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1.Understand the role of capital budgeting techniques in the capital
budgeting process.
2.Calculate, interpret, and evaluate the payback period.
3.Calculate, interpret, and evaluate the net present value (NPV).
4.Calculate, interpret, and evaluate the internal rate of return (IRR).
5.Discuss NPV and IRR in terms of conflicting rankings and the
theoretical and practical strengths of each approach.

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Capital budgeting is the process of evaluating and selecting long
term investment consistent with the firm’s goal of owner’s wealth
maximization.
Thus, the capital budgeting process has the following steps:
Estimate cash flows (inflows & outflows).
Assess risk of cash flows.
Determine appropriate discount rate (i = WACC) for project.
Evaluate cash flows. (Find NPV or IRR etc.)
Make Accept/Reject Decision

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 Capital Budgeting Techniques

Traditional or Non- Modern or Discount

discount Method method

Accounting
Pay-back Net Present Internal Rate Profitability
Rate of
Period Value of Return Index
Return

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Pay-back period is the time required to recover the initial
investment in a project.
Merits:
a. It is easy to calculate and simple to understand.
b. It provides further improvement over the accounting rate of
return.
c. It reduces the possibility of loss on account of obsolescence.
Demerits:
a. It ignores the time value of money.
b. It ignores all cash inflows after the pay-back period.

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 Formula for calculating Pay-Back period (PBP):
a. In case of equal cash inflow:
Initial Investment
PBP =
Annual equal cash inflow

b. In case of mixed cash inflow:

Unreccovered cost at start of the year
PBP = Year before full recover +
cash inflow during the year

 Accept /Reject criteria:

If the actual pay-back period is less than the predetermined pay-back
period, the project would be accepted. If not, it would be rejected.
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Example: Projects A and B, of equal risk, are alternatives for expanding Rosa Company’s capacity.
The firm’s cost of capital is 13%. The cash flows for each project are shown in the following table.

•Calculate the Pay Back Period (PBP) for each project.

Solution:
•For Project A: PBP = 3.67 years
Using the given formula
•For Project B: PBP = 3.33 years

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Net Present Value (NPV) is a sophisticated capital budgeting technique
found by subtracting a project’s initial investment from the present value
of its cash inflows discounted at a rate equal to the firm’s cost of capital.

Merits:
a. It considers the time value of money and the total benefits arising
out of the proposal.
b. It is the best method for the selection of mutually exclusive projects.

Demerits
a. It is difficult to understand and calculate.
b. It needs the discount factors for calculation of present values.

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 Formula for calculating Net Present Value (NPV):

In case of equal cash inflow: Where,

A = Equal cash inflow over a period
1 - ( 1 + i ) 
-n

NPV = A  - Io i = Annual interest rate

 i 
n= Number of years
Io = Initial investment
In case of mixed cash flow:
CF1 = Cash inflow at the end of year 1.
CF1 CF2 CFn
NPV = [ 1 + 2 + -----------+ ] – Io CF2 = Cash flow at the end of year 2.
(1+i) (1+i) (1+i)n CFn = Cash flow at the end of year n.

 Accept /Reject criteria:

 If NPV is greater than or equal to $0, accept the project.

 If NPV is less than $0, reject the project.
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Example: Projects A and B, of equal risk, are alternatives for expanding Rosa Company’s capacity.
The firm’s cost of capital is 13%. The cash flows for each project are shown in the following table.

•Calculate the Net Present Value (NPV) for each project.

Solution:
•For Project A: NPV = 3,655
Using the given formula
•For Project B: NPV = 2,755

•Decision: In case of independent project, both projects are accepted but in case of
mutually exclusive project only project A should be accepted.
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Internal Rate of Return (IRR) for an investment proposal is the discount
rate that equates the present value of the expected net cash flows (CFs)
with the initial cash outflow (ICO) that is NPV =0.
Merits:
a. It considers the time value of money and cash flows
b. It gives the approximate/nearest rate of return.

Demerits:
a. It produces multiple rates which may be confusing for taking
decisions.
b. It is assumed that all intermediate cash flows are reinvested at the
internal rate of return.

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 Formula for calculating Internal Rate of Return(IRR):

NPV of LDR
IRR = LDR + × (HDR − LDR)
NPV of LDR−NPV of HDR

Where,
LDR = Lower Discount Rate
HDR = Higher Discount Rate
NPV of LDR = Net present value of LDR
NPV of HDR = Net Present value of HDR
 Accept /Reject criteria:
a. If IRR is greater than or equal to the cost of capital, accept the project.
b. If IRR is less than the cost of capital, reject the project.

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Example: Projects A and B, of equal risk, are alternatives for expanding Rosa Company’s capacity.
The firm’s cost of capital is 13%. The cash flows for each project are shown in the following table.

•Calculate the internal rate of return (IRR) for each project.

Solution:
•For Project A: IRR = 14.61%
By Interpolation
•For Project B: IRR = 15.24%

•Decision: In case of independent project, both projects are accepted but in case of
mutually exclusive project only project B should be accepted.
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On a purely theoretical basis, NPV is the better approach because

NPV assumes that intermediate cash flows are reinvested at the cost of capital
whereas IRR assumes they are reinvested at the IRR,
Certain mathematical properties may cause a project with non-conventional cash
flows to have zero or more than one real IRR; this problem does not occur with the
NPV approach.

Despite its theoretical superiority, however, financial managers prefer to use the IRR
because of the preference for rates of return.

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