0 Y1 Y2 Y3 … … Yn

EL
CF1 CF2 CF3 … … CFn
–CF0

IRR of such a project can be:

PT
𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝒏
−𝑪𝑭𝟎 = + + ⋯+

N
𝟏 + 𝑰𝑹𝑹 𝟏 (𝟏 + 𝑰𝑹𝑹)𝟐 (𝟏 + 𝑰𝑹𝑹)𝒏

• Consider time value of money; it is the discount rate at which NPV becomes zero.
• Decision criteria (independent projects):
• Accept a project if IRR > the threshold rate, otherwise do not accept.
• Among mutually competing projects, higher the IRR, the better it is.
Alternative to Net Present Value (NPV) Method
4. Internal Rate of Return (IRR)
Example: Sinfosys Ltd. Is considering an investment of Rs. 50 crore in a capital project that
will return after-tax cash flows of Rs. 16 crore per year for the next four years plus another
Rs. 20 crore in the fifth year. The required rate of return is 10%. Suggest if it’s acceptable.

EL
PT
IRR of such a project can be calculated as:

N
𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝒏
−𝑪𝑭𝟎 = + + ⋯ +
𝟏 + 𝑰𝑹𝑹 𝟏 (𝟏 + 𝑰𝑹𝑹)𝟐 (𝟏 + 𝑰𝑹𝑹)𝒏

𝟏𝟔 𝟏𝟔 𝟏𝟔 𝟏𝟔 𝟐𝟎
−𝟓𝟎 = 𝟏
+ 𝟐
+ 𝟑
+ +
𝟏 + 𝑰𝑹𝑹 𝟏 + 𝑰𝑹𝑹 𝟏 + 𝑰𝑹𝑹 (𝟏 + 𝑰𝑹𝑹)𝟒 (𝟏 + 𝑰𝑹𝑹)𝟓
Alternative to Net Present Value (NPV) Method
4. Internal Rate of Return (IRR)
Example: Sinfosys Ltd. Is considering an investment of Rs. 50 crore in a capital project that
will return after-tax cash flows of Rs. 16 crore per year for the next four years plus another
Rs. 20 crore in the fifth year. The required rate of return is 10%. Suggest if it’s acceptable.
𝟏𝟔 𝟏𝟔 𝟏𝟔 𝟏𝟔 𝟐𝟎
−𝟓𝟎 = + + + +

EL
𝟏 + 𝑰𝑹𝑹 𝟏 𝟏 + 𝑰𝑹𝑹 𝟐 𝟏 + 𝑰𝑹𝑹 𝟑 (𝟏 + 𝑰𝑹𝑹)𝟒 (𝟏 + 𝑰𝑹𝑹)𝟓

PT
Using trial-and-error method, we find IRR of such the project as following:
r NPV (Rs. Crore)

N
₹11.94 𝑪𝑭𝒕
NPV @ 10% −𝑪𝑭𝟎 + σ𝒏𝒕=𝟏 = 𝟎, where IRR* = 19.52%
𝟏+𝑰𝑹𝑹 𝒕
NPV @ 12% ₹8.88
NPV @ 14% ₹6.15
NPV @ 16% ₹3.70
NPV @ 18% ₹1.51
NPV @ 20% (₹0.45)
NPV @ 19% ₹0.50 *Refer to the spreadsheet example
 Alternative to Net Present Value (NPV) Method
4. Internal Rate of Return (IRR)
• The threshold rate (cut-off rate): the opportunity cost of capital.
• Sometimes we get multiple IRRs (particularly when there are negative cash flows in
future periods; the sign of cash flows changes in future).
• Confusing outcome in loan-type cash flow scenarios.

EL
For example, see the following:

PT
Initial Investment CF1 NPV @ IRR IRR Rank
(CF0) 10% Rank

N
Project A (Investment)– Rs. 10,000 Rs. 15,000 Rs. 3,306 50% 1 +ve NPV only if r < 50%

Project B 2UGT3:GQKT Rs. 10,000 – Rs. 15,000 – Rs. 3,306 50% 1 +ve NPV only if r > 50%

• IRR criteria suggest both project being equal (if actual opportunity cost of capital = 10%)
• But, Project A has positive NPV @ r < 50%, and Project B @ r > 50%.
• Ideally, we should accept Project A and reject Project B. Hence, use NPV!
CONCLUSION

• As alternatives to the Net Present Value (NPV) method, we often use tools such

EL
as Profitability Index (PI) and Internal Rate of Return (IRR) for capital budgeting
decisions.

PT
• Profitability Index, as the benefit-to-cost ratio, suggests the value that we

N
receive for every rupee of investment in a project. The higher PI, the better it is.
• IRR is the discount rate that makes the present value of future cash flows equal
to the initial investment. The higher IRR, the better it is for the decision.
• While using IRR we face certain issues in peculiar cases where there are
changes in the sign of cash flows (e.g., negative cash flows in future periods).
REFERENCES

EL
⮚ Fundamentals of Corporate Finance, 12rd ed. (2017), Ross et al. Pearson

PT
N
N
PT
EL
 EL
PT
CORPORATE FINANCE

N
ABHIJEET CHANDRA
Vinod Gupta School of Management, IIT KHARAGPUR

Lecture 15: Capital Budgeting Techniques - III

CONCEPTS COVERED

⮚ Issues with IRR

EL
⮚ NPV vs IRR

PT
N
Capital Budgeting Decisions
Alternatives to Net Present Value (NPV) Method
• As alternatives to the Net Present Value (NPV) method, we often use tools such
as Accounting Rate of Return (ARR), Payback Period, Profitability Index (PI) and
Internal Rate of Return (IRR) for capital budgeting decisions.
• While ARR and Payback Period methods are simple to understand and easy to

EL
use, they do not consider time value of money concept and/or entire cash flows
for making decisions. Profitability Index and IRR are still better in that sense.

