202005021259597527vijayshankarpandey Capital Budgeting Techniques
202005021259597527vijayshankarpandey Capital Budgeting Techniques
202005021259597527vijayshankarpandey Capital Budgeting Techniques
By:
Dr. Vijay Shankar Pandey
Asst. Professor
IMS, New Campus,
University of Lucknow,
Lucknow
Learning Objective:
We can calculate the payback period for ABC Ltd. projects A and
B using the data in Table 1.
– For project A, which is an annuity, the payback period is 3.0
years (Rs.42,000 initial investment ÷ Rs.14,000 annual cash
inflow).
– Because project B generates a unequal stream of cash inflows,
the
• In year 1, the firm will recover Rs.28,000 of its Rs.45,000 initial investment.
calculation of its payback period is not as clear-cut as of project
• By the end of year 2, Rs.40,000 (Rs.28,000 from year 1 + Rs.12,000 from
A.
year
2) will have been recovered.
• At the end of year 3, Rs.50,000 will have been recovered.
• Only 50% of the year-3 cash inflow of Rs.10,000 is needed to
– Thecomplete
paybackthe payback
period of the initial
for project B is Rs.45,000.
therefore 2.5 years (2 years + 50%
of year 3).
Payback Period: Pros and Cons of Payback
Analysis
Table 2 and 3 both are showing the payback time period for
respective projects for their companies.
In table 2 payback period is same but cash flow in various year is
different put a question mark in the selection of the project. As
per the cash flow of in table 2, silver project is better than the
gold project because it provide earliest recovery of cash that
affect the time value of money. In table 3 project x has earliest
recovery of cash but after 2 year its cash inflow drastically
reduced give edge to project y.
Therefore under this method instead of numerical value manager
rationality is important for the selection of the project.
Accounting Rate of Return method
IT considers the earnings of the project of the economic life. This
method is based on conventional accounting concepts. The rate of
return is expressed as percentage of the earnings of the investment
in a particular project. This method has been introduced to
overcome the disadvantage of pay back period. The profits under
this method is calculated as profit after depreciation and tax of the
entire life of the project.
The formula is as:
ARR = Average Profits after tax/ Net investment x 100
Merits
It is very simple to understand and use.
This method takes into account saving over the
entire economic life of the project.
Therefore, it provides a better means of comparison of project than the pay back
period. This method through the concept of "net earnings" ensures a
compensation of expected profitability of the projects and It can readily be
calculated by using the accounting data.
Demerits
1. It ignores time value of money.
2. It does not consider the length of life of the projects.
3. It is not consistent with the firm's objective of maximizing the market value of
shares.
4. It ignores the fact that the profits earned can be reinvested. -
Net Present Value (NPV)
Net present value (NPV) is a modern capital budgeting
technique used by project managers in their analysis; found
by subtracting a project’s initial investment from the
present value of its cash inflows discounted at a rate equal
to the firm’s cost of capital or required rate of return or
hurdle rate which one is preferred by the project manager.
Formula is as;
NPV = Present value of cash inflows – Initial investment
Net Present Value (NPV) (cont.)
Decision criteria:
If the NPV is greater than Rs. 0 (Zero), accept the project.
If the NPV is less than Rs. 0 (Zero), reject the project.
If the NPV is greater than Rs.0, the firm will earn a return
greater than its cost of capital or required rate of return or
hurdle rate which one is preferred by the project manager.
Such action should increase the market value of the firm,
and therefore the wealth of its owners by an amount equal
to the NPV.
P r o j e c t A a n d P r o j e c t B U s i n g N P V Te c h n i q u e s
Ye a r 0 1 2 3 4 5
Ye a r 0 1 2 3 4 5
Under the Choice of the project, Project A has more NPV than the
Project B show Project A will be selected
Net Present Value (NPV):
NPV and the Profitability Index
For a project that has an initial cash outflow followed by a
series of cash inflows, the profitability index (PI) is
simply equal to the present value of cash
inflows divided by the present value of initial cash
outflow:
Decision criteria:
If the IRR is greater than the cost of capital or required rate
of return, accept the project.
If the IRR is less than the cost of capital or required rate
of return, reject the project.
This criteria guarantee that the firm will earn at least its
required return. Such an outcome should increase the
market value of the firm and, therefore, the wealth of its
owners.
Project A and Project B Using IRR Techniques
Year 0 1 2 3 4 5
Year 0 1 2 3 4 5
• Comparing the IRRs of projects A and B given ABC ltd. 10% cost of
capital, we can see that both projects are acceptable because
IRRA = 19.9% > 10.0% cost of
capital
IRRB
= 21.7% > 10.0% cost of
• Comparing capital
the two projects’ IRRs, we would prefer project B
over project A because IRRB = 21.7% > IRRA = 19.9%.
Internal Rate of Return (IRR): Calculating the IRR
(cont.)
• It is interesting to note in the preceding example that the
IRR suggests that project B, which has an IRR of 21.7%, is
preferable to project A, which has an IRR of 19.9%.
• This conflicts with the NPV rankings obtained in an
earlier example.
• Such conflicts are not unusual.
• There is no guarantee that NPV and IRR will rank projects in
the same order. However, both methods should reach the
same conclusion about the acceptability or nonacceptability
of projects.
Personal Finance Example
25,000
20,000
15,000
Project A
Project B
10,000
5,000
0
0% 5% 10% 15% 20% 25%
-5,000
Comparing NPV and IRR Techniques: Conflicting Rankings
NPV at 10%=16,847
IRR=15%
Comparing NPV and IRR Techniques: Conflicting Rankings
(cont.)
If the future value in each case in Table were viewed as the return
received 3 years from today from the Rs.170,000 investment, then
the cash flows would be those given in nest Table on the
following slide.
Table: Project cash flows after reinvestment
Investment rate
10% 15%
Initial investment Rs. 170,000
2 00 00
3 148,720 258,470
NPV at 10% 16,867 24,418
IRR 13.5% 15%
Comparing NPV and IRR Techniques: Timing of the
Cash Flow
Another reason why the IRR and NPV methods may provide different
rankings for investment options due to differences in the timing of
cash flows.
When much of a project’s cash flows arrive early in its
life, the project’s NPV will not be more sensitive to the
discount rate.
On the other hand, the NPV of projects with cash flows
that arrive later will more sensitive to the discount rate
changes.
The differences in the timing of cash flows between the
two projects does not affect the ranking provided by the
IRR method.
Comparing NPV and IRR Techniques: Magnitude of
the Initial Investment
– However, The Kuwait Fund was established as the first institution in the Middle
East that took an active role in international development efforts. The fund
finances development projects and their feasibility studies in developing countries.
One of the major objectives of the Kuwait Fund is to build a solid bridge of
friendship
– Thesolidarity
and success ofbetween
the Kuwait FundofinKuwait
the state achieving
andthis
the objective
developinghelped the state of Kuwait
nations.
– to get the necessary votes in the United Nations and the U.N. Security Council for the
war against Iraq to liberate Kuwait in
The
1991.Kuwait Fund offers many forms of assistance, including direct loans or the
provision of guarantees, and grants-in-aid to
–
finance technical, economic, and financial studies.
What are the potential benefits to the state of Kuwait of the ethical behavior of the
Kuwait Fund?
–
References: