Techniques of Capital Budgeting

Investment Evaluation Criteria

 Investment Evaluation Criteria
Three steps are involved in the evaluation of an
investment:
• Estimation of Cash flows
• Estimation of required RoR (i.e., the OCC)
• Application of a decision rule for making the
choice
The first two steps are assumed as given. The third
step is where we focus on its merits and demerits.
 Investment Decision Rule
• The rule may be referred to as capital
budgeting techniques, or investment criteria.
• The essential property of a sound technique
is that it should maximize the shareholders’
wealth.
• A sound appraisal technique should be used
to measure the economic worth of an
investment project.
 Evaluation Criteria
Discounted Cash Flow (DCF) Criteria:
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI)
Non-discounted Cash Flow Criteria:
• Payback Period (PB)
• Accounting Rate of Return (ARR)
 Net Present Value
• It is a DCF technique that explicitly
recognizes the time value of money.
• It correctly postulates that CFs arising at
different times differ in value;
• And are comparable only when their
equivalents – PVs – are found out.
• Following steps are involved in calculating
the NPV:
• CFs of the project should be forecasted
based on realistic assumptions.
• Appropriate discount rate should be
identified to discount the forecasted CFs.
This rate is the project’s OCC, which is
equal to the required RoR expected by
investors on investments of equivalent risk.
• PV of CFs should be calculated using the
OCC as the discount rate.
• NPV should be found out by subtracting PV
of cash outflows from PV of cash inflows.
• The project should be accepted if NPV is
positive. That is, NPV > 0.
 Example
• Assuming that project X costs Rs.2500 now
and is expected to generate year-end cash
inflows of Rs.900, 800, 700, 600, and 500
in years 1 thru 5. The OCC may be assumed
to be 10%. The NPV for the project can be
calculated by referring to the PV table.
• The calculations are as follows:
NPV = [(900 x 0.909) + (800 x 0.826) + (700 x 0.751) +
(600 x 0.683) + (500 x 0.620)] – 2500

NPV = 2725 – 2500 = Rs.225

Project X’s PV of Cash inflows (Rs.2725) is greater than that of the

Cash outflow (Rs.2500).
Thus, it generates a positive NPV (Rs.225). This project adds to the
Wealth of owners, therefore, it should be accepted.
 Evaluation of the NPV Method
• It recognizes the time value of money.
• It uses all CFs occurring over the entire life of the
project in calculating its worth. Hence, it is a
measure of project’s true profitability.
• If we know the NPVs of individual projects, the
values of the firm will increase by the sum of their
NPVs. This refers to the Value-additive principle. In
other words, if we know values of individual assets,
the firm’s value can be found simply by adding their
values. That is, NPV(A + B) = NPV(A) + NPV(B).
• This method is always consistent with the objective
of the shareholder value maximization. This is the
greatest virtue of the method.
 Internal Rate of Return
• It is the rate that equates the investment
outlay with the PV of cash inflow received
after one period.
• This also implies that the RoR is the
discount rate which makes NPV = 0. That is,
when there is no difference between the PV of cash
outflow and cash inflows.
• There is no satisfactory way of defining the
true RoR of a long-term asset.
• IRR is the best available concept.
• The IRR equation is the same as the one
used for the NPV method.
• In the NPV method, the required RoR is
known and the NPV is found;
• While in the IRR method the value of ‘r’
has to be determined at which the NPV
becomes zero.
 Calculation of IRR
Uneven Cash Flows: Calculating by Trial and Error
The approach is to select any discount rate to
compute the present value of cash inflows. If
the calculated present value of the expected
cash inflow is lower than the present value of
cash outflows, a lower rate should be tried. On
the other hand, a higher value should be tried if
the present value of inflows is higher than the
present value of outflows. This process will be
repeated unless the net present value becomes
zero.
Level Cash Flows
Let us assume that an investment would cost Rs 20,000 and
provide annual cash inflow of Rs 5,430 for 6 years.
The IRR of the investment can be found out as follows:

