Capital Budgeting – Long
Term Decision Making
Objective 6
a) Non-discounting methods – payback and the
accounting rate of return (ARR).
(b) Time value of money (present value and
future value).
(c) Discounting techniques: (i) compute net
present value (NPV), discounted payback and
profitability index (PI)
Definition: Net present value is a tool of Capital budgeting to analyze the profitability of a
project or investment. It is calculated by taking the difference between the present value of
cash inflows and present value of cash outflows over a period of time.
Formulas:
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NPV= Benefits - Investments
Formula to Calculate Benefits
_C_
(1+r) t
Investments
Definition- Investments is the total amount of money the
company decides to invest in the project.
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Notes
If NPV>0 then the project is worth investing in
If NPV<0 then the project is not worth investing in
Profitability index
Definition- The profitability index (PI) helps measure the attractiveness of a
project or investment. It is calculated by dividing the present value of future
expected cash flows by the initial investment amount in the project.
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Formula - NPV/ Upfront Investments
Notes:
The project with the highest Profitability Index is worth investing in
The set of projects must completely exhaust the resource
There is only a single resource constraint
(ii) use the internal rate of return (IRR) in an
investment decision.
Definition: The internal rate of return is used to evaluate projects or investments. The IRR estimates a
project’s breakeven discount rate (or rate of return) which indicates the project’s potential for profitability.
Formula-
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Steps to Use IRR in Investment Decision-Making
Calculate IRR – Use Excel, a financial calculator, or software to find the IRR of the investment.
Compare IRR to Required Return – If IRR is higher than your target return, accept the investment; otherwise,
reject it.
Check for Limitations – Be aware of multiple IRRs, unrealistic reinvestment assumptions, and the investment’s
actual size.
Use Other Metrics Too – Consider NPV, payback period, and profitability index for a complete evaluation.
Example
investment A:
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Initial Investment: $100,000
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Expected Cash Flows: $30,000, $40,000, $50,000 over 3 years
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IRR Calculation: 22%
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Required Rate of Return: 15%
✅ Decision: Since IRR (22%) is higher than the required return (15%), the investment is attractive.