PT
• We can use PI and IRR for ranking projects and make decisions: a higher value is
better.

N
The Basics of NPV
A company’s shareholders always prefer to be rich than poor. Therefore, they want the
firm to invest in every project that is worth more than its costs. The difference
between a project’s value and its cost is the net present value (NPV).
How will you analyze a proposed investment of, say $1million, in a new venture, say project X?

The SOP:

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• Forecast the cash flows generated by project X over its economic life, say n years;

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• Determine the opportunity cost of capital, r, reflecting both time value of money

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and the risk involved in the project X;
• Discount the expected cash flows of project X using r,
• Calculate the NPV;
• Accept the poject X if NPV is positive.
Why is NPV so important?
When a firm invests some money to undertakes a new project, the firm’s market value
looks like this:

If project X is
Assets Current status
accepted

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Cash 1 0

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Other assets 9 9

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Project X 0 PV

Total 10 9+PV
What about the discounting rate, r ?

Cash

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Investment Investment
opportunities Firm Shareholders opportunities in

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financial assets
in real assets

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• The opportunity cost (r) of taking the project is the returns shareholders
could have earned had they invested the funds on their own (in financial
assets/markets).
• The rate, r, is usually the cost of capital (plus premium, sometimes).
Key Features of NPV
• The NPV rule recognizes the concept of time value of money; a rupee
today is worth more a rupee tomorrow.
• NPV depends on expected cash flows from the project and the
opportunity cost of investment; and
• Because PVs are all measured in today’s rupees, they can be added up:

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• NPV (A+B) = NPV (A) + NPV (B)

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• It cautions against deciding whether a package of a good and bad project
is better than the good project on its own.

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 NPV vs. Other Measures
0.90 0.85
0.80 0.75 0.76
0.70 0.65 0.68

0.60 0.57

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0.50
Int'l Evidence
0.40 0.35 0.35

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Indian Experience
0.30

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0.20
0.20
0.12
0.10
0.00
NPV IRR PBP ARR PI
Sources: Graham & Harvey [2001, JoFinEco]; Anand M. [2002, Vikalpa]
NPV vs. Other Measures
PBP vs. NPV
Cash flows (Rs.) Payback NPV at
Period 10%
Project C0 C1 C2 C3 (in Yrs.) Rs.

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A -2000 500 500 5000 3 +2,624

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B -2000 500 1800 0 2 -58
C -2000 1800 500 0 2 +50

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Misleading outcomes:
•The PBP rule ignores all cash flows after the cutoff date;
•The PBP rule gives equal weight to all cash flows before the cut off date.
 NPV vs Other Measures
IRR vs. NPV
Let’s consider a project with the following cash flows:
Cash flows (in Rs.)
C0 C1 C2
-4,000 2000 4000

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2,500.00
2,000.00

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1,500.00

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1,000.00
IRR = 28%
Estd. IRR
500.00
NPV
0.00
-500.00

Refer to the spreadsheet -1,000.00

-1,500.00
Problem #1 with IRR
When the signs of cash flows are reversed, IRR fails to give sound judgment.

Cash flows (Rs.)

Project C0 C1 IRR NPV at 10%
A -1,000 +1,500 50% +364

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B +1,000 -1,500 50% -364

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IRR suggests both projects as equally attractive. Is it so??

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In case of project A, we are essentially lending or investing money and we
want higher rate of return, whereas in case of project B, we are borrowing
money and we ideally want a lower rate of return.
Problem #2 with IRR
• Sometimes, IRR rule gives multiple rates of return that is unacceptable. See this:
Cash flows (in $ millions)
C0 C1 ….. C9 C10
-60 12 …... 12 -15

• Let us calculate both IRR and NPV; we get:

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• IRR (%): -44.0 and 11.6%

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• NPV at 10%: $3.3 mn

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NPV vs Other Measures
IRR vs. NPV
• IRR rule sometime presents confusing picture, and hence may lead to
unfavorable investment decisions.
• To overcome the pitfalls of IRR rule, a number of adaptations of the IRR
rule have been devised.

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• Not only they are inadequate, but they are also unnecessary, for the

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simple reason is to use NPV rule.

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• IRR rule can be a good supplement to the NPV rule in some cases.
CONCLUSION

• ARR, PBP, and PI have limited applications in the real world capital

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budgeting decisions.
• IRR rule sometime presents confusing picture, and hence may lead

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to unfavorable investment decisions.
• To overcome the pitfalls of IRR rule, a number of adaptations of the

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IRR rule have been devised.
• Not only they are inadequate, but they are also unnecessary, for the
simple reason is to use NPV rule.
• IRR rule can be a good supplement to the NPV rule in some cases.
REFERENCES

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⮚ Fundamentals of Corporate Finance, 12rd ed. (2017), Ross et al. Pearson

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