Capital Budgeting
S S S Kumar
Corporate Finance
1
Course
Administration
Assessment
Weigh
tage
Quizzes
25%
Midterm Exam
30%
End term Exam
35%
Projects/Assignments/Submissions
10%
Attendance policy




Roll call
Occupy the designated seats only
Late attendance
Closure of attendance
3
What is in this
course?
In a nutshell – decisions that a chief financial officer
must make
4
What are those decisions?



How to make good investment decisions?
How to make good financing decisions?
How to manage the firm’s cashflows while doing the first two.
5
6
Key Ideas
Unless you enter the tiger's den, you cannot
take the cubs
7
Key Ideas
Money is like manure. You have to spread it around or
it smells.
8
Key Ideas
Free Lunch
9
Corporate objective








Survive
Avoid financial distress and bankruptcy
Beat the competition
Maximize sales or market share
Minimize costs
Maximize the profits
Balance the needs of all stakeholders
Maximize shareholders wealth
10
Ultimate Corporate
Objective..
SWM
11
What is Capital budgeting?



When a firm considers a new project, corporate acquisition, plant
expansion or asset acquisition that will produce income over the
course of many years…this is called capital budgeting.
It is imperative that in the analysis of such projects that we consider
the timing, riskiness and magnitude of the after‐tax cash flows that
the project is expected to generate.
Capital budgeting decisions can be the most complex decisions
facing management.
12
Pl note that..

Capital budgeting a.k.a
– Capex
– Investments
– Projects
13

Features of
capex projects



Large cashflows
Affect LT profitability
Costly to reverse
Top management’s attention

How are capex
projects
classified?


Independent
– Acceptance or rejection has no
affect on other projects.
Mutually Exclusive
– Acceptance of one automatically
rejects the others.
Contingent
– Acceptance of one project is
dependent upon the selection of
another.
Expansion
Revenue
expansion
New product
Strategic
Capex projects
Replacement
Cost reduction
Modernization
16
Payback
Non DCF
A/C RoI
Capex evaluation
techniques
NPV
DCF
IRR
PI
17
A good
capex
evaluation
technique
Good evaluation technique should:
• Takes into consideration TVM
• Includes risk adjustment
• Consistent with the SWM
Payback


This is a simple approach to capital budgeting that is designed to
tell you how many years it will take to recover the initial
investment.
It is often used by financial managers as one of a set of investment
screens, because it gives the manager an intuitive sense of the
project’s risk.
How is it computed?
Decision Rule
Accept if the payback period is less than some preset limit
19
Calculation of
Payback
20
Payback
calculation
Year
A
0
1
2
3
4
Payback
B
C
-200
-200
-100
40
40
30
20
20
40
10
10
50
130
60
4 years
2.6 years Never
21
Pros and Cons
•
Ease of
– Calculation
– Comprehension
– Communication
•
Ignores
– TVM
– CFs after payback period
22
Discounted payback



Calculates the time it takes to recover the initial investment in
current or discounted dollars.
Incorporates time value of money by adding up the discounted cash
inflows at time 0, using the appropriate hurdle or discount rate, and
then measuring the payback period.
It is still flawed in that cash flows after the payback are ignored.
23
Discounted Payback
Initial cost =
AT cash flow benefits =
Useful life(years) =
Cost of Capital =
Year
0
1
2
3
4
5
6
Cashflow
Initial cost
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
$1,00,000
$60,000
6
12%
Cumulative
After-tax incremental CF PV Factor Cash Flows
-$1,00,000
1
-$1,00,000
60,000 0.892857
$53,571
60,000 0.797194
$47,832
60,000
60,000
60,000
60,000
Payback period =
1.97 years
24
Accounting Rate of
Return/Investment
• How is it computed?
• ARR = avg. income / avg. investment
• A project will cost Rs 50000 and produces a stream of earnings as
shown in the table. Assuming 50% tax rate and SLM method of
depreciation compute the project’s ARR.
25
ARR Contd..
EBDIT
DEP
EBIT
TAX
EBIT(1-t)
OPENEING BV
CLOSING BV
1
14000
10000
4000
2000
2000
50000
40000
2
16000
10000
6000
3000
3000
40000
30000
3
18000
10000
8000
4000
4000
30000
20000
4
20000
10000
10000
5000
5000
20000
10000
5 AVERAGE
22000
10000
12000
6000
6000
4000
10000
0
25000
ARR
16.00%
Decision Rule
 Accept if the ARR is more than cutoff level
Pros and Cons
 Uses Income rather than Cash Flow
 Ignores time value of money
26
Net Present Value


The difference between the market value of a project and its cost
How much value is created from undertaking an investment?
27
Net Present Value contd…
• This rule is always consistent with maximizing the value of the firm
• Economically, take all projects for which benefits > costs (in PV
rupees)
• Mathematically, sum the present values of all the cash flows
28
Net Present Value contd…
Decision rule
If the NPV is positive, accept the project
Example:
Year
0
1
2
3
4
5
6
Initial cost =
AT cash flow benefits =
Useful life(years) =
Cost of Capital =
$100,000
$60,000
6
12.0%
Cashflow
Initial cost
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
After-tax incremental CF
-$100,000
$60,000
$60,000
$60,000
$60,000
$60,000
$60,000
NPV =
PV Factor Present Value
1
-$100,000
0.892857
$53,571
0.797194
$47,832
0.71178
$42,707
0.635518
$38,131
0.567427
$34,046
0.506631
$30,398
$146,684
29
NPV with Excel
Discount Rate
Future Cash flows
Assumption that cash
flows occur at the end
of the period
30
NPV and Shareholder Wealth




A project’s NPV is the net effect that undertaking a project is
expected to have on the firm’s value
A project with an NPV > (<) 0 should increase (decrease) firm value
Since the firm desires to maximize shareholders wealth, it should
select the project with the highest NPV
Why +ive NPV projects lead to SWM?
31
NPV Example
Initial cost = $100,000
$60,000
AT cash flow benefits =
6
Useful life(years) =
0.0%
Cost of Capital =
Year
0
1
2
3
4
5
6
Cashflow
Initial cost
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
Discount Rate =
0.0%
NPV =
$260,000
After-tax
incremen PV
Present
tal CF
Factor
Value
-$100,000
1.000 -$100,000
$60,000
1.000 $60,000
$60,000
1.000 $60,000
$60,000
1.000 $60,000
$60,000
1.000 $60,000
$60,000
1.000 $60,000
$60,000
1.000 $60,000
NPV =
$260,000
NPV Example
Initial cost = $100,000
$60,000
AT cash flow benefits =
6
Useful life(years) =
10.0%
Cost of Capital =
Year
0
1
2
3
4
5
6
Cashflow
Initial cost
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
Discount Rate =
0.0%
10.0%
NPV =
$260,000 $161,316
After-tax
incremen PV
Present
tal CF
Factor
Value
-$100,000
1.000 -$100,000
$60,000
0.909 $54,545
$60,000
0.826 $49,587
$60,000
0.751 $45,079
$60,000
0.683 $40,981
$60,000
0.621 $37,255
$60,000
0.564 $33,868
NPV =
$161,316
NPV Example
Initial cost = $100,000
$60,000
AT cash flow benefits =
6
Useful life(years) =
20.0%
Cost of Capital =
Year
0
1
2
3
4
5
6
After-tax
incremen PV
Present
tal CF
Factor
Value
-$100,000
1.000 -$100,000
$60,000
0.833 $50,000
$60,000
0.694 $41,667
$60,000
0.579 $34,722
$60,000
0.482 $28,935
$60,000
0.402 $24,113
$60,000
0.335 $20,094
NPV =
$99,531
Cashflow
Initial cost
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
Discount Rate =
0.0%
10.0%
NPV =
$260,000 $161,316
20.0%
$99,531
NPV Example
Initial cost = $100,000
AT cash flow benefits =
$60,000
Useful life(years) =
6
Cost of Capital =
30.0%
Year
0
1
2
3
4
5
6
After-tax
incremen PV
