Capital Budgeting

Road map

Net Present Value

Internal Rate of Return
Profitability Index
Payback Period
Time Value of Money
A step back!
A
twist!
 2019

2029
What changed?
Time value of Money

Today
Tomorrow
>
Simple isn’t it ?

11
Accept or Reject ?

A sum of $ 400,000 dollars invested today in an IT project

may give a series of below cash inflows in future:
• $ 70,000 in year 1
• $ 120,000 in year 2
• $ 140,000 in year 3
• $ 140,000 in year 4
• $ 40,000 in year 5
• If Opportunity cost of capital is 8% per annum, then should
we accept or reject the project?
I must be
kidding😊
NOT simple yet 
Without knowing other
complementing
factors

14
Discounted
Cash Flow
2 Options
Example
1. Invest in a Project
2. Invest in a Bank

• Project Annual Returns : 10%

• Bank Annual Returns: 8%

• What is that you loose if invested in the Bank?

• What is that you loose if invested in the Project?

What you loose is the opportunity cost.

16
Other names for opportunity cost
1. Discounted cash
2. Discounted Cash flow
3. Cost of Capital
4. Opportunity cost of capital

17
Capital Budgeting Techniques

• NPV - Net present Value

Discounte • IRR - Internal Rate of
d Cash Return
• PI – Profitability Index
Flow
• Payback period
• Payback period (Payback period is usually
Non-
calculated considering the Non discounted
Discounted
cash flow.
Cash flow

18
2 more key terms that we need to know
• Present Value
• Future Value

In total 4 Key important terms to keep in mind.

1. Future Value (let’s call it “FV”)

2. Present Value (let’s call it “PV”)
3. Let’s call the time as “n”
4. Opportunity cost (let’s call it “K”)
20
Relationship b/w Future Value & Present Value

FV = PV (1 + FV = Future Value
PV = Present Value
k)n K = Discounted Rate
n = Number of
Years

21
 Let’s build on Future Value
For 1 year
How do we calculate the Future Value ?

Example
If $ 100 dollars is invested in a bank today may earn 8% per year. what
is the future value of the $ 100 dollars for 1st, 5th and 15th year?

For 5 years
FV = PV (1 + k)n

PV = 100 = = = 100
K= 8% = 8/100 = 0.08
For 15 years
(1+K)= (1+0.08) = 1.08 = 1.08

After 1 year(n=1): FV = 100 X (1.08)1 = 100*1.08 = $108

After 5 years (n=5): FV = 100 X (1.08)5 = 100*1.08*1.08*1.08*1.08*1.08 = $146.93
After 15 years (n=15): FV = 100 X (1.08)15 = $317.22

22
Let’s build on Present Value For 1 year

How do we calculate the Present Value ?

Example
If $ 100 dollars is to be received after 1 year, what is the present value of $100 dollars today?
If $ 100 dollars is to be received after 5 years, what is the present value of $100 dollars
today?
For 5 years
If $ 100 dollars is to be received after 15 years, what is the present value of $100 dollars
today?
Note: Discounted rate is 8% per year.

FV= 100 = = = 100

K= 8% = 8/100 = 0.08
(1+K)= (1+0.08) = 1.08 = 1.08
For 15 years

The Present value of $ 100 to be received after 1 year is $93 dollars today.
The Present value of $ 100 to be received after 5 years is $68 dollars today.
The Present value of $ 100 to be received after 15 year is $32 dollars today.

23
Financial Management
Overview
Financial
Functions
Corporate Accounting &
Finance Control

Resource Investment Risk Managemen

Mobilization Decisions Management t
Accounting

Short Term Long Term Physica

Financia

✔
Finance Finance l Assets Financia Financial
l Derivative
/ l
Assets s Cost
Project Strategy
s Accountin
g

Technical Financia Fixed Income Variable

Feasibilit
y
✔ l
Viability
Security Income

Securit Financial
y Accountin
✔ Capital
g
Budgeting
Technique
s
Road map

✔ N e t Present
Value
Internal Rate of Return
Profitability Index
Payback Period
Net Present Value
Net present value = “Present value of cash all Inflows” – “Present value of all cash Outflows”.

Example: Your pay slip

Net Salary = Gross Salary - Deductions

Similarly:

Net Present value is : All Cash Inflows – All Cash Outflows.

IF NPV > 0 (positive), The project can be accepted, The

greater the NPV, the better the project financial
benefits.
Net Present Value
Example: Calculating NPV
A sum of $ 400,000 dollars invested today in an IT project may give a series of below cash inflows in future:

$ 70,000 in year 1
$ 120,000 in year 2
$ 140,000 in year 3
$ 140,000 in year 4
$ 40,000 in year 5

If Opportunity cost of capital is 8% per annum, then should we accept or reject the project?

Solution:
Step 1: Calculate the PV value of year 1, year2, year3, year4, and year5
Step 2: Sum up the PV of all years
Step3: NPV = Present value of all cash inflows – Present value of all cash outflow.
Step 4: If NPV is positive, Accept the project, if not Reject the project.
Net Present Value
PV for year1 = 70000/1.08 64814.81
PV for year2 = 120000/(1.08)2 102880.7
PV for year3 = 140000/(1.08)3 111136.5
PV for year4 = 140000/(1.08)4 102904.2
PV for year5 = 40000/(1.08)5 27223.33
Cash Inflow of all PVs = 408959.5

Cash Inflow of all Present Values is : $ 408,959

Present value of Cash outflow is : $400,000

Net Present Value = PV of Cash inflows – PV of Cash Outflows

= ($408959 – $400000) = $8959 dollars.

Since NPV is positive, (i.e., $8959, This project can be accepted)

Net Present Value
Same example: Calculating NPV however with Discount rate or Opportunity cost of capital at 15%
A sum of $ 400,000 dollars invested today in an IT project may give a series of below cash inflows in future:

$ 70,000 in year 1
$ 120,000 in year 2
$ 140,000 in year 3
$ 140,000 in year 4
$ 40,000 in year 5

If Opportunity cost of capital is 15% per annum, then should we accept or reject the project?

Solution: Calculating NPV

Step 1: Calculate the PV value of year 1, year2, year3, year4, and year5
Step 2: Sum up the PV of all years
Step3: NPV = Present value of all cash inflows – Present value of all cash outflow.
Step 4: If NPV is positive, Accept the project, if not Reject the project.
Net Present Value

PV for year1 = 70000/1.15 60869.57

PV for year2 = 120000/(1.15)2 90737.24
PV for year3 = 140000/(1.15)3 92052.27
PV for year4 = 140000/(1.15)4 80045.45
PV for year5 = 40000/(1.15)5 19887.07
Cash Inflow of all PVs = 343591.6

Cash Inflow of all Present Values is : $ 343591

Present value of Cash outflow is : $400,000
Net Present Value = PV of Cash inflows – PV
of Cash Outflows = ($343591– $400000) = $
-56408
dollars.
Since NPV is Negative, (i.e., -$56408, This
project should be rejected)
N.B: Though we have the same inflow & outflow of cash as in the previous example, the NPV value
changed with the change in the Discount rate of interest.
Road map
Net Present Value

✔ Internal Rate of
Return
Profitability Index
Payback Period
IRR - Internal Rate of Return
IRR (Internal Rate of Return) is a discount rate at which NPV (Net Present Value) becomes Zero.

In other words, IRR is the opportunity cost at which the NPV becomes Zero.

IRR as the name suggests, it tells how much rate of return (percent) we are getting from the project.

To put it simple: It is the percentage of Return of your investment.

Why IRR, what is the use of calculating IRR?

 IRR is used to rank different projects.

 The higher a project's internal rate of return, the more desirable it is to undertake the project.

 If all the other factors are same for different projects then the project with the Highest Internal
rate of
return value should be considered.
IRR - Internal Rate of Return

Note:
For Constant rate of Cash inflow for every year, Internal Rate of Return can be calculated with the
help of a formula

For Uneven rate of Cash inflows for every year, IRR can be calculated by little trail & error
adjustments.

Accept the project when Internal rate of return > Discount rate or Opportunity cost of capital.

Reject the project when Internal rate of return < Discount rate or Opportunity cost of capital.

May accept the project when Internal rate of return = Discount rate or Opportunity cost of capital.
Relationship between IRR, Discount rate and NPV

If IRR > Discount rate or Opportunity cost of capital → The NPV is always
Positive.

If IRR < Discount rate or Opportunity cost of capital → The NPV is always
Negative.

If IRR = Discount rate or Opportunity cost of capital → The NPV is Zero.

Note: As long as the NPV is Positive, the project is financially viable.

The moment that NPV becomes Negative, the Project is NOT financially viable.
IRR - Internal Rate of Return
Example:

The cost of a project is $1000. It has a time horizon of 5 years and the expected year wise incremental cash flows are:

Year 1 : $200
Year 2: $300
Year 3 : $300
Year 4: $400
Year 5 :
$500

Compute
IRR of the
project. If
opportunity
cost of
Capital is
12%,

And tell us,

should we
accept the
project?
IRR - Internal Rate of Return
At Discount Rate of 12%, the NPV is 169 (positive)

