Financial Management

Session -2 & 3
Capital Budgeting & Project Valuation

Stages in Capital Budgeting

A firm must continually evaluate possible
investments, therefore, capital budgeting is an
ongoing process.
Long-term decisions; involve large expenditures.
Analysis of potential additions to fixed assets.
Stages in Capital Budgeting

Investment screening and selection

Capital budget proposal
Budgeting approval and authorization
Project tracking
Post-completion audit
2

Project Classifications
Independent Projects
If the cash flows of one are unaffected by the acceptance of
the other.

Mutually Exclusive Projects

If the cash flows of one can be adversely impacted by the
acceptance of the other

Contingent Projects
Complementary Projects

Mutually Exclusive Projects: Example

BRIDGEvs.BOATtoget
productsacrossariver.

(1) Steps in Capital Budgeting

A firm must continually evaluate possible
investments, therefore, capital budgeting is an
ongoing process. A project can be viewed in financial
terms as inflow and outflows of cash at certain points
of time.
1)The first step is to estimate project cost and cash
outflows along with the timings. Project cost is the sum of
the cost of fixed assets and margin money required for
organizing working capital for the business.

Steps in Capital BudgetingContd

2)An estimation of net cash inflows from the project after its
implementation is called for, along with the timings of such
inflows. The sale value of assets created in the project will also
have to be estimated at a specified terminal date based on
economic life of the assets.
3)The possible variations in project cash flows due to changes
in parameters affecting the project are also to be estimated.
The risk factor of cash flows also needs to be evaluated.

Steps in Capital BudgetingContd

4) A decision has to be taken regarding the discount rate to be
used for calculating present values of cash flows. The discount
rate should reflect the risk factors of the business.
5) Finally, the project has to be evaluated based on an
appropriate capital budgeting decision rule.

(2) Estimating Project Cash Flows

Incremental Cash Flows
Cash flow during a particular period
= Cash flow if the project is implemented Cash flow
without the project.

Sunk Costs
Sunk cost is a cost that has already been incurred and as
such, exists irrespective of whether the project is
undertaken or not. This cost should not to be considered as
part of project cash flows

Estimating Project Cash FlowsContd

Opportunity Costs
Opportunity costs should be part of project cash flows.
Suppose, a company has some vacant land. It now wants to
set up a factory on that land as part of an investment
project.
The project should be charged with the current selling price of the
piece of land.

Net Working Capital

Increase in NWC is cash outflow and vice versa. At the end
of the project life, remaining NWC is cash inflow.

Estimating Project Cash FlowsContd

Externalities
All side effects should be considered for calculating
incremental cash flows for a project.

Post-tax Cash Flows

Taxes are positive cash outflows. So, they have to be
accounted as cash outflows whenever payments are made.
So, we consider only the post-tax incremental cash flows.

Timing of Cash Flows

The cash flows have to be reckoned when they are incurred
and not when they accrue in an accounting sense.

10

(3) Evaluation of Project Using Cash Flows

i. Payback Period
ii. Discounted Payback Period
iii. Accounting Rate of Return (ARR)
iv. Net Present Value (NPV)
v. Internal Rate of Return (IRR)
vi. Modified Internal Rate of Return (MIRR)
vii. Profitability Index

11

Evaluation of Project : Example

Consider two projects A and B, whose cash flows are
given with timings
Year
0
1
2
3
4
5

Project A
(1000)
100
200
400
500
600

Project B
(1000)
500
400
300
200
100
12

(i) Payback Period

The number of years required to recover a projects
cost, or how long does it take to get the businesss
money back?
The decision rule for accepting an investment is that
an investment is acceptable if its calculated payback
period is less than the specified time of the project.
While comparing two investment projects using this
rule, then the project with shorter payback period
would be preferred.
13

Payback PeriodContd
Project A
Initial cost = 1000
Recovery over the first 3 years = 100 + 200
+ 400 = 700
Balance amount to be recovered
= 1000 700 = 300
Cash flow during the 4th year = 500
So, payback period = 3+300/500 = 3.6 years
Similarly for Project B 2.3 years
14

Payback PeriodContd
Advantages
Provides an indication of a projects risk and liquidity.
Because projects with lower payback period get selected.
These projects would free up cash for other uses more
quickly than projects with longer payback period.