Present
tal CF
Factor
Value
-$100,000
1.000 -$100,000
$60,000
0.769 $46,154
$60,000
0.592 $35,503
$60,000
0.455 $27,310
$60,000
0.350 $21,008
$60,000
0.269 $16,160
$60,000
0.207 $12,431
NPV =
$58,565
Cashflow
Initial cost
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
Discount Rate =
0.0%
10.0%
NPV =
$260,000 $161,316
20.0%
$99,531
30.0%
$58,565
NPV Example
Initial cost = $100,000
AT cash flow benefits =
$60,000
Useful life(years) =
6
Cost of Capital =
40.0%
Year
0
1
2
3
4
5
6
After-tax
incremen PV
Present
tal CF
Factor
Value
-$100,000
1.000 -$100,000
$60,000
0.714 $42,857
$60,000
0.510 $30,612
$60,000
0.364 $21,866
$60,000
0.260 $15,618
$60,000
0.186 $11,156
$60,000
0.133
$7,969
NPV =
$30,078
Cashflow
Initial cost
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
Discount Rate =
0.0%
10.0%
NPV =
$260,000 $161,316
20.0%
$99,531
30.0%
$58,565
40.0%
$30,078
NPV Example
Initial cost = $100,000
AT cash flow benefits =
$60,000
Useful life(years) =
6
Cost of Capital =
50.0%
Year
0
1
2
3
4
5
6
After-tax
incremen PV
Present
tal CF
Factor
Value
-$100,000
1.000 -$100,000
$60,000
0.667 $40,000
$60,000
0.444 $26,667
$60,000
0.296 $17,778
$60,000
0.198 $11,852
$60,000
0.132
$7,901
$60,000
0.088
$5,267
NPV =
$9,465
Cashflow
Initial cost
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
Discount Rate =
0.0%
10.0%
NPV =
$260,000 $161,316
20.0%
$99,531
30.0%
$58,565
40.0%
$30,078
50.0%
$9,465
NPV Example
Initial cost = $100,000
AT cash flow benefits =
$60,000
Useful life(years) =
6
Cost of Capital =
60.0%
Year
0
1
2
3
4
5
6
After-tax
incremen PV
Present
tal CF
Factor
Value
-$100,000
1.000 -$100,000
$60,000
0.625 $37,500
$60,000
0.391 $23,438
$60,000
0.244 $14,648
$60,000
0.153
$9,155
$60,000
0.095
$5,722
$60,000
0.060
$3,576
NPV =
-$5,960
Cashflow
Initial cost
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
Discount Rate =
0.0%
10.0%
NPV =
$260,000 $161,316
20.0%
$99,531
30.0%
$58,565
40.0%
$30,078
50.0%
$9,465
60.0%
-$5,960
NPV Example
Initial cost = $100,000
AT cash flow benefits =
$60,000
Useful life(years) =
6
Cost of Capital = 55.806%
Year
0
1
2
3
4
5
6
IRR =
After-tax
incremen PV
Present
tal CF
Factor
Value
-$100,000
1.000 -$100,000
$60,000
0.642 $38,510
$60,000
0.412 $24,716
$60,000
0.264 $15,864
$60,000
0.170 $10,182
$60,000
0.109
$6,535
$60,000
0.070
$4,194
NPV =
$0
Cashflow
Initial cost
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
ATCF operating benefit
Discount Rate =
0.0%
10.0%
NPV =
$260,000 $161,316
55.8058%
20.0%
$99,531
30.0%
$58,565
40.0%
$30,078
50.0%
$9,465
55.8%
$0
39
NPV to IRR Rule
NPV
$
IRR
0
Discount Rate
40
IRR Rule
This is the most important alternative to NPV.
 It is often used in practice and is intuitively appealing.
 It is based entirely on the estimated cash flows and is
independent of any external rates/returns.
Definition
IRR is the return that makes the NPV = 0
Decision Rule
Accept the project if the IRR is greater than the required return

