29-11-2022

Capital Budgeting
Dr. Arpita Amarnani,
Goa Institute of Management

Coverage
• Understanding the various techniques for capital budgeting like
– Payback period
– Net Present Value (NPV),
– Internal Rate of Return (IRR),
– Profitability Index,
– Modified IRR and
– Discounted Payback period.
• Understanding the advantages and limitations of each of these
techniques.
• Evaluating variety of projects
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Capital Budgeting
What is Capital Budgeting?
Investment Decision: Which projects to invest in?
Characteristics of this decision:
• Long-term decision
• There are multiple options available
• The value of the company depends on the value of these projects
• Risk and uncertainty is high

Typical Project Cash flows

0 1 2 3 4 5 6 7 8 9 10
I____I____I_____I____I____I____I____I____I____I_____I
-I A B C D E F G H I J+SV
Where,
I= Initial Investment
A to J are annual cash inflows from the Project
SV is the salvage value or scrap value or terminal value
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Techniques in Capital Budgeting

Payback Period
• Meaning:
Number of years in which you get your money back.
Eg. Suppose you invest ₹50,000 in a 4-year project. The net cash flow
in the 1st year is ₹10,000, 2nd year ₹20,000 and 3rd year it is again
₹20,000 and 4th year it is 15,000.
0 1 2 3 4
I________I_________I________I________I
-50 10 20 20 15
So, -50,000+10,000+20,000+20,000 = 0
This means that the payback period is 3 years.
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Payback Period
Decision Criteria:
Independent Projects: A particular cut off period is used by
a company for making an investment decision. So all
projects within that cut off period are accepted. Otherwise
rejected.
Mutually Exclusive Project: Select the project with lower
payback period.

Net Present Value

• Meaning:
Net Present Value = PV of cash inflows- PV of Cash outflows
For a typical project,
NPV = -Initial Inv. + Σ CFi
(1+r)i
Where i varies from 1 to n and n = life of the project
0 1 2 3 4 5 n
I_____I_____I_____I_____I_____I___......___I
-I Inv. CF1 CF2 CF3 CF4 CF5 CFn
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Net Present Vaue

• Decision Criteria:
Independent Projects: Accept the project that has positive
NPV and reject the project with negative NPV
Mutually Exclusive Project: Accept the project with higher
NPV

Basic Example
1. Maxwell Software, Inc. has the following mutually exclusive projects

Year Project A Project B

0 -$ 20,000 -$ 24,000
1 13,200 14,100
2 8,300 9,800
3 3,200 7,600

a. Suppose the company's payback period cut-off is two years. which of

these two projects should be chosen?
b. Suppose the company uses the NPV rule to rank these two projects'
which project should be chosen if the appropriate discount rate is 15
percent?
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Payback Period
Cumulative Cash flows
Year Project A Cumulative Project B Cumulative

0 -20,000 -24,000
1 13,200 -6,800 14,100 -9,900
2 8,300 1,500 9,800 -100
3 3,200 7,600 7,500

Project A: 1 + (6800/8300) = 1.819 years

Project B: 2 + (100/7600) = 2.013 years
Project A has a payback period less than the cut-off period of 2 and
can be accepted. However, project B has a payback period greater
than 2 and should be rejected.

NPV
Discount each project’s cash flows at 15 percent.
Project A:
NPV = –$20,000 + $13,200/1.15 + $8,300/(1.15)2 + $3,200/(1.15)3
NPV = –$141.69

Project B:
NPV = –$24,000 + $14,100/1.15 + $9,800/(1.15)2 + $7,600/(1.15)3
NPV = $668.20
Choose the project with the higher NPV i.e. Project B
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Example 2
2. The Yurdone Corporation wants to set up a private cemetery
business. According to the CFO, Barry .M. Deep, business is ‘looking
up’. As a result, the cemetery project will provide a net cash inflow of $
315,000 for the firm during the first year, and the cash flows are
projected to grow at 4.5% forever. The project requires an initial
investment of $ 4,100,000.
a)If Yurdone requires a return of 11% on such undertakings should the
cemetery business be started?
b)The company is somewhat unsure about the assumption of it’s growth
rate of 4.5% for it’s cash flows. At what constant growth rate would the
company just break even if it still requires a return of 11% on
investment?

a) PV of cash inflows = C1 / (R – g)
PV of cash inflows = $315,000 / (.11 – .045)
PV of cash inflows = $4,846,153.85
NPV = PV of the inflows - PV of the outflows,
so the NPV is:
NPV = –$4,100,000 + 4,846,153.85
= $746,153.85
The NPV is positive, so we would accept the project.
b) 0 = –$4,100,000 + $315,000 / (.11 – g)
Solving for g, we get: g = 3.32%
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Example 2 cont…
3. Calculate the NPV when the company requires a return of
13% and 9%.
For 13% PV of cash inflows = $315,000 / (.13 – .045)
PV of cash inflows = $3,705,882.35
NPV = PV of the inflows - PV of the outflows,
so the NPV is: NPV = –$4,100,000 + 3,705,882.35
= -$394,117.65
For 9% PV of cash inflows = $315,000/(.09 – .045) = 7,000,000
NPV = PV of the inflows - PV of the outflows,
so the NPV is: NPV = –$4,100,000 + 7,000,000 = $ 2,900,000

NPV and Discount Rates

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Discounted Payback
• Discounted payback is the same as pay back period but it takes the PV
of the cash flows.
• Number of years in which you get your money back considering the time
value of money.

Decision Criteria:
A particular cut off period is used by a company for making an
investment decision. So all projects within that cut off period are
accepted. Otherwise rejected.

Discounted Payback
Eg. Suppose you invest ₹50,000 in a 4-year project. The net cash
flow in the 1st year is ₹10,000, 2nd year ₹20,000 and 3rd year it is
again ₹20,000 and 4th year it is 15,000. Assume that the cost of
capital is 10%.
0 1 2 3 4
I________I________I________I________I
-50 10 20 20 15
-50,000+10,000/1.1+20,000/(1.1)2+20,000/(1.1)3 = -9353.87
This means that the payback period is more than 3 years.
PV of the 4th yr cash flow = 15000/(1.1)4 = 10,245.2
Discounted Payback Period = 3 +(9353.87/10245.2) = 3.913 years
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Example 3
4. An investment project has annual cash inflows of $5,000, $5,500,
$6,000, and $7,000, and a discount rate of 12%. what is the payback
period and the discount payback period for these cash flows if the initial
cost is $8,000? What if the initial cost is $12,000?
Year Cashflows Cumulative PV of CFs Cumulative Year Cashflows Cumulative PV of CFs Cumulative
0 -8000 -8000 0 -12000 -12000
1 5000 -3000 4464.29 -3535.71 1 5000 -7000 4464.29 -7535.71
2 5500 2500 4384.57 848.85 2 5500 -1500 4384.57 -3151.15
3 6000 4270.68 3 6000 4500 4270.68 1119.53
4 7000 4448.63 4 7000 4448.63

Initial Investment 8000 Initial Investment 12000

Payback 1.545 Payback 2.250
Disc Payback 1.806 Disc Payback 2.738

Drawbacks of Payback Period

• Timing of the cash flow within the payback period
Eg. From payback period point of view both the projects A & B in the table below
are the same but in fact in project A you get four times the amount back in the first
year compared to project B.
0 1 2 3
Project A -10,000 8000 2000 1000
Project B -10,000 2000 8000 10000

• Payments after the payback period

For the two projects A & B the difference in the cash flow in the 3rd year which is
significant will not be taken into consideration by the payback period
• Arbitrary Standard for payback period
The benchmark set is an arbitrary value fixed by a company and could vary from
one manager to another.
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Points to be noted for NPV

• The value of the firm rises by the NPV of the project.
• NPV rule uses the cost of capital for the discounting rate
which is appropriate.
• NPV uses all cash flows.
• NPV is an absolute value and does not compare with the size
of initial investment.

Profitability Index (PI)

• Meaning:
PI = PV of cash flows subsequent to initial investment
Initial Investment
PI is a ratio and compares two cash flows.
PI > 1 when NPV is positive and
< 1 when NPV is negative
• Decision Criteria:
Independent projects: Accept projects with PI greater than 1 and
Reject projects with PI less than 1
Mutually Exclusive projects: Select the project with higher PI. PI is
largely used in situations of capital constraints.
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Example 5
5. Bill plans to open a self grooming center in a storefront. The
grooming equipment will cost $265,000, to be paid immediately. Bill
expects after tax cash inflows of $ 59,000 annually for seven years,
after which he plans to scrap the equipment and retire to the beaches of
Goa. The first cash flow occurs at the end of the first year. Assume that
the required rate of return is 13%. What is the project’s PI? Should it be
accepted?
PV of cash inflows = $ 59,000 x (1-(1.13)-7 )/(0.13) = $ 260,934.02
PI = 260934.02/265000 = 0.987
PI<1, Reject the project

Example6:PI and NPV

Consider the following two mutually exclusive projects available to Global
Investments, Inc.
0 1 2
Project A -1000 1000 500
Project B -500 500 400

At 10% discount rate calculate the PI and NPV for both the projects. Which
project will you select?
PV of cash inflows for project A = 1000/1.1 + 500/(1.1)2 = 1322.31
PV of cash inflows for project B = 500/1.1 + 400/(1.1)2 = 785.12
NPVa = -1000+1322.31 = 322.31 PIa = 1322.31/1000 = 1.322
NPVb = -500+785.12 = 285.12 PIb = 785.12/500 = 1.57
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Incremental Project
Objective: Is it worth spending the additional 500 @ 10%
discount rate?
0 1 2
Project A -1000 1000 500
Project B -500 500 400
Incremental -500 500 100
Project (A-B)

NPV of the Incremental Project = -500+500/1.1+100/(1.12)

= -500 + 537.19 = 37.19

Internal Rate of Return (IRR)

• Meaning:
The rate of return at which,
PV of cash inflows = PV of cash outflows
OR NPV = 0
0 = -Initial Inv. + Σ CFi
(1+IRR)i
• Decision Criteria
Standalone projects: IRR > Required rate of return Accept
IRR < Required rate of return Reject
Mutually Exclusive Projects: Select the project with higher IRR
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Example 7:Calculating the IRR

• Compute the internal rate of return for the cash flows of the
following two projects:

Year Project A Project B

0 -5700 -3450
1 2750 1380
2 2800 1800
3 1600 1200

• Using the trial and error method. Calculate NPV at several

discounting rates
NPV @10% 316.15 193.73
NPV @ 11% 219.93 131.59
NPV @ 12% 126.35 71.23
NPV @ 13% 35.32 12.56
NPV @ 14% -53.26 -44.47
IRR 13.40% 13.22%

• IRRA = 13% + (1% x 35.32) = 13.40%

(35.32+53.26)
• IRRB = 13% + (1% x 12.56) = 13.22%
(12.56+44.47)
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Example 8
The Utah Mining Corporation is set to open a gold mine near Provo,
Utah. The mine will cost $2,700,000 to open and will have an economic
life of 11 years. It will generate a cash inflow of $435,000 at the end of
the first year and the cashflows are projected to grow at 8% per year for
the next ten years. After 11 years the mine will be abandoned.
Abandonment costs will $ 400,000 at the end of year 11.
a) What is the IRR of the gold mine?
b) The Utah Mining Corporation requires a return of 10% on such
undertakings. Should the mine be opened?

0 1 2 10 11
I________I________I_______......_______I_________I
-2700 435 435(1.08) 435(1.08)9 435(1.08)10
-400

Year 0 1 2 3 4 5 6 7 8 9 10 11

Cashflows -2700 435 469.80 507.38 547.97 591.81 639.16 690.29 745.51 805.15 869.57 539.13

NPV = 0 = –$2700 + $435/(1+IRR) + $469.8/(1+IRR)2 + $507.38/(1+IRR)3 +

$547.97/(1+IRR)4 + $591.81/(1+IRR)5 + $639.16/(1+IRR)6 + $690.29/(1+IRR)7 +
$745.51/(1+IRR)8 + $805.15/(1+IRR)9 + $869.57/(1+IRR)10 + 539.13/(1+IRR)11

IRR = 17.50%
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Problems with IRR

1. Multiple IRRs

Year Cash flows

0 -2016
1 11448
2 -24280
3 22800
4 -8000

Example 9: Problems with IRR

2. Cannot differentiate between lending and borrowing
Suppose you are being offered $ 9400 today but must make the
following payments:
Year Cash flows $
0 9400
1 -4500
2 -3100
3 -2400
4 -1800

a) What is the IRR of this offer?

b) If the appropriate discount rate is 10%, should you accept this
offer?
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• Calculating NPVs at various discounting rates

Disc rate NPV

10% -285.47

11% -110.66

12% 58.64

• So, the IRR is between 11 and 12%. Finding the value,

• IRR = 11%+1%x(110.66/(110.66+58.64)) = 11.65 %
Since this is an example of borrowing, IRR < discount rate
Reject the project

3) IRR assumes the reinvestment rate to be the IRR itself

0 = -Initial Inv. + Σ CFi

(1+IRR)i
In this formula you assume the reinvestment at the
discounting rate which in this case is your IRR.
This inflates the value of IRR more so for projects with
higher returns.
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Modified Internal Rate of Return

• Meaning
MIRR is the rate that equates PV of cash outflows @ cost of capital with FV
of cash inflows @ cost of capital
PV of cash outflows @ CoC = FV of cash inflows @ CoC/any suitable rate
(1+MIRR)n
Where, n is the life of the project,
CoC is the cost of capital or your financing cost
Suitable rate is the rate at which you expect reinvestment
• Decision Criteria
Standalone projects: MIRR > Required rate of return Accept
MIRR < Required rate of return Reject
Mutually Exclusive Projects: Select the project with higher MIRR

Example10
Taking the Utah Mining Corporation Example forward, assuming a CoC
of 12% find the MIRR.
Year 0 1 2 3 4 5 6 7 8 9 10 11

Cashflows -2700 435 469.80 507.38 547.97 591.81 639.16 690.29 745.51 805.15 869.57 539.13

PV of cash outflows = 2700

FV of cash inflows = 435(1.12)10+ 469.8(1.12)9+ 507.38(1.12)8+
547.97(1.12)7+ 591.81(1.12)6+ 639.16(1.12)5+ 690.29 (1.12)4+
745.51(1.12)3+ 805.15(1.12)2+ 869.57(1.12) +539 = 12072.7

2700 = 12072.7 MIRR = 14.586%

(1+MIRR)11
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Example11
• Compute the MIRR for the cash flows of the following two
projects at 10% cost of capital. Assume that the reinvestment
will happen at the cost of capital.

Project A:
PV of Cash outflow = 5700
FV of Cash inflows = 2750(1.1)2+2800(1.1)+1600 = 8007.5
5700 = 8007.5/(1+MIRR)3
MIRR = 12%
Project B:
PV of Cash outflow = 3450
FV of Cash inflows = 1380(1.1)2+1800(1.1)+1200 = 4849.8
3450 = 4849.8/(1+MIRR)3
MIRR =12.02%
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Example 12: Comparing Investment Criteria

The treasurer of Amaro Canned Fruits, Inc., has projected the cashflows:
Year Project A Project B Project C
0 -225,000 -450,000 -225,000
1 165,000 300,000 180,000
2 165,000 300,000 135,000

Suppose the relevant discount rate is 12 percent per year,

a. Compute the PI, NPV, IRR, MIRR and payback period for each of the three projects.
b. Suppose these three projects are independent. Which project(s) should Amaro
accept?
c. Suppose these three projects are mutually exclusive. Which project(s) should Amaro
accept?
d. Suppose Amaro's budget for these projects is $450,000. The projects are not
divisible. Which project(s) should Amaro accept?

Comparing Investment Criteria

NPV @ 12% (₹) 53858.42 57015.31 43335.46

Profitability Index 1.24 1.13 1.19

Payback period 1.36 1.50 1.33

IRR (%) 29.82% 21.53% 27.18%

MIRR (%) 24.69% 18.88% 22.31%

Year Incremental Project

(A-B) PV
0 -2,25,000 -225000.00
1 1,35,000 120535.71
2 1,35,000 107621.17
NPV 3156.89
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Mutually Exclusive Projects

Year 0 Year 1 Year 2 Year3
• Scale Problem
Project A -10,000 6000 4000 3000
– PI and IRR not suitable Project B -1000 700 500 300

– Use NPV and calculate the NPV and IRR for the incremental
project
• Timing Problem Year 0 Year 1 Year 2 Year3
Project A -10,000 6000 4000 3000
– NPV and MIRR can be used
Project B -10,000 3000 5000 7000

• Life of the Project Problem

– Calculate the Equivalent Annual Value
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Project A -10,000 6000 4000 3000 4000 3000
Project B -10,000 9000 8000