Disadvantages
Does not consider the time value of money.
Ignores cash flows beyond the payback period.
Negatively biased towards projects like R&D which have
longer payback period.
15

(ii) Discounted Payback Period

A discounted payback period is calculated by finding
out the payback period based on discounted net cash
flows.
The rate of discount used is the projects overall cost
of capital.
Suppose the overall cost of capital of the projects A
and B are 10 % p.a. What will be the discounted
payback period for project A and B
Discounted payback period for project A = 4.27 year
Project B 2.95 years
16

(iii) Accounting Rate of Return (ARR)

Accounting rate of return (ARR)
= Average net accounting income / Average book value
of investment

The decision rule :

A project is acceptable if its accounting rate of return is
more than the target rate of return.

17

ARRExample
Suppose a project needs investment of Rs.1000, has a life of 5
years and PAT in each of the 5 years are as follows.

Year
Net Accounting Income (PAT)
1
112
2
167
3
233
4
150
5
58
Then, the average net accounting income = Rs.144
The book values of investment at the start of the project and at
the end are Rs.1000 and zero respectively.
So, average book value of investment = Rs.500
So, accounting rate of return (ARR) = 144/500 = 28.8 %
18

Accounting Rate of Return (ARR)Contd

Advantages:
Required simple calculation and easy availability of desired
information

Disadvantages:
Does not consider time value of money,
Uses book value of investment and accounting income
instead of market value of investment and cash flows.
An arbitrary cut-off rate of return is used to approve a
project.

19

(iv) Net Present Value (NPV)

Net present value is the difference between the
present values of cash inflows and cash outflows.
NPV =

where CFt = cash flow during the period t

n = number of periods
r = discount rate of return

20

Net Present Value (NPV)Contd

Steps Involved in estimating NPV
Estimate CFs (inflows & outflows).
Assess riskiness of CFs.
Determine k = WACC for project.
Find NPV
Accept if NPV > 0

21

Net Present Value (NPV)Example

With 10% discount rate,
NPV of Project A = -1000 +100/1.1 + 200/1.1^2 +
400/1.1^3 + 500/1.1^4 + 600/1.1^5 = Rs. 270.79
NPV of Project B = -1000 +500/1.1 + 400/1.1^2 +
300/1.1^3 + 200/1.1^4 + 100/1.1^5 = Rs. 209.21
The decision rule using NPV method is that an
acceptable project should have positive NPV because
in that case the investment earns more than it costs.
The value of the firm rises by the positive NPV of the
project. It also has value additivity property.
22

(v) Internal Rate of Return (IRR)

Internal rate of return (IRR) is defined as that discount
rate at which the net present value of cash flows is equal
to zero.
This means that the present value of cash inflows is equal
to the present value of cash outflows.
The decision rule using IRR is that an investment is
acceptable if IRR exceeds the required rate of return.
IRR summarizes the information about a project in a
single rate of return.
23

Internal Rate of Return (IRR)

NPV = CFt/(1+IRR)^t = 0 over the life period.
IRR for Project A = 17.73%
IRR for Project B = 20.27%

24

NPV Profile
The Net present value profile is a graphical
representation of the relationship between an
investments NPVs and various discount rates.
Discount Rate
NPV Project A NPV Project B
NPVProfile
0%
6%
10%
14%
16%
17.73%
20.27%

NPVA
800.00
452.59
270.78
119.26
52.92
(0.08)
(71.26)

NPVB
500.00
312.73
209.21
119.23
78.57
45.46
0.03
25

NPV ProfileContd
NPVProfile
900.00
800.00
700.00

Crossoverrate
CrossOverRate

600.00
500.00
400.00
300.00
200.00
100.00
0.00
0%

6%

10%

14%

16%

17.73%

20.27%

(100.00)
(200.00)
NPVA

NPVB

26

Cross Over Rate

Specific return required for the projects to have the
same net present value
Helps to determine out of two projects which will be
more profitable in the short and long terms
Steps Involved in Calculating CoR:
Find cash flow differences between the projects.
Calculate IRR on cash flow differential. Crossover rate =
14% for project A and B.
Can subtract cash flows of A from B or vice versa, but
better to have first CF negative.
If profiles dont cross, one project dominates the other.
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Two Reasons NPV Profiles Cross

Size (scale) differences. Smaller project frees up
funds early.
The higher the opportunity cost, the more valuable
these funds, so high k favours small projects.
Timing differences. Project with faster payback
provides more CF in early years for reinvestment.
If k is high, early CF especially is good, NPVShort >
NPVLong.

28

NPV ProfileContd
NPVs of the projects A and B are same at the
discount rate of 14 %. This rate is called the crossover
rate.
The NPV of project A is higher than the NPV of
project B at discount rates lower than the crossover
rate but
the NPV of project B is higher than the NPV of project A at
discount rates higher than the crossover rate.

