Capital Budgeting Techniques

CAPITAL BUDGETING

Capital Budgeting refers to the process of evaluating and making decisions regarding long term investments in projects and assets. It involves assessing the potential opportunities, allocating resources, and determining the financial viability of different investment options. The goal of capital budgeting is to maximize the value of a company by selecting projects that generate positive returns and contribute to overall growth.

CAPITAL BUDGETING TECHNIQUES

There are 4 key capital budgeting techniques:

1. Net Present Value (NPV)
2. Internal Rate Return (IRR)
3. Profitability Index
4. Payback Period

Let’s try to understand them one by one.

1. NET PRESENT VALUE (NPV)

NPV tells us the total value of return on Investment.

Calculation of IRR: NPV = Present Value of all cash inflows – Present Value of all cash outflows

Criteria to select the project:

• If NPV > 0 (NPV is positive, Accept the Project)
• If NPV < 0 (NPV is negative, Reject the Project)
• If NPV = 0 (May Accept the project)

THE GREATER THE NPV, THE BETTER IT IS

Why do we use Present Value for calculation of NPV?

The answer lies in the fact that the money sitting in our wallet today will not have the same value tomorrow. Value of money depreciates over time. This concept of money & time is also known as Time Value of Money where

FV = PV (1+K)n i.e. PV = FV / (1+K)n

• FV = Future Value
• PV = Present Value
• K = Discounted Rate in %
• n = Number of Years

Kindly note that discount rate and NPV are inversely proportional i.e. if we increase the discount rates, NPV value decreases

Example: A company is considering an investment in a new project that requires an initial investment of INR 1Lac. The expected cash inflow of next 5 years is as follows:

• Year 1: INR 30,000
• Year 2: INR 35,000
• Year 3: INR 40,000
• Year 4: INR 45,000
• Year 5: INR 50,000

The discount rate is 8%.

NPV Calculation:

• NPV = 30,000/(1+.08)1 + 35,000/(1+.08)2 + 40,000/(1+.08)3 + 45,000/(1+.08)4 + 50,000/(1+.08)5 – 1,00,000
• NPV = 32,453.68 + 40,799.71 + 50,424.69 + 61,224.49 + 73,458.89 – 1,00,000
• NPV = 158,361.46

Conclusion: Since NPV is positive, the project is financially viable. It indicates that investment is expected to generate value above cost of capital.

2. IRR

Internal Rate of Return tells us about the % of return on investment. IRR is the discount rate at which NPV becomes 0.

Calculation of IRR:

1. IRR needs to be calculated by little trial & error adjustments.
2. Calculate NPV using the discount rate
3. Increase the rate, if NPV is positive, Decrease the rate if NPV is negative and try again
4. Do trial till you hit the target of 0 NPV. The used discounted rate would be the IRR.

Criteria to select the project:

• If IRR > Discount Rate -----> NPV is positive -----> Accept the project
• If IRR < Discount Rate -----> NPV is negative -----> Reject the project
• If IRR = Discount Rate -----> NPV is 0 -----> May Accept the project

Example: A company is considering an investment in a new project that requires an initial investment of INR 1.2Lac. The expected cash inflow of next 5 years is as follows:

• Year 1: INR 30,000
• Year 2: INR 40,000
• Year 3: INR 50,000
• Year 4: INR 60,000
• Year 5: INR 80,000

The cost of capital is 8%.

IRR Calculation:

IRR is rate at which NPV is equal to 0.

NPV = 0 = 30,000/(1+IRR)1 + 40,000/(1+IRR)2 + 50,000/(1+IRR)3 + 60,000/(1+IRR)4 + 80,000/(1+IRR)5 – 1,20,000

After doing trial and error, we will see that NPV is 0 at 15% rate. That means IRR is 15%.

Conclusion: Since IRR > Cost of capital, investment is expected to generate value above cost of capital. Hence, it should be selected.

3. Profitability Index (PI)

In layman terms, Profitability index tells us about the money we are getting back for every penny invested.

Calculation of Profitability Index: Profitability Index = Sum of all cash inflows / Sum of cash outflows

Criteria to select the project:

• If PI > 1 -----> Accept the project
• If PI < 1 -----> Reject the project
• If PI = 1 -----> May Accept the project

Example: A company is considering an investment in a new project that requires an initial investment of INR 2.0 Lac. The expected cash inflow of next 5 years is as follows:

• Year 1: INR 50,000
• Year 2: INR 60,000
• Year 3: INR 70,000
• Year 4: INR 80,000
• Year 5: INR 90,000

The discount rate is 10%.

PI Calculation:

• PI = Present Value of Cash Inflows / Present Value of Cash Outflows
• PI = [50,000/(1+.10)1 + 60,000/(1+.10)2 + 70,000/(1+.10)3 + 80,000/(1+.10)4 + 90,000/(1+.10)5] / 2,00,000
• PI = 1.27

Conclusion: Since PI > 1, project is expected to generate a positive return. Hence, it should be selected.

4. PAYBACK PERIOD

Payback period is the break even point to recover the investment. Payback period is the time (number of years) required to recover the cash outflow invested in the project.

Calculation of Payback Period: Payback period = Number of years before full recovery + Unrecovered Initial Investment at the beginning of the payback year/ Cash Inflow during the payback year

Criteria to select the project:

1. Select the project which has payback period within the maximum period set up my management or industry norms.
2. Project with shortest payback period should be ranked first.

Note: In most of the cases, non-discounted cash flows should be used for payback period calculation instead of discounted cash flows.

Example: A company is considering an investment in a new project that requires an initial investment of INR 1.5 Lac. The expected cash inflow of next 5 years is as follows:

• Year 1: INR 30,000
• Year 2: INR 40,000
• Year 3: INR 50,000
• Year 4: INR 60,000
• Year 5: INR 70,000

Payback Period Calculation

Payback Period = 3 + 30,000/60,000 = 3.5 years

Conclusion: If 3.5 years payback period is below industry norms or maximum ceiling set up management, accept the proposal.

CONFLICTS BETWEEN NPV and IRR

Sometimes NPV and IRR might show conflicting results while evaluating mutually exclusive projects. Mutually exclusive projects are those where one precludes the selection of others.

Example: Project A & Project B are mutually exclusive projects. Discount Rate is 10%. The cash flow for each projects are as follows:

Project A

• Initial Investment = INR 1,00,000
• Cash Inflows = INR 40,000 per year for 3 years

Project B

• Initial Investment = INR 1,20,000
• Cash Inflows = INR 50,000 per year for 3 years

Results:

NPV suggests Project A is more financially attractive while IRR suggests choosing Project B.

Resolution: In such scenario, one should rely more on NPV as it accounts for the time value of money and provides a clear indication of the value added to the company.

The conflict arises because IRR assumes that cash flows are reinvested at the project’s rate of return, which might not be practical. NPV, on other hand, assumes that cash flows are reinvested at the company’s cost of capital, which is a more realistic assumption. Hence, NPV should be preferred over IRR in case of conflicts.