Capital Budgeting Rules 04

Author: Dilip ThosarFor IIIT Hinjewadi, PuneJanuary 2008

Capital Budgeting : Investment Decision Rules(Measuring Return on Investment)

Slide no. 1

April 10, 2023

Capital Budgeting Techniques(Investment Decision Rules)

(Measuring Return on Investment)



Slide no. 2

April 10, 2023

Capital Budgeting• A formal means of analyzing long-range capital

investment decisions~Planning acquisition of capital assets (used for long

periods of time)

• Investment Decision Rules~How do we decide if a capital investment project should

be accepted or rejected?

• Important Management Decision~Very large values involved

.

Should we Build/buy this

plant?



Slide no. 3

April 10, 2023

Important Points for Evaluation• Include all cash flows during of the project

• Consider the time value of money

• Incorporate required rate of return on project

• View Opportunity Cost of Cash outlays



Slide no. 4

April 10, 2023

Alternative Decision (RoI) Rules• A machine costing Rs.10,000 earns as shown. Discounting rate is 12%.

~ Should the machine be purchased?~ Is there a “Business Case” for buying the machine?~ What is the RoI of buying the machine?

• NPV : Net Present Value ~ Uses DCF : Discounted Cash Flow

• IRR (Internal Rate of Return)• MIRR (Modified internal rate of return ) • PP (Payback Period)• DPP (Discounted Payback)• Profitability Index

0 1 2 3 4 5

2000 2500 3000 3500 4000-10,000



Slide no. 5

April 10, 2023

NPV: Net Present Value • NPV (DCF:Discounted Cashflow

~= PVinflows – PVoutflows ~>0 => accept project

• Nominal flow

• Cash Flow Discounted @12%

• PVinflows = 10,408.05. PVoutflows = 10,000.00• NPV = 408.05>0. Project to be accepted

0 1 2 3 4 5

2000 2500 3000 3500 4000-10,000

0 1 2 3 4 5

1785.71 1992.98

2135.34 2224.312269.71-10,000



Slide no. 6

April 10, 2023

IRR: Internal Rate Of Return• IRR is the discount rate at which NPV of project is 0

~ PV of inflows equals the PV of outflows~ A project’s average annual earning rate over life of project

• Project Acceptance Criterion~ if IRR > required return for borrowed funds~ if IRR < required return for lent funds

• IRR can be calculated but only by trial and error process• For our example, the IRR is 13.45% by solving the following:

• The MS Excel “IRR(range)” function~ http://office.microsoft.com/en-us/excel/HA011136321033.aspx



Slide no. 7

April 10, 2023

Deciding Multiple Projects: NPV/IRR• Independent projects

~ Are those whose cash flows are unaffected by the acceptance/rejection of others

~ Accept those projects having IRR > Wacc (also would have NPV>0)~ NPV and IRR methods always lead to the same accept/reject decisions.

• Mutually exclusive projects~ if the cash flows of one can be adversely impacted by the acceptance of the

other.~ Choosing from a pair of projects, accept one with higher IRR (may not give

higher NPV)~ Crossover point = Discount Rate (Wacc) where NPV1 = NPV2

~ If Wacc > “crossover point”, NPV and IRR lead to same decision (no conflict)~ If Wacc > “crossover point”, the two methods lead to different accept/reject

decisions.

.0

1020304050

5 10 15 20 23.6

NPVRs.

Discount Rate (%)

IRRL = 18.1%

IRRS = 23.6%

Crossover Point = 8.7%

S

L.

.18.1



Slide no. 8

April 10, 2023

IRR v/s NPV• Mutually Exclusive Projects

~ Project with higher IRR is not necessarily better. It may not have higher NPV

~ Compute IRR for the incremental CFs (CFs of project B – CFs of project A)

~ IRRB-A>Required return => NPVB-

A>0. Choose B. Else Choose A.

• Consider projects A & B~ IRRA=24%, IRRB=17%. ~ At 10% discount rate, NPVA=256

and NPVB=1,435~ For B-A, IRR=16.6%~ IRRB-A > required return 10%~ so we choose B

Period 0 1 2 3

Project A -1,000 505 505 505

Project B -11,000 5,000 5,000 5,000

B – A -10,000 4,495 4,495 4,495



Slide no. 9

April 10, 2023

IRR v/s NPV• Consider A & B again:

~ Cash Flows:~ NPV is 0 at IRRA=24% and IRRB=17%. ~ At 10% discount rate, NPVA=256 and NPVB=1,435 ~ Based on IRR, A is better. But NPV of B is higher.~ A gives you higher %earning on a much smaller investment, so the

amount of NPV is small; B gives you a smaller percentage return on a much bigger dollar investment, so the amount NPV B gives is large.

~ To maximize shareholders’ wealth, choose B!

• Theoretically, NPV is better than IRR as an approach~ NPV assumes that intermediate cash flows are reinvested at the cost

of capital but IRR assumes they are reinvested at the IRR,

• Financial managers prefer to use the IRR : preference for rates of return.

Period 0 1 2 3

Project A -1,000 505 505 505

Project B -11,000 5,000 5,000 5,000



Slide no. 10

April 10, 2023

Problems with the IRR• “Non-conventional” cashflows

~ Conventional: Invest/Borrow, periodic returns

• IRR may be uninterpretable!~ IRR is -32% => ?

