Capital Budgeting (NPV PI)

Capital Budgeting Decisions
Capital Budgeting Decisions
Capital budgeting is used by companies to evaluate major investment

opportunities or projects, such as setting up a new factory, warehouse, plant
or equipment.
Long-term investment decisions are taken based on the estimated cash flows
(inflows and outflows) rather than accounting profit.
Various types of investment avenues include new projects, expansion plans,

replacement projects, research & development projects (generally not
measurable), and miscellaneous projects like installation of safety
mechanisms or pollution control devices etc..
Features of Capital Budgeting
▪ Long-term projects (duration between initial investments and expected

returns)
▪ Involves High Capital
▪ Involves High Risk
▪ Irreversible Decisions
▪ Long-term Impact on Profitability and competitive strength of the
company.
Principles of Capital Budgeting
▪ Separation Principle: Consider only operating costs and incomes, not

financing costs.
▪ Incremental Cash Flows are considered.
▪ Sunk Costs are ignored.
▪ Cash flow should be adjusted for taxes.
Steps in the Capital Budgeting Process
▪ Identify Investment Projects

▪ Evaluate the Projects
• Estimate the Cash Flows, i.e., inflows and outflows of the projects.
• Estimate the required rate of return/hurdle rate.
▪ Selecting a Project (application of a decision rule for making a choice)
▪ Implementation
▪ Project Review
From the Perspective of Decision Making
▪ Mutually Exclusive Decisions

Two or more alternative proposals are said to be mutually exclusive when
acceptance of one alternative results in the automatic rejection of others.
Rank all the alternatives and select the best one.
▪ Accept-Reject Decisions
An accept-reject decision occurs when a proposal is independently accepted
or rejected without regard to any other alternative proposals.
Must exceed a MINIMUM acceptance criteria

Capital Budgeting Techniques
▪ Payback Period/ Discounted Payback Period

▪ Net Present Value (NPV)
▪ Internal Rate of Return (IRR)
▪ Profitability Index (PI)
Payback Period
The time period required to recover the initial investment back or the
time taken to break even on an investment.
Rule: Accept the project if the payback period is less than or equal to the
standard payback period decided by the management; otherwise, reject.
Payback Period = number of years to recover initial costs

Payback Period
▪ Advantages:
• Easy to understand
• Biased toward liquidity
▪ Disadvantages:
• Ignores the time value of money
• Ignores cash flows after the payback period
• Biased against long-term projects
• Requires arbitrary acceptance criteria
• A project accepted based on the payback criteria may not have a positive NPV
Payback Period
Fuji Software, Inc. has the following mutually exclusive projects.t B

Suppose Fuji’s payback period cutoff is two years. Which of these two projects
should be chosen?
Discounted Payback Period
▪ This method is a combination of the payback period method and the

discounted cash flow technique.
▪ In this method, the cash flows of the project are discounted to find
their present values.
▪ This method takes care of the main drawback of the payback period
and allows the consideration of the time value of money.
▪ In the discounted payback period, a project is acceptable if its
discounted payback is less than its target payback period.
t Cash flow (in USD)
Suppose we have a project with the following
cash flows and required returns. What is the 0 (30,000)
payback period for the project?

1 8,000
The required return is 10%. The maximum
payback period is 3.5 years. 2 10,000
3 11,000
4 17,000
5 12,000
t Cash flow (in USD) Discounted Cash Flows
0 (30,000) $ (30,000.00)
1 8,000 7,272.73
2 10,000 8,264.46
3 11,000 8,264.46
4 17,000 11,611.23
5 12,000 7,451.06
Decision: Reject the Project

Net Present Value (NPV)
• The NPV of an investment proposal may be defined as the sum of the

present values of all the cash inflows less the sum of the values of all
the cash outflows associated with the proposal.
• We calculate NPV using the following formula:
Where C0 is the initial cost of the proposal at time t0

CFi are the cash flows occurring at time 0, 1, 2….
R is the discount rate, and t is the life of the project.
Decision Rule:
▪ Accept the proposal if the NPV is positive and reject the proposal if
the NPV is negative.
▪ In the case of Accept-Reject situations, all projects with positive NPV
are qualified to be accepted.
▪ In the case of mutually exclusive proposals, the proposals should be
ranked in order of their NPV, and the project with the highest positive
NPV should be given priority.
Net Present Value
ABC Ltd. is considering the following project.

The initial cash outlay is Rs. 1,70,000. The cash
inflows for the next four years are given in the 1 20,000
table. In the final year of project operation, cash
inflows include annual inflows of Rs. 30,000, 2 50,000
salvage value of Rs. 25,000 and a working capital

3 60,000
worth Rs. 20,000 being released.
4 40,000
Given that the required rate of return is 10%,

should the project be accepted?
Net Present Value
Y Ltd. is considering the following projects.
Project A: Initial investment of Rs. 5,00,000. Cash inflows of Rs. 95,000

for the next 6 years.
Project B: Initial investment of Rs. 4,00,000. Cash inflows of Rs. 80,000

for the next 6 years.
The required rate of return is 8%. Using the NPV method, suggest which
project should be selected.
The benefits of using the NPV method:
▪ Recognizes the time value of money

▪ NPV uses all the cash flows of the project irrespective of the timing
of their occurrence.
▪ The value of the firm rises by the NPV of the project.
▪ Accepting positive NPV projects increase shareholder wealth.
▪ NPV discounts the cash flows properly (incorporating the required
rate of return).
The limitations of the NPV method are:
▪ Expressed in absolute terms. Doesn’t factor in the scale of

investments.
▪ When projects have different lives, NPV is biased towards longer-
duration projects.
Profitability Index (PI)
▪ Profitability Index is defined as the benefits (in present value terms)

per rupee invested in the proposal.
▪ This technique which is a variant of NPV, is also known as Cost-
Benefit Ratio.
▪ PI can be calculated as the total present value of cash inflows divided
by the total present value of cash outflows.
▪ Minimum Acceptance Criteria:

• Accept if PI > 1
▪ Ranking Criteria:
• Select the alternative with the highest PI
Profitability Index
ABC Ltd. is considering a project that
requires a cash outlay of Rs.40,000 at present 0 (40,000)
and of Rs. 20,000 at the end of the third year.

1 20,000
It is expected to generate cash inflows of
Rs.20,000, Rs.40,000, and Rs.20,000 at the 2 40,000
end of the first, second and fourth year.
3 (20,000)
Given that the required rate of return is 10%, 4 20,000
should the project be accepted?

Profitability Index (PI)
▪ Advantages:
• May be useful when available investment funds are limited
• Easy to understand and communicate
• Correct decision when evaluating independent projects

Capital Budgeting (NPV PI)

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Capital Budgeting Decisions

Capital Budgeting Decisions

Capital budgeting is used by companies to evaluate major investment

Various types of investment avenues include new projects, expansion plans,

▪ Long-term projects (duration between initial investments and expected

▪ Separation Principle: Consider only operating costs and incomes, not

▪ Identify Investment Projects

▪ Mutually Exclusive Decisions

Rank all the alternatives and select the best one.

Must exceed a MINIMUM acceptance criteria

▪ Payback Period/ Discounted Payback Period

Payback Period = number of years to recover initial costs

Fuji Software, Inc. has the following mutually exclusive projects.t B

▪ This method is a combination of the payback period method and the

payback period for the project?

t Cash flow (in USD) Discounted Cash Flows

Decision: Reject the Project

• The NPV of an investment proposal may be defined as the sum of the

Where C0 is the initial cost of the proposal at time t0

ABC Ltd. is considering the following project.

salvage value of Rs. 25,000 and a working capital

Given that the required rate of return is 10%,

Project A: Initial investment of Rs. 5,00,000. Cash inflows of Rs. 95,000

Project B: Initial investment of Rs. 4,00,000. Cash inflows of Rs. 80,000

The benefits of using the NPV method:

▪ Recognizes the time value of money

The limitations of the NPV method are:

▪ Expressed in absolute terms. Doesn’t factor in the scale of

▪ Profitability Index is defined as the benefits (in present value terms)

▪ Minimum Acceptance Criteria:

and of Rs. 20,000 at the end of the third year.

Given that the required rate of return is 10%, 4 20,000

should the project be accepted?

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