29

NPV Vs IRR
NPV is calculated using a discount rate (k) and
assumes reinvest at k (opportunity cost of capital).
IRR is the discount rate at which NPV is equal to zero
and IRR assumes reinvest at IRR.
Reinvest at opportunity cost, k, is more realistic, so
NPV method is better. NPV should be used to choose
between mutually exclusive projects.

30

NPV Vs IRRContd
For any independent project, if the project has a
positive NPV at a discount rate equal to the cost of
capital,
Then its IRR will automatically be higher than the cost of
capital.

This implies that both the NPV and the IRR decision
rules will lead to the same conclusion for independent
projects.
So, the IRR and the NPV rules have no conflict for
such projects.
31

NPV Vs IRRContd
NPV and IRR always lead to the same accept/reject
decision for independent projects

N
P
V

IRR > k
and NPV > 0
Accept.

k > IRR
and NPV < 0.
Reject.

k (%)
IRR
32

NPV Vs IRRContd
However, for mutually exclusive projects the
situation is different.
Suppose, the projects A and B are mutually exclusive
meaning that if the project A is taken up then the project B
need not be taken up.

Then, which project is financially superior?

If we apply the IRR rule then the project B with IRR
of 20.27 % will be accepted instead of project A,
whose IRR is 17.73 %.
33

NPV Vs IRRContd
If we apply the NPV rule and the cost of capital is
more than the crossover rate of 14 % then the NPV of
project B is higher than the NPV of project A. So, the
project B should be accepted.
If the cost of capital is less than the crossover rate of
14 % then the NPV of project A is higher than the
NPV of project B and the project A should be
accepted.
The conflict arises because of differences in scale and
timings of the cash flows.
34

NPV Vs IRRContd
The critical issue is the reinvestment rate at which the
intermediate cash inflows can be reinvested.
The implicit assumption in the IRR method is that the
intermediate cash inflows are reinvested at the IRR
rate.
However, in case of NPV method, it is assumed
implicitly that the intermediate cash inflows are
reinvested at the cost of capital that is generally used
as the discount rate for estimating NPV.
35

NPV Vs IRRContd
So, we need to decide which is the better reinvestment
rate
IRR or cost of capital.

IRR is usually higher than the cost of capital and if it is

possible to raise money from capital markets at the cost of
capital.
So, reinvestment of the intermediate cash inflows at the rate of
cost of capital is certainly a more logical assumption.

In view of the above argument, NPV method would be

preferred for mutually exclusive projects whenever
conflict arises.
36

Disadvantages of IRR
Lending/Investing or Borrowing/Financing
Multiple IRRs
The equation used to calculate IRR, is a polynomial equation of
degree n. So, there will be n solutions of IRR.
This is usually not a problem when initial negative cash flow is
followed by a series of positive cash flows. In this case, all
except one solution will be imaginary.
However, when project cash flows are such that initial negative
cash flows are followed by positive cash flows and again
followed by negative cash flows in some of the future periods,
then mathematically multiple real solutions of IRR are available.
37

Disadvantages of IRRContd
Multiple IRRsExample
Suppose a company takes a machine on rent from a
supplier for a period of 2 years with the understanding that
the company will pay the rent of the machine of Rs.20
million at the end of 2 years when the machine will be
returned.
The company spends Rs.2 million to install the machine
and earns Rs.10.5 million and Rs.10 million in the 1st and
2nd year respectively before returning the machine. What is
the IRR of this investment?

38

Disadvantages of IRRContd
Multiple IRRs..Example
The cash flows are as follows:
Time (Yrs)
Amount
0
- Rs.2 million
1
+ Rs.10.5 million
2
Rs.10 million [ -20+10 ]
So, the IRR of the investment can be calculated by solving
the equation,
- 2 + 10.5/(1+k) -10/(1+k)^2 = 0
Solving we get,
K = 25% and also 300%
39

NP V (Rs. th o u san d )

Disadvantages of IRRContd

1000
0
0

25

90.5

300

-1000
-2000
Discount rate (%)

40

Disadvantages of IRRContd
Multiple IRRsExample
Now, we are in a dilemma - which IRR is correct?
In some cases there may be more than two solutions
In all such cases, the NPV rule should be applied.

41

(vi)Modified Internal Rate of Return (MIRR)

Returns the modified internal rate of return for a series of
periodic cash flows by considering both the cost of the
investment and the interest received on reinvestment of
cash.
The PV of all cash outflows are calculated using cost of
capital as the discount rate.
Then the terminal values of all cash inflows are calculated
using the cost of reinvestment.
Finally the sum of the PV of cash outflows and the sum of
the terminal values of cash inflows are equated to
calculate the MIRR.
42

(vii) Profitability Index (PI)

PI is the ratio of payoff to investment of a proposed
project
PI is defined as:
PI = PV (cash inflows subsequent to initial
investment) / Initial investment
An investment is acceptable only if the PI is greater than
1.0.
The PI decision rule is a variant of the NPV.
PI method is very useful for capital rationing.
43

Mutually Exclusive Projects

In case of mutually exclusive projects, one of the
projects needs to be selected.
Such projects differ in three ways:
Size of investment
Cash flow pattern
Life of the project

44

Mutually Exclusive Projects with Unequal Lives

If size of investment is the only difference, then NPV
method may be preferred.
Use incremental cash flows if uses PI.

If cash flow pattern is the only difference, then NPV/PI

method should be used.
If lives are different, then one of the following methods
should be used.
Equivalent annual annuity method (EAA)
Replacement chain method
In both methods we assume that the firms reinvestment opportunities
in future will be similar to the current ones.

45

Evaluating Mutually Exclusive Projects with

Unequal Lives
Equivalent annuity method
Calculates the constant annual cash flow generated by a
project over its lifespan if it was an annuity.
The annuity value that provides the same NPV over the
economic life is calculated for each project using the cost
of capital as the discount rate.
Then, the annuities of the mutually exclusive projects are
compared and the project with the higher annuity is
accepted.
46

Evaluation of Project : Example EAA

Consider two projects A and B, whose cash flows are
given with timings, Project A & B has economic life of 3
years and 5 years respectively.

Year
0
1
2
3
4
5

Project A
(400)
100
200
400

Project B
(1000)
500
400
300
200
100
47

Evaluating Mutually Exclusive Projects with

Unequal Lives
Equivalent annuity method
NPV(A.) is Rs.156.72, NPV(B) is 209.21
Then, the equivalent annuity, A can be determined by
using the equation:
156.72 = A/1.1+A/1.1^2+A/1.1^3
A = 63.02

Similiarly
209.21 = B/1.1+B/1.1^2+B/1.1^3+B/1.1^4+B/1.1^5
B = 55.19
Therefore, Project A is better
48

Mutually Exclusive Projects with Unequal Lives

Replacement chain method
Each of the individual projects is replicated until the lowest
common life span is reached.
Each replication is treated as if the initial NPV is received
at the replication dates of each project, and this stream of
NPVs is discounted to the present day to give a common
life NPV.
The decision is then made on the current NPVs.

49

Mutually Exclusive Projects with Unequal Lives

Replacement chain method
t

A 156
B 209

156

156

7 8

1
0

156

2
0
9

1 12
1

1
3

1 15
4

156
2
0
9

NPV(A) = 477.13
NPV(B) = 419.35
Therefore project A is better
50

Capital Rationing
Capital rationing is undertaken when a company has
many positive NPV projects but not enough funds to
take up all of them.
This can be solved by linear programming but if the
number of projects is small, then all possible sets of
projects can be checked and the set which provides
the highest NPV can be selected.

51

Capital RationingContd
Suppose, a company has five projects with investment,
NPV and PI as follows: Project
Investment
NPV
PI
1
Rs.100, 000
Rs.10, 000
1.1
2
Rs.100, 000
Rs.25, 000
1.25
3
Rs.200, 000
Rs.30, 000
1.15
4
Rs.200, 000
Rs.10, 000
0.95
5
Rs.300, 000
Rs.15, 000
1.05
Suppose, the company has Rs.400, 000 for investment.
Then, which projects are to be selected?
52

Capital RationingContd
The project 4 need not be considered because PI < 1.0
and has negative NPV. In terms of ranking, the
project 2 is most profitable (highest PI) and the
projects 3, 1 and 5 are attractive in that order.
Now, since investible fund is Rs.400, 000, the
possible selection could be (2 and 5), (1 and 5) and
(1, 2 and 3). All these would require Rs.400, 000 of
investment.
The net NPVs of these sets are Rs.40,000, Rs.35,000
and Rs.65,000 respectively.
The final selection is the projects 1, 2 and 3 since this
set of projects would maximize the NPV.
53

Exercise: 1
Identify which of the following items would be part
of net cash flow of an investment proposal.
1. Savings due to reduction of wastage of raw materials because
of the implementation of the project.
2. Depreciation of new machinery purchased for the project.
3. Fees of a consultant engaged for evaluating the investment
proposal.
4. Loss of sale of some existing products resulting from sale of
some products, available from the new investment project.
Options
a) 1, 2 and 3
b) 1 and 4
c) 1 and 2
d) all of them
54