41
IRR definition
42
Finding IRR




There is no general algebraic closed‐form formula that solves the
IRR for a project with multiple cash flows.
The IRR solution is the zero‐point of a higher‐order polynomial.
With three or more cash flows, this is a mess or impossible.
Manual iteration = intelligent trial‐and‐error.
43
More about IRR




Many spreadsheets and calculator have trial‐and‐error methods
built‐in.
In Excel, this function is called IRR().
Intuitively, a project with a higher IRR is more profitable.
Multiplying each cash flow by the same factor, positive or negative,
will not change the IRR. (Look at the formula.)
44
More about IRR


The IRR rule leads often (but not always) to the same answer as the
NPV rule, and thus to the correct answer. This is also the reason
why IRR has survived as a common method for capital budgeting.
If you use IRR correctly and in the right circumstances, it can not
only give you the right answer, but it can also often give you nice
extra intuition about your project itself, separate from the capital
markets.
45
Profitability Index
Measures the benefit per unit cost, based on the time value of
money
 A profitability index of 1.1 implies that for every Re. 1 of
investment, we create an additional Re. 0.10 in value
 Used occasionally. Not as common as IRR.
Acceptance Rule
 Invest if PI > 1. Reject if PI < 1.
 Often gives the same recommendation as NPV.

𝑃𝐼
𝑃𝑉 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠
𝑃𝑉 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠
46
NPV and IRR ‐ dilemmas

NPV and IRR give consistent results when the projects are not
mutually exclusive and when IRR > k (cost of capital)
Which one would you select?
Project A
year cash flow
0
(135,000)
1
60,000
2
60,000
3
60,000
required return = 12%
IRR = 15.89%%
NPV = 9,110= 1.07
Project B
year cash flow
0
(30,000)
1
15,000
2
15,000
3
15,000
required return = 12%
IRR = 23.38%
NPV = 6,027
Pattern of cashflows
The prevailing cost of capital is 10%. Now consider two exclusive projects which one should
you take?
Time
M
N
0
‐500
‐500
1
75
290
2
175
200
3
225
150
4 IRR
NPV
300
16% ₹ 86.76
50
19% ₹ 75.77
Fisher’s intersection/crossover
200
150
NPVM = 56.24 = NPVM
100
IRRN = 19%
50
0
0.03
0.05
0.07
0.09
0.11
0.13
0.15
0.17
0.19
0.21
0.23
0.25
‐50
12%
IRRM = 16%
‐100
‐150
M
N
50
…. dilemmas


NPV profiles of projects can cross when project size differences
exist (the cost of one project is larger than that of the other) or
When timing differences exist (most of the cash flows from one
project come in the early years, while most of the cash flows from
the other project come in the later years)
….dilemmas


If the cost of capital is greater than this crossover rate, the two
methods give same answer
If the cost of capital less than crossover rate, two methods give
separate answers
A close look at IRR
If C0 = $40, C1 = ‐$80, C2 = 104, what is the IRR?
A close look at IRR contd..
If C0 = ‐$100, C1 = $360, C2 = ‐$431, C3 = +$171.60, is 10% the IRR?
A close look at IRR contd..
If C0 = ‐$100, C1 = $360, C2 = ‐$431, C3 = +$171.60, is 20% the IRR?
A close look at IRR contd…
If C0 = ‐$100, C1 = $360, C2 = ‐$431, C3 = +$171.60, is 30% the IRR?
A close look at IRR
contd…


Which is the correct IRR for the earlier
project?
Which answer will Excel give?
Why do you get multiple IRRs?
0
‐800,000
1
5,000,000
2
‐5,000,000
Are these irrelevant and absurd IRRs a problem?
A little but not greatly.
– You are guaranteed one unique IRR if you have at first only up‐front
cash flows that are investments (negative numbers), followed only by
payback (positive cash flows) after the investment stage.
– This cash flow pattern is the case for financial bonds.
– This cash flow pattern is also usually the case for most normal
corporate investment projects.
 Outside the classroom, most projects do not have both positive and
negative cash flows that alternate many times. (But there are projects that
require big overhauls/maintenance, where it can happen.)
You must be aware of these issues, lest they bite you one day unexpectedly.

Which one would you prefer?
Project A
Project B
Indifferent.
1000
‐1000
‐1500
1500
IRR = 50%
IRR = 50%
In case of conflicts..
Year
0
1
2
3
4
5
6
IRR
NPV @10%
P
-250
100
100
75
75
50
25
22%
$76.29
Q
-250
50
50
75
100
100
125
20%
$94.08
Q~P
0
-50
-50
0
25
50
100
15%
$17.79
MIRR



The interest rate where the FV of a project’s inflows (TV) are
discounted to equal the PV of a project’s outflows.
Assumes cash inflows are reinvested at the project’s cost of capital
(k).
This slight difference, makes the MIRR more accurate than the IRR.
Steps to find MIRR
Find
• Find the sum of the FVs of all inflow as at the end of
the project.
Find
• Find PV of all outflows as at the beginning of the
project.
Find
• Then find rate over the n years that equates the sum
of FVs to the sum of the PVs.
Compare
• Decision rule same as IRR: Compare MIRR to cost of
capital.
MIRR

Compute the MIRR for the following project
65
What do the practitioners use?
Indian Practice Scene
Source: S. Singh, P.K. Jain, S.S. Yadav (2012) “Capital budgeting decisions: Evidence from India” Journal of
Advances in Management Research, 9 (1), pp. 96‐112
67
What do the practitioners use?
PI
16.90%
IRR
68.90%
NPV
ARR
Payback
0.00%
67.60%
18.20%
68.90%
10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00%
Source: Batra and Verma (2017)