Chapter 20

Capital Budgeting Methods

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FINANCIAL MANAGEMENT

Ravi M Kishore
MCom, BL, AICWA, FCS, PGDPM

EIGHTH EDITION

20
Capital Budgeting Methods
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20.1 Capital Budgeting

 It is a process of planning capital expenditure which is to be made to maximize long-term
profitability of organization.
 It is the art of finding assets that are worth more than they cost to achieve goals of optimizing
wealth of owners.
 It is a long-term planning exercise in selection of projects which generates returns over number
of years in future and heavy expenditure is to be incurred in initial years of project to generate
returns over life of project.
 Future costs and revenues associated with each investment alternative are : (a) capital assets, (b)
operating assets, (c) revenue, (d) depreciation, and (e) residual value.
 In some capital budgeting methods, time value of money is recognized.
 Process of converting future sums into their present equivalents is called ‘discounting’, which is
used to determine present value of future cash flows.
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20.1 Contd .....

 Discount rate takes into account returns that are available from alternative investment
opportunities during specific future time period.
 Under discounted cash flow techniques, future net cash flows generated by capital project are
discounted to ascertain their present values.
 Discount factor is computed as follows:
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20.2 Capital Budgeting Methods

Methods available for appraisal of investment proposals are:
 Non-discounted cash flow methods
(i) Payback period method
(ii) Accounting rate of return method
 Discounted cash flow methods
(a) Net present value method
(b) Internal rate of return method
(c) Profitability index method
(d) Discounted payback period method
(e) Adjusted present value method
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20.3 Payback Period Method

 Accumulation of cash flows is made year after year until it meets initial capital outlay, to identify
recovery time of capital amount invested.
 Length of time this process takes gives payback period for project.
 At payback period, cash inflows from project will be equal to project’s cash outflows.
 It can be defined as number of years required to recover cost of investment.
 When deciding between two or more competing projects, usual decision is to accept one with
shortest payback.
 Used as a first screening method.
 Recognizes recovery of original capital invested in project.
 In capital rationing situation, project with earliest payback period would be given preference
over others.
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20.4 Accounting Rate of Return Method

 Also called ‘return on investment’ or ‘return on capital employed’ method.
 Uses normal accounting technique to measure increase in profit expected to result from an
investment.
 Net accounting profit arising from investment is expressed as percentage of that capital
investment.
 Calculated as percentage of average annual profits after tax to average investment in project.
 Project with higher rate of return will be selected.
 Does not take into consideration all years involved in life of the project.
 Sometimes, initial investment is used in place of average investment.
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20.5 Net Present Value Method

 Future cash flows are discounted at minimum required rate of return of project and then deduct
it from initial capital outlay to arrive at NPV of project.
 If NPV is positive, then project can be selected.
 If NPV is negative, project is unable to pay for itself and is thus unacceptable.
 Considers stream of cash flows over whole life of project.
 Explicitly recognizes time value of money.
 Discounting rate used is normally, WACC.
 Changing discount rate can be built into NPV calculations by altering the denominator.
 Particularly useful for selection of mutually exclusive projects.
 NPV is absolute measure, i.e. expressed in terms of money value.
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20.6 Internal Rate of Return Method

 It is a percentage discount rate used in capital investment appraisals which equates present
value of anticipated cash inflows with initial capital outlay.
 IRR is compared with desired rate of return or WACC to evaluate capital investment decision.
 IRR is rate at which net present value is zero.
 IRR can be stated in the form of a ratio as shown below:
Cash Inflows
=1
Cash Outflows
P.V. of Cash Inflows - P.V. of Cash Outflows = Zero
 IRR is also called as ‘cutoff rate’ for accepting investment proposals.
 If cash inflow of project is not uniform, then IRR will have to be calculated by trail and error
method.
 IRR method takes into account total cash inflows and cash outflows.
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20.7 NPV and IRR : Reasons for Conflict

 NPV ranking depends on the discount rate used. Assuming the IRR for a project is 12%, then for a
rate of discount greater than 12% no contradiction arises. If the discount rate used is less than
12%, two methods of evaluation will give different rankings for same project.
 IRR expresses result as a percentage rather than in money terms, comparison of percentages
may sometimes be misleading.
 Implicit assumption of NPV is that cash flows from project will be re-invested at cost of capital.
 Majority of projects produce conventional cash flows, that is initial cash outflows followed by
inflows in subsequent years. If in later years there are more number of net outflows, multiple
IRRs will be produced.
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20.8 Profitability Index Method

