Pay back period method, NPV, PI, IRR with illustration.

1. Investment Decision
The investment decision is concerned with the selection of
assets in which funds will be invested by a firm
Capital Budgeting
Where to invest the money?
Through

2. $60,00,000 $70,00,000 $50,00,000

3. Capital Budgeting
Capital budgeting refers to the process of making decision
regarding capital investment in fixed assets such as machinery,
land, building etc.
Process of Capital Budgeting
Planning Evaluation Selection Implementation
Estimation
of cash
flow
Evaluation
techniques
Control
Review

4. Evaluation Techniques
Non - Discounting Discounted
Non-discounting method
 It is simple and easy to use.
 But these do not consider the time value of money
or inflation.
 There are two main non-discounting methods.
• Payback Period method
• Accounting rate of return

5. Pay back Period method
 This is the simplest and one of the most widely used methods in
India.
 It simply takes into account the time and cash flow.
 When the project cash flow will return the initial investment is the
only criteria under this method.
Accounting Rate of Return Method
 PBP method does not consider the cash flows beyond payback
period, whereas this method takes into consideration projects
total cash flow.
 In this method many rate of returns can be calculated for
different type of analysis.
The formula for ARR ;
ARR = Average annual profit
Initial investment

6. Years Total invest = 1,00,000 for 7 years
1 10,000
2 25,000
3 35,000
4
PBP Method
30,000
5 35,000
6 15,000
7 40,000

7. Discounting Methods
 Major advantage of discounting techniques is that they
take care of inflation and time value of money.
 There are many discounting techniques but most
widely used are ;
Discounting Methods
• Net Preset value (NPV)
• Internal rate of return (IRR)
• Profitability index or (PI)

8. Net present value;
 The net present value of project is the sum of cash flows that are
expected to occur over the life of the project.
 It consider the project suitable for investment if project return a
positive NPV value and reject the project if the NPV is negative.
Internal rate of return ;
 IRR of a project is the discount rate which makes its NPV equal to
zero. So, it is the discount rate which equates the present value of
future cash flows with the initial investment.
 It considers the project suitable for investment if project returns an
IRR greater than cost of capital and reject the project if IRR is less than
cost of capital.

9. Profitability Index or Benefit cost Ratio
• It is ratio of the present value of benefits to
the present value of investment.
Present value of benefits
initial investment
BCR =
• It considers only those projects suitable for
investment which return index value more than 1.

10. Investment evaluation
Method % of companies
considering importance
Internal rate of return 85
Pay back period 67
Net present value 58
Profitability index 35

11. Example
The expected cash flow of a project are;
Years Cash Flow(Rs)
1 20,000
2 30,000
3 40,000
4 50,000
5 30,000
The cash outflow is Rs. 1,00,000
The cost of capital is 10%
Calculate the following;
1.) NPV 2.) Profitability index
3.) IRR 4.) Pay back period

12. Computation of NPV and PI
Year Cash flow(Rs) PV Factor
@10%
PV of cash
flow(Rs)
1 20,000 0.909 18,180
2 30,000 0.826 24,780
3 40,000 0.751 30,040
4 50,000 0.683 34,150
5 30,000 0.620 18,600
Total cash inflow 1,25,750
Less; cash outflow 1,00,000
NPV 25,750
P.I 1.2575

13. Computation of IRR
Year Cash flow(Rs) PV Factor
@19%
PV of cash
flow(Rs)
PV Factor
@18%
PV of cash
flow(Rs)
1 20,000 0.84 16,800 0.847 16,940
2 30,000 0.706 21,180 0.718 21,540
3 40,000 0.593 23,720 0.609 24,360
4 50,000 0.499 24,950 0.516 25,800
5 30,000 0.42 12,600 0.437 13,110
Total cash inflow 99,250 1,01,750
Less; cash
outflow
1,00,000 1,00,000
NPV -750 +1750

14. NPV of higher rate
IRR = higher rate - *1
difference in cash flows
IRR = 19 – 750/2500 * 1
= 18.7%
Prepared by Gurjot Singh