SIGNIFICANCE OF CAPITAL BUDGETING

● Capital budgeting is an essential tool in financial management

● Capital budgeting provides a wide scope for financial managers to
evaluate different projects in terms of their viability to be taken up
for investments
● It helps in exposing the risk and uncertainty of different projects
● It helps in keeping a check on over or under investments
● The management is provided with an effective control on cost of
capital expenditure projects
● Ultimately the fate of a business is decided on how optimally the
available resources are used
Discounted cash flow method: ​The discounted cash flow technique calculates the
cash inflow and outflow through the life of an asset. These are then discounted
through a discounting factor. The discounted cash inflows and outflows are then
compared. This technique takes into account the interest factor and the return after
the payback period.

● Net present Value (NPV) Method:

This is one of the widely used methods for evaluating capital investment proposals.
In this technique the cash inflow that is expected at different periods of time
is discounted at a particular rate. The present values of the cash inflow are
compared to the original investment. If the difference between them is
positive (+) then it is accepted or otherwise rejected. This method considers
the time value of money and is consistent with the objective of maximizing
profits for the owners.

● NPV = PVB – PVC

where,
PVB = Present value of benefits
PVC = Present value of Costs
Net present value uses discounted cash flows in the analysis, which makes the
net present value more precise than of any of the capital budgeting methods as it
considers both the risk and time variables.
A net present value analysis involves several variables and assumptions and
evaluates the cash flows forecasted to be delivered by a project by
discounting them back to the present using information that includes the
time span of the project (t) and the firm's ​weighted average cost of capital
(i)​. If the result is positive, then the firm should invest in the project. If
negative, the firm should not invest in the project.
Application
Companies often use net present value as a ​capital budgeting method​ because
it's perhaps the most insightful and useful method to evaluate whether to invest in
a new capital project. It is more refined from both a mathematical and
time-value-of-money point of view than either the ​payback period​ or ​discounted
payback period​ methods. It is also more insightful in certain ways than the ​
profitability index​ or internal rate of return calculations.​​
Say that firm XYZ Inc. is considering two projects, Project A and Project B, and
wants to calculate the NPV for each project.

● Project A is a four-year project with the following cash flows in each of the
four years: $5,000, $4,000, $3,000, $1,000.
● Project B is also a four-year project with the following cash flows in each of
the four years: $1,000, $3,000, $4,000, $6,750.
● The firm's cost of capital is 10 percent for each project, and the initial
investment is $10,000.

The firm wants to determine and compare the net present value of these cash
flows for both projects. Each project has uneven cash flows. Following is the
basic equation for calculating the present value of cash flows, ​NPV(p),​ when
cash flows differ each period:
NPV(p) = CF(1)/(1 + K)n + CF(2)/(1 + K)n+ CF(3)/(1 + K)n + CF(4)/(1 + K)n -C
Where:

● K= firm's cost of capital

● n = the year in which the cash flow is received

To calculate the NPV for Project A:

NPV(A) = $5,000/(1.10)1 + $4,000/(1.10)2 + $3,000/(1.10)3 + $1,000/(1.10)4 –C
= $788.20
The NPV of Project A is $788.20, which means that if the firm invests in the
project, it adds $788.20 in value to the firm's worth.
NPV Disadvantages
Although NPV offers insight and a useful way to quantify a project's value and
potential profit contribution, it does have its drawbacks. Since no analyst has a
crystal ball, every capital budgeting method suffers from the risk of incorrectly
estimated critical formula inputs and assumptions, as well as unexpected or
unforeseen events that can affect a project's costs and cash flows.
The NPV calculation relies on estimated costs, an estimated discount rate, and
estimated projected return. It also can't factor in unforeseen expenses, time
delays, and any other issues that come up on the front or back end, or during the
project.
Also, the discount rate and cash flows used in an NPV calculation often don't
capture all of the potential risks, assuming instead the maximum cash flow
values for each period of the project. This leads to a false sense of confidence for
investors, and firms often run different NPV scenarios using conservative,
aggressive, and most-likely sets of assumptions to help mitigate this risk.

● Internal Rate of Return (IRR):

This is defined as the rate at which the net present value of the investment is zero.
The discounted cash inflow is equal to the discounted cash outflow. This method
also considers time value of money. It tries to arrive to a rate of interest at which
funds invested in the project could be repaid out of the cash inflows. However,
computation of IRR is a tedious task.
The internal rate of return (IRR) is a metric used in ​capital budgeting​ to estimate
the profitability of potential investment.​ It is called internal rate because it depends
solely on the outlay and proceeds associated with the project and not any rate
determined outside the investment.
Internal Rate of Return (IRR) is a widely used technique. It is also very easy to
utilize Internal Rate of Return with the help of a ​financial calculator​. It is much
more challenging to calculate it by hand. Again, as in utilizing the NPV
method, it is important to first understand the logic behind the calculation.
In simple terms, the IRR is ​a ​discount rate​ that makes the ​net present
value​ (NPV) of all cash flows from a particular project equal to zero​. If IRR higher
than cost of capital than project should be accepted and vice versa. If IRR at
least equals cost of capital than we know that business will earn at least rate
equal to its cost of capital on this particular project.

The Formula for IRR Is

● C​t​ = net cash inflow during the period t

● C​o =​ total initial investment costs
● r = the discount rate, and
● t = the number of time periods

IRR is sometimes referred to as "economic rate of return" or "discounted

cash flow rate of return." The use of "internal" refers to the omission of
external factors, such as the ​cost of capital​ or ​inflation​, from the
calculation.