NPV  Rs 20,000 + Rs 5,430(PVAF6,r ) = 0

Rs 20,000  Rs 5,430(PVAF6, r )
Rs 20,000
PVAF6, r   3.683
Rs 5,430
• The rate, which gives a PVIFA of 3.683 for
6 years, is the project’s IRR. Looking at the
table across the 6-year row, we find it
approximately under the 16% column.
• Thus, 16% is the project’s IRR that equates
the present value of the initial cash outlay
(Rs.20,000) with the constant annual cash
flows (Rs.5,430 per year) for 6 years.
 NPV Profile and IRR
• NPV of a project declines as the discount
rate increases;
• And for discount rates higher than the
project’s IRR, NPV will be negative.
• At 16%, the NPV is zero; therefore, it is the
IRR of the project.
• NPV profile of the project at various
discount rates is shown in the next slide:
 A B C D E F G H
1 NPV Profile
Discount
2 Cash Flow rate NPV
3 -20000 0% 12,580
IR
4 5430 5% 7,561
R
5 5430 10% 3,649
6 5430 15% 550
7 5430 16% 0
8 5430 20% (1,942)
9 5430 25% (3,974)
Figure 8.1 NPV Profile
 Evaluation of IRR Method
Merits of this method are as under:
• Recognizes the time value of money.
• Considers all CFs occurring over the entire life
of the project to calculate its of return.
• Gives the same acceptance rule as the NPV
method.
• Consistent with the objective of maximizing
shareholders’ wealth. Whenever a project’s IRR
is greater than the OCC, the wealth will be
enhanced.
• Like the NPV method, the IRR method is
also theoretically a sound investment
evaluation criterion.
• However, IRR rule can give misleading and
inconsistent results under certain
circumstances.
• Also, properly stated, the two criteria are
formally equivalent, the IRR rule contains
several pitfalls.
• The problems that IRR rule may suffer from
is mentioned in the subsequent slides.
 Profitability Index
• Profitability index is the ratio of the present
value of cash inflows, at the required rate of
return, to the initial cash outflow of the
investment.
• The initial cash outlay of a project is Rs
100,000 and it can generate cash inflow of Rs
40,000, Rs 30,000, Rs 50,000 and Rs 20,000
in year 1 through 4. Assume a 10 per cent rate
of discount. The PV of cash inflows at 10 per
cent discount rate is:
 PV  Rs 40,000(PVF1, 0.10 ) + Rs 30,000(PVF2, 0.10 ) + Rs 50,000(PVF3, 0.10 ) + Rs 20,000(PVF4, 0.10 )
= Rs 40,000  0.909 + Rs 30,000  0.826 + Rs 50,000  0.751 + Rs 20,000  0.68
NPV  Rs 112,350  Rs 100,000 = Rs 12,350
Rs 1,12,350
PI   1.1235.
Rs 1,00,000

The following are the PI acceptance rules:

Accept the project when PI is greater than one. PI > 1

Reject the project when PI is less than one. PI < 1
May accept the project when PI is equal to one. PI = 1

The project with positive NPV will have PI greater than one.
PI less than means that the project’s NPV is negative.
 Evaluation of PI Method
• It recognises the time value of money.
• It is consistent with the shareholder value
maximisation principle. A project with PI greater
than one will have positive NPV and if accepted, it
will increase shareholders’ wealth.
• In the PI method, since the present value of cash
inflows is divided by the initial cash outflow, it is a
relative measure of a project’s profitability.
• Like NPV method, PI criterion also requires
calculation of cash flows and estimate of the
discount rate. In practice, estimation of cash flows
and discount rate pose problems.
 Payback Method
• Payback is the number of years required to
recover the original cash outlay invested in a
project.
• If the project generates constant annual cash
inflows, the payback period can be computed
by dividing cash outlay by the annual cash
inflow. That is:
Initial Investment C0
Payback = =
Annual Cash Inflow C
 Assume that a project requires an outlay of Rs
50,000 and yields annual cash inflow of Rs
12,500 for 7 years. The payback period for the
project is:
Rs 50,000
PB = = 4 years
Rs 12,000

Unequal cash flows In case of unequal cash

inflows, the payback period can be found out
by adding up the cash inflows until the total is
equal to the initial cash outlay.
 Suppose that a project requires a cash outlay of
Rs 20,000, and generates cash inflows of Rs
8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during
the next 4 years. What is the project’s payback?
3 years + 12 × (1,000/3,000) months
3 years + 4 months
• The project would be accepted if its payback
period is less than the maximum or standard
payback period set by management.
• As a ranking method, it gives highest ranking
to the project, which has the shortest payback
period and lowest ranking to the project with
highest payback period.
 Evaluation of Payback
Certain virtues
– Simplicity. Simple to understand and easy to
calculate.
– Cost effective. That is, not a sophisticated technique.
– Short-term effects. Favourable for short term effects
on EPS.
– Risk shield. By having a shorter payback period as a
Standard reduces risk.
– Liquidity. Such situation is created when there is
early recovery of the investment.
Serious limitations
– Cash flows after payback. Does not take account of
cash flows after payback period.
– Cash flows ignored. That is, does not consider all
cash flows.
– Cash flow patterns. That is, it gives equal weights
to returns of equal amounts even though they occur
in different times periods.
– Administrative difficulties. Difficulties in
determining maximum acceptable payback period.
– Inconsistent with shareholder value. Share values
do not depend on payback periods of investment
projects.
 Book Rate of Return Method
• Also known as Accounting Rate of Return is the ratio of
the average after-tax profit divided by the average
investment. The average investment would be equal to
half of the original investment if it were depreciated
constantly.
Average income
ARR = or Book Income / Book Assets
Average investment
• A variation of the ARR method is to divide average
earnings after taxes by the original cost of the project
instead of the average cost.
Acceptance Rule
• This method will accept all those projects
whose ARR is higher than the minimum
rate established by the management and
reject those projects which have ARR less
than the minimum rate.
• This method would rank a project as
number one if it has highest ARR and
lowest rank would be assigned to the
project with lowest ARR.
 Evaluation of ARR Method
• The ARR method may claim some merits
– Simplicity
– Accounting data. Easy availability of information.
– Accounting profitability. Incorporates entire stream of income.
• Serious shortcoming
– Cash flows ignored
– Time value ignored
– Arbitrary cut-off. Generally, this yardstick is the firm’s current
return on its assets (book value). Because of this, the growth
companies earning very high rates on their existing assets may
reject profitable projects (positive NPVs).