Year (n) FV PV K K K% 1+K

1 200 (1+K) 1.12
1
178.5714286 12% 12 0.12 1.12
2 300 (1+K)2 1.2544 239.1581633
3 300 (1+K) 1.404928
3
213.5340743
4 400 (1+K)4 1.57351936 254.2072314 Cash Inflow Cash outflow NPV
5 500 (1+K)5 1.762341683 283.7134279 1169.184325 1000 169.1843254
1169.184325

At Discount Rate of 17.7%, the NPV is 0 (Zero), there fore the IRR is 17.7%, Since IRR > Discount rate,
Project can be accepted

Year (n) FV PV K K K% 1+K

1 200 (1+K)1 1.177 169.9235344 12% 17.7 0.177 1.177
2 300 (1+K)2 1.385329 216.5550566
3 300 (1+K)3 1.630532233 183.9890031
4 400 (1+K)4 1.919136438 208.4270779 Cash Inflow Cash outflow NPV
5 500 (1+K)5 2.258823588 221.3541609 1000.248833 1000 0.248832951
1000.248833
Road map
Net Present Value
Internal Rate of Return

✔ Profitability
Index
Payback Period
PI – Profitability Index
Present Value of all future cash inflows divided by Cash outflows

Note: In NPV, we subtracted cash out flows from Present value of all cash inflows, whereas in PI, we divide
Present value of all cash inflows by Cash Outflows.

Project acceptance criteria using Profitability Index method.

Accept the project when PI > 1

Reject the project when PI < 1
May accept the project when PI = 1
Higher the profitability Index of the project, the better.

Note:
For a project with NPV > 0, PI is always greater than 1.
For a project with NPV < 0, PI is always less than 1
PI – Profitability Index
A sum of $ 25,000 invested today in a project may give a series of cash
inflows in future as described below:
$ 5000 in year 1
$ 9000 in year 2
$ 10,000 in each of year 3
$ 10,000 in each of year 4
$ 3000 in year 5
If the required rate of return is 12% pa, what is the Profitability Index?
Year (n) FV PV K K K% 1+K
1 5000 (1+K)1 1.12 4464.285714 12% 12 0.12 1.12
2 9000 (1+K)2 1.2544 7174.744898
3 10000 (1+K)3 1.404928 7117.802478
4 10000 (1+K)4 1.57351936 6355.180784 Cash Inflow Cash outflow PI
5 3000 (1+K)5 1.762341683 1702.280567 26814.29444 25000 1.072571778
26814.29444

Profitability Index is 1.07 and since it is greater than 1, we can accept the project.
Road map
Net Present Value
Internal Rate of Return
Profitability Index

✔ Payback
Period
Pay back period

The time it takes for the project to generate money to pay for itself.

Payback period is the number of years required to recover the cash outflow invested
in the project.

The project would be accepted if its payback period is less than the maximum or
standard payback period set by Industry, Senior Leadership.

In terms of Projects ranking, it gives highest ranking to the project with the shortest
payback period.

Note: In general, the discounted cash flow is not considered for Pay back period.
Some do, but most don’t!
Pay back period
A sum of $25,000 invested today in an IT project, may give a series of cash inflows in future
as described below.

$ 5,000 in year 1
$ 9,000 in year 2
$ 10,000 in each of year 3 Year Cash Inflow Cumulative Cash infow
1 5000 5000
$ 10,000 in each of year 4 2 9000 14000
$ 3,000 in year 5 3 10000 24000
4 10000 34000 833.3333333 pm
What is the Payback Period (Non-discounted)? 5 3000 37000

Initial Cash Outlay = $25,000

Cumulative Non-discounted Cash Inflow in $ dollars
End of Year 1: 5,000
End of Year 2: 14,000
End of Year 3: 24,000
End of Year 4: 34,000

Payback Period (Non-discounted) = In between 3 years 1 month and 3 years 2 months

Important: Few tips to Remember
For PMP / PgMP aspirants and other competitive exams.

 Always choose projects with highest NPV.

 If NPV is same for the given projects, choose the project with highest IRR.
 If NPV, IRR remains the same for the given projects, choose the projects
with early pay back period.
 NPV = All Cash Inflows – Cash Outflows
 PI = All Cash Inflows / Cash Outflows
 IRR = Discount rate at which the NPV becomes zero, this tell us what is the
percent of return for the project.
 Payback period is a major consideration for every project, business or
organization, it tells us how soon we can recover our investment and this
investment can be utilized for other business needs/projects later on.
Quick Recap
Concepts learnt (simple but plays an important role)

• Time Value of Money

• Opportunity Cost / Discounted Cash flow
• Calculating Future value
• Calculating Present value

Based on the above concepts, we learnt how to solve

• Capital Budgeting techniques.

 Net Present Value - NPV

 Internal Rate of Return - IRR
 Profitability Index – PI
 Payback Period - PBP
Finally

Rating & Comments

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