`Test yourself solve an example

Comparing NPV and IRR

Theoretically, it is advisable to use Net Present Value method because NPV assumes
that cash inflows are reinvested at cost of capital, which is more realistic than
assumption made in Internal Rate of Return method (IRR) that cash inflows
reinvested at IRR.

However, in real life, the IRR is more common because it considers the rate of return
instead of dollar amount considered in the Net Present Value method and the former
seems to be more intuitive to users of techniques. There are, however, ways to deal
with shortcomings of IRR and therefore IRR is still can be considered a sophisticated
and reliable technique.

Both NPV and IRR will show whether the project is acceptable. However, the
ranking of specific acceptable projects may differ between two techniques
 ● Profitability Index (PI):
The profitability index (PI), also known as the profit investment ratio (PIR) and
value investment ratio (VIR), is a capital budgeting tool that measures the
profitability of an investment or project. In layman's terms, it is an indication of the
costs and benefits to a business firm if they invest in a particular capital project.
In other words, it is the ratio of the present value of future cash benefits, at the
required rate of return to the initial cash outflow of the investment.​ The index is a 
useful tool for ranking investment projects and showing the ​value​ created per 
unit of investment.
The profitability index is an appraisal technique applied to potential capital
outlays and is a useful tool for ranking projects because it allows you to quantify
the amount of value created per ​unit of investment​.
The Formula
The profitability index is calculated by dividing the present value of future cash
flows to be generated by a capital project by the initial cost, or ​initial investment​,
of the project. The initial investment is the cash flow required at the start of the
project. The future cash flows do not include the initial investment amount.
Profitability Index = Present Value of Future Cash Flows Generated by the
Project/Initial Investment in the Project.
Therefore: 

● If the PI is greater than 1, the project generates value and the company 
should proceed with the project. 
● If the PI is less than 1, the project destroys value and the company should 
not proceed with the project. 
● If the PI is equal to 1, the project breaks even and the company is 
indifferent between proceeding and not proceeding with the project. 

The higher the profitability index, the more attractive the investment.
Application
The profitability index is often used to rank a firm's investments and/or projects.
Because companies usually have limited financial resources or must maximize
profits for shareholders, they often invest in only the most profitable projects. If
there are a number of possible investment projects available, the company can
use the profitability index to rank those projects from high to low and decide
which offers the greatest benefit. Although some projects result in a higher net
present value, those projects may be passed over because they do not represent
the most beneficial use of company assets.
It's important to note that one problem with using the profitability index is that it
does not allow a business owner to consider the size of the project. Using the ​net
present value​ method of evaluating investment projects solves this problem.
Obviously, the time the project will require and the time to profitability are also
concerns.
Example of Profitability Index 
Company A is considering two projects: 

Project A requires an initial investment of $1,500,000 to yield estimated ​annual 

cash flows​ of: 

● $150,000 in Year 1 
● $300,000 in Year 2 
● $500,000 in Year 3 
● $200,000 in Year 4 
● $600,000 in Year 5 
● $500,000 in Year 6 
● $100,000 in Year 7 
● PHOTOS 

The appropriate discount rate for this project is 10%. 

  

Project B requires an initial investment of $3,000,000 to yield estimated annual 

cash flows of: 

● $100,000 in Year 1 
● $500,000 in Year 2 
● $1,000,000 in Year 3 
● $1,500,000 in Year 4 
● $200,000 in Year 5 
● $500,000 in Year 6 
● $1,000,000 in Year 7 

  PHOTOS 2 
  

The appropriate discount rate for this project is 13%. 

  

Company A is only able to undertake one project. Using the profitability index 
method, which project should the company undertake? 

Using the PI formula, Company A should do Project A. Project A creates value – 

Every $1 invested in the project generates $.0684 in additional value. 

  

Discounting the Cash Flows of Project A: 

● $150,000 / (1.10) = $136,363.64 

● $300,000 / (1.10)^2 = $247,933.88 
● $500,000 / (1.10)^3 = $375,657.40 
● $200,000 / (1.10)^4 = $136,602.69 
● $600,000 / (1.10)^5 = $372,552.79 
● $500,000 / (1.10)^6 = $282,236.97 
● $100,000 / (1.10)^7 = $51,315.81 

Present value of future cash flows: 

$136,363.64 + $247,933.88 + $375,657.40 + $136,602.69 + $372,552.79 + 

$282,236.97 + $51,315.81 = $1,602,663.18 

Profitability index of Project A: $1,602,663.18 / $1,500,000 = $1.0684. Project A 

creates value. 

  

Discounting the Cash Flows of Project B: 

● $100,000 / (1.13) = $88,495.58 

● $500,000 / (1.13)^2 = $391,573.34 
● $1,000,000 / (1.13)^3 = $693,050.16 
● $1,500,000 / (1.13)^4 = $919,978.09 
● $200,000 / (1.13)^5 = $108,551.99 
 ● $500,000 / (1.13)^6 = $240,159.26 
● $1,000,000 / (1.13)^7 = $425,060.64 

Present value of future cash flows: 

$88,495.58 + $391,573.34 + $693,050.16 + $919,978.09 + $108,551.99 + 

$240,159.26 + $425,060.64 = $2,866,869.07 

Profitability index of Project B: $2,866,869.07 / $3,000,000 = $0.96. Project B 

destroys value.