 It is present value of anticipated cash inflows divided by initial investment.
 In NPV method, initial outlay is deducted from present value of anticipated cash inflows,
whereas in profitability index method initial outlay is used as a divisor.
 Project is acceptable if its profitability index value is greater than 1.
 Project offering profitability index greater than 1 must also offer net present value which is
positive.
 When more than one project proposals are evaluated, for selection of one among them, project
with higher profitability index will be selected.
 Profitability can be expressed as follows:
Present Value of Cash Inflows
Profitability Index (PI) =
Present Value of Cash Outlay
 Profitability index is also called as ‘benefit-cost ratio’ or ‘desirability ratio’.
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20.9 Discounted Payback Period Method

 Cash flows involved in project are discounted back to present value terms.
 Cash inflows are then directly compared to original investment in order to identify period taken
to payback original investment in present value terms.
 Overcomes one of the main objections to original payback method, in that it now fully allows for
timing of cash flows.
 Unlike ordinary payback method, ensures achievement of atleast minimum required return.
 Ascertained by accumulating present values of net cash inflows year after year, till original cash
outlay is recovered.
 Discounting of cash flows is done as in case of NPV method.
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20.10 Adjusted Present Value (APV) Method

 Project is splitted into various strategic components.
 Cash flow estimates of project are first discounted at cost of equity, and a base case present
value is arrived at as if project is all-equity financed.
 After that financial side effects are analyzed one by one and duly valued.
 Lays more emphasis on financial risk ignoring business risk.
 If debt is proposed to be used as component of capital, then positive impact of tax shield is
added to base-case present values.
 Likewise, different aspects in cost of financing like capital investment subsidy, floatation cost of
public issue, administrative cost of equity/debt funds etc.
 Under APV approach, tax shields are discounted at cost of debt.
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20.11 Assumptions in Use of DCF Techniques

 Discount rate is constant over life of investment.
 All cash flows can be predicted with certainty so that a risk premium need not be added to
discount rate in order to compensate for risk.
 In project appraisal, managers work with uncertain future events and estimated cash flows
expected to occur in future years. This involves substantial amount of estimation, means that
spurious accuracy.
 Discount figures used can be calculated with great accuracy but when they are applied to these
future estimated cash flows, resultant calculation is only as accurate as cash flows estimates.
 There is a tendency to produce discounted cash flow computation with several decimal places on
each of present values. This creates a totally fallacious appearance of accuracy in evaluation
process.
 It is normal practice in capital project evaluations to assume that all cash flows take place at end
of year.
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20.11 Contd .....

 Initial cash outflows or investment in a project is assumed to take place now.
 Cash flows which go out now are taken to be at Year 0.
 In appraising long-term projects, it is normal to use an arbitrary horizon period of 10 to 15 years.
 Firms do not consider cash flows beyond horizon even if they expect project to last longer.
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20.12 Capital Rationing

 Refers to selection of investment proposals in situation of constraint on availability of funds, to
maximize wealth by maximizing NPV of its projects selected for implementation.
 Refers to situation where a company cannot undertake all positive NPV projects it has identified
because of shortage of capital.
 Under this situation, a decision-maker is compelled to reject some of viable projects having
positive NPV because of shortage of funds.
 Selection process under capital rationing will involve two steps:
(a) Ranking of projects according to some measure of profitability - PI, NPV, IRR etc.;
(b) Selecting projects in descending order of profitability until budget figures are exhausted
keeping in view objective of maximizing value of firm.
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20.13 Situations of Capital Rationing

Situation I - Projects are Divisible and Constraint is a Single Period One
Step 1 Calculate the profitability index of each project.
Step 2 Rank projects on the basis of profitability index calculated in Step-1 above.
Step 3 Choose optimal combination of projects.
Situation II - Projects are Indivisible and Constraint is a Single Period One
Step 1 Construct a table showing feasible combinations of project (whose
aggregate of initial outlay does not exceed the fund available for investment).
Step 2 Choose combination whose aggregate NPV is maximum and consider it as
optimal project mix.
Situation III - Projects are Divisible and Constraint is Multi-period one Problem of capital
rationing can be solved with the help of linear programming. It is a mathematical
programming approach.