• Multiple IRRs exist~ IRR is 40% and 50%

• The IRR is a popular technique primarily because it is a percentage which is easily compared to the WACC

• The calculation of the IRR assumes that the cash flows are reinvested at the IRR. This may not always be realistic.

• Percentages are misleading - would you rather earn 100% on a Rs.100 investment, or 10% on a Rs.10,000 investment?

Period 0 1 2

E-F 1000 3000 -2500

Period 0 1 2

E-F 50 -145 105 ($1,000)

($800)

($600)

($400)

($200)

$0

$200

$400

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

Discount Rate

NPV



Slide no. 11

April 10, 2023

MIRR: Modified IRR• The modified IRR (MIRR) is the average

annual rate of return that will be earned on an investment if the cash flows are reinvested at the specified rate of return (usually, the WACC)

• Formula:



Slide no. 12

April 10, 2023

Calculating MIRR• Cash Flows:

~WACC = 12%

• Find the total future value of cash flows at WACC

• Apply the formula:

• MIRR>WACC, so this project is acceptable

0 1 2 3 4 5

2000 2500 3000 3500 4000-10,000



Slide no. 13

April 10, 2023

Payback Period• Payback Period is the time that it takes to recover the investment.• If the cash flows are an annuity, then the PP is investment divided by the

annual cash flow• Generally, subtract the cash flow from first year onwards from

investment until the remainder is zero

• The shorter the payback period, the better• Generally, firms will have some maximum allowable payback period

against which all investments are compared

0 1 2 3 4 5

2000 2500 3000 3500 4000-10,000



Slide no. 14

April 10, 2023

Payback Period : problems• PP ignores the time value of money

~ Investment of Rs. 1000 has PP of 3 years for each of following cash flows:• Rs.0 in year 1, Rs.1000 in year 2• Rs.500 in year 1, Rs.500 in year 2• Rs.999 in year 1, Rs.1 in year 2

• PP ignores all cash flows beyond the payback period~ Investment of Rs. 1000 has PP of 3 years for each of following cash flows:

• Rs.0 in year 1, Rs.1000 in year 2, Rs. 1,00,00,000 in third year• Rs.500 in year 1, Rs.500 in year 2, • Rs.999 in year 1, Rs.1 in year 2

• The criteria is naturally biased against long-term projects. This is a serious problem that can lead to under-investment and it does not maximize shareholder value.

• PP basically ignores the risk of the cash flows, though ignoring distant cash flows shows some consideration of risk.

• There is really no good way to determine an appropriate payback period hurdle.

• PP is still frequently used because~ It is quick and easy to calculate~ It gives a measure of the liquidity of the project



Slide no. 15

April 10, 2023

NPV(DCF), IRR, PP• Cash flows are Rs.1000 initial investment,

Rs.0 for the next 5 years and Rs.1 million in year 6. The PP cutoff period is 5 years. ~The payback method would reject this project~The IRR is over 215%.~NPV would be large and positive at any

reasonable discount rate.



Slide no. 16

April 10, 2023

Discounted Payback Period• DPP is exactly the same as the PP, except

that the present values of the cash flows are used rather than the nominal values.

• Investment 10,000 and required return 12%~PP = 3-4 years

Cash Flows:

~DPP = 4-5 yearsDCF:

• The DPP is always longer than the PP

0 1 2 3 4 5

1785.711992.982135.342224.312269.71-10,000

0 1 2 3 4 5

2000 2500

3000 3500 4000-10,000



Slide no. 17

April 10, 2023

Problems with the DPP• The DPP considers the TVM, but it still

ignores the cash flows beyond the payback period

• One may reject projects that have large cash flows after the DPP, that make it actualy very profitable

• In other words, any measure of payback can lead to a focus on short-run profits at the expense of larger long-term profits



Slide no. 18

April 10, 2023

Profitability Index• PI = NPV / Investment : Biggest Bang for the Buck• Accept all projects with PI >= 1.00

• Useful when capital is rationed and multiple projects to choose from: Choose highest PI first

• Note: Picking projects in order of PI is guaranteed to give the best combination, only if the entire budget is fully used up by the selected projects.

0 1 2 3 4 5

2000 2500 3000 3500 4000-10,000



Slide no. 19

April 10, 2023

PV, NPV, PI• Consider these 5 projects in a situation when

investment is limited to a maximum of Rs. 50 lakhs:

~Pick the projects with highest PI till budget is used up: Select C, E, B and D for total NPV of Rs. 21.5 lakhs

~ If you pick the projects with highest NPV till budget is used up, pick A and B for total NPV of Rs.17 lakhs

All amunts In Rs. Lakhs

Projects Investment PV NPV PI

A 30 39 9 0.3

B 20 28 8 0.4

C 10 16 6 0.6

D 15 20 5 0.33



Slide no. 20

April 10, 2023

Numericals1. Choose among these mutually exclusive projects

using IRR alone. What would the choice be if required return for each project is 12%.

C0 C1 C2

Project A -100,000 65,000 52,000

Project B -99,200 67,400 50,600

Project C -50,000 32,000 31,000



Slide no. 21

April 10, 2023

Numericals2. Which of these projects would you pick, if you are

given a capital budget of 60?

Investment PV NPV P.I. = NPV/Inv

A 30 39 9 0.3

B 20 28 8 0.4

C 10 16 6 0.6

D 15 20 5 0.33

E 5 7.5 2.5 0.5



Slide no. 22

April 10, 2023

Interactive Session

Capital Budgeting Rules 04

Economy & Finance

Transcript of Capital Budgeting Rules 04