Exercise: 2
The implicit assumption in the IRR rule is that the
reinvestment of the intermediate cash flows takes
place at the rate equivalent to :
a) cost of capital
b) appropriate market rates prevailing when the cash
inflows are received
c) internal rate of return
d) none of the above rules

55

Exercise: 3
A company is planning an overseas expansion
project. The estimated cash flows are as follows:Year
Cash flow
0
-Rs.2,000,000
1
Rs.200,000
2
Rs.300,000
3-10
Rs.500,000
The payback period for the project is
a) 10 years
b) 8 years
c) 5 years
d) None of the above
56

Exercise: 4
A company is planning an overseas expansion
project. The estimated cash flows are as follows:Year
Cash flow
0
-Rs.2,000,000
1
Rs.200,000
2
Rs.300,000
3-10
Rs.500,000
The cost of capital is 10 %. The NPV of the project is:
a) Rs.634,268
b) Rs.441,496
c) Rs.2,634,268
d) None of the above
57

Exercise: 5
A machine has an NPV of Rs.15 million for one 4year replacement cycle. The cost of capital for this
machine is 10 percent. The equivalent annuity for the
NPV of this machine is
a) Rs.3.75 million
b) Rs.1.50 million
c) Rs.4.73 million
d) None of the above

58

Exercise: 6
A company is considering a capital investment project
that has the following expected cash flows.
abandonment values that the company expects to
receive if the project is Abandoned at the end of the
particular years are also given.
Year
0 1 2 3 4 5 6
Cash flow
- 80 30 30 40 30 20 10
Abandonment value
60 50 35 25 10

Cost of capital of the project is 12 %. For maximizing

shareholders wealth, At the end of which year it will
be optimal to abandon the project. The figures are in
Rupees million.
59

Exercise: 6Contd
Solution:
NPV of the project if not abandoned
= - 80 + 30/1.12 + 30/1.12^2 + 40/1.12^3 +
30/1.12^4 + 20/1.12^5 + 10/1.12^6 = 32.88
NPV if abandoned after one year
= - 80 + 90/1.12 = -5
NPV if abandoned after two years
= - 80 + 30/1.12 + 80/1.12^2 = 8.78
60

Exercise: 6Contd
NPV if abandoned after three years
= - 80 + 30/1.12 + 30/1.12^2 + 40/1.12^3 = 22.30
NPV if abandoned after four years
= - 80 + 30/1.12 + 30/1.12^2 + 40/1.12^3 +
30/1.12^4 = 32.34
NPV if abandoned after five years
= - 80 + 30/1.12 + 30/1.12^2 + 40/1.12^3 +
30/1.12^4 + 20/1.12^5 = 33.48
So, NPV is maximized if the project is abandoned
after 5 years.
61

Exercise: 7
For a project the projected initial investment is Rs.1m
The net cash flow after tax is expected to be Rs.0.5m
per year for each of five years of plant life. The
market- based marginal cost of capital is 15 %. The
new project will reduce the after-tax cash flow from
the existing lines by Rs.0.1m per year. Should the
project be taken?
a) Yes
b) No
c) Yes, if the cost of capital could be reduced to 12
percent
d) Do not know
62

Exercise: 7Contd
The cash flows are as follows considering the reduced
cash flows from the existing lines.
Year
0
1
2
3
4
5

Net Cash flow

- Rs.1, 000, 000
400, 000
400, 000
400, 000
400, 000
400, 000
NPV

PV of cash flow
-1, 000, 000
347, 826
302, 457
263, 006
228, 701
198, 871
__________
340, 861
63

Exercise: 8
A company takes a machine on rent from a supplier
for a period of 2 years with rent of Rs.2 million
payable at the time of return of the machine after 2
years. The company spends Rs.100, 000 for
installation of the machine and earns net cash revenue
(after deducting all cash expenses) of Rs.700,000 and
Rs.1,000,000 respectively in the first and second
years. What is the IRR of the investment? What is
your recommendation regarding the method to be
used for the appraisal of the project?

64

Exercise: 8
Solution:
The project cash flows are: Year
Cash flow
0
- 100,000
1
+ 700,000
2
1,000,000 (- 2,000,000 + 1,000,000)
If the IRR is K, then,
-100,000+700,000/(1+k)-1,000,000/(1+K)^2 = 0
Solving, we get,
K = 4 or 1
or, IRR = 400% or 100%
This is a case of multiple IRR.
It is better to use NPV method.

65

Thank You!

66