This chapter discusses various capital budgeting techniques for evaluating investment projects, including net present value (NPV), internal rate of return (IRR), payback period, and profitability index. It recommends using NPV as the primary decision rule, as NPV accounts for the time value of money and considers all cash flows. IRR can produce incorrect decisions for projects with multiple IRRs, differing scales of investments, or non-standard cash flow timing. Payback period ignores the time value of money.
The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.
Describes in detail the steps involved in the calculation of Internal Rate of Return. Useful to students of Under graduate, post graduate and professional course students pursuing course in finance
The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.
Describes in detail the steps involved in the calculation of Internal Rate of Return. Useful to students of Under graduate, post graduate and professional course students pursuing course in finance
Payback period (PP) is the number of years it takes for a company to recover its original investment in a project, when net cash flow equals zero. In the calculation of the payback period, the cash flows of the project must first be estimated. The payback period is then a simple calculation.
What is the 'Time Value of Money - TVM'
The time value of money (TVM) is the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. TVM is also referred to as present discounted value.
BREAKING DOWN 'Time Value of Money - TVM'
Money deposited in a savings account earns a certain interest rate. Rational investors prefer to receive money today rather than the same amount of money in the future because of money's potential to grow in value over a given period of time. Money earning an interest rate is said to be compounding in value.
BREAKING DOWN 'Compound Interest'
Compound Interest Formula
Compound interest is calculated by multiplying the principal amount by one plus the annual interest rate raised to the number of compound periods minus one.The total initial amount of the loan is then subtracted from the resulting value.
This pdf is only to learn payback, timevalue of money and IIr
and there example are also given by me to easy to lean there example if any doute then contact me...
Capital Budgeting is about how one should evaluate the financing options based on the superior financial performance through mathematical techniques. These techniques have been discussed in the presentation in detail.
Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. It may be positive, zero or negative.
NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.
Also known as sophisticated technique for capital budgeting exercise.
It accounts for time value of money by using discounted cash flows in the calculation.
Payback period (PP) is the number of years it takes for a company to recover its original investment in a project, when net cash flow equals zero. In the calculation of the payback period, the cash flows of the project must first be estimated. The payback period is then a simple calculation.
What is the 'Time Value of Money - TVM'
The time value of money (TVM) is the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. TVM is also referred to as present discounted value.
BREAKING DOWN 'Time Value of Money - TVM'
Money deposited in a savings account earns a certain interest rate. Rational investors prefer to receive money today rather than the same amount of money in the future because of money's potential to grow in value over a given period of time. Money earning an interest rate is said to be compounding in value.
BREAKING DOWN 'Compound Interest'
Compound Interest Formula
Compound interest is calculated by multiplying the principal amount by one plus the annual interest rate raised to the number of compound periods minus one.The total initial amount of the loan is then subtracted from the resulting value.
This pdf is only to learn payback, timevalue of money and IIr
and there example are also given by me to easy to lean there example if any doute then contact me...
Capital Budgeting is about how one should evaluate the financing options based on the superior financial performance through mathematical techniques. These techniques have been discussed in the presentation in detail.
Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. It may be positive, zero or negative.
NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.
Also known as sophisticated technique for capital budgeting exercise.
It accounts for time value of money by using discounted cash flows in the calculation.
Explain the general concept of opportunity cost of capital.
Distinguish between the project cost of capital and the firm’s cost of capital.
Learn about the methods of calculating component cost of capital and the weighted average cost of capital.
Understand the concept and calculation of the marginal cost of capital.
Recognise the need for calculating cost of capital for divisions.
Understand the methodology of determining the divisional beta and divisional cost of capital.
Illustrate the cost of capital calculation for a real company.
Understand the nature and importance of investment decisions.
Distinguish between discounted cash flow (DCF) and non-discounted cash flow (non-DCF) techniques of investment evaluation.
Explain the methods of calculating net present value (NPV) and internal rate of return (IRR).
Show the implications of net present value (NPV) and internal rate of return (IRR).
Describe the non-DCF evaluation criteria: payback and accounting rate of return and discuss the reasons for their popularity in practice and their pitfalls.
Illustrate the computation of the discounted payback.
Describe the merits and demerits of the DCF and Non-DCF investment criteria.
Compare and contract NPV and IRR and emphasise the superiority of NPV rule.
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Slide 1
8-1
Capital Budgeting
• Analysis of potential projects
• Long-term decisions
• Large expenditures
• Difficult/impossible to reverse
• Determines firm’s strategic direction
When a company is deciding whether to invest in a new project, large sums of money can be at stake. For
example, the Artic LNG project would build a pipeline from Alaska’s North Slope to allow natural gas to
be sent from the area. The cost of the pipeline and plant to clean the gas of impurities was expected to be
$45 to $65 billion. Decisions such as these long-term investments, with price tags in the billions, are
obviously major undertakings, and the risks and rewards must be carefully weighed. We called this the
capital budgeting decision. This module introduces you to the practice of capital budgeting. We will
consider a variety of techniques financial analysts and corporate executives routinely use for the capital
budgeting decisions.
1. Net Present Value (NPV)
2. Payback Period
3. Average Accounting Rate (AAR)
4. Internal Rate of Return (IRR) or Modified Internal Rate of Return (MIRR)
5. Profitability Index (PI)
Slide 2
8-2
• All cash flows considered?
• TVM considered?
• Risk-adjusted?
• Ability to rank projects?
• Indicates added value to the firm?
Good Decision Criteria
All things here are related to maximize the stock price. We need to ask ourselves the following
questions when evaluating capital budgeting decision rules:
Does the decision rule adjust for the time value of money?
Does the decision rule adjust for risk?
Does the decision rule provide information on whether we are creating value for the firm?
Slide 3
8-3
Net Present Value
• The difference between the market value of a
project and its cost
• How much value is created from undertaking
an investment?
Step 1: Estimate the expected future cash flows.
Step 2: Estimate the required return for projects of
this risk level.
Step 3: Find the present value of the cash flows and
subtract the initial investment to arrive at the Net
Present Value.
Net present value—the difference between the market value of an investment and its cost.
The NPV measures the increase in firm value, which is also the increase in the value of what the
shareholders own. Thus, making decisions with the NPV rule facilitates the achievement of our
goal – making decisions that will maximize shareholder wealth.
Slide 4
8-4
Net Present Value
Sum of the PVs of all cash flows
Initial cost often is CF0 and is an outflow.
NPV =∑
n
t = 0
CFt
(1 + R)t
NPV =∑
n
t = 1
CFt
(1 + R)t
- CF0
NOTE: t=0
Up to now, we’ve avoided cash flows at time t = 0, the summation begins with cash flow zero—
not one.
The PV of future cash flows is not NPV; rather, NPV is the amount remaining after offsetting the
PV of future cash flows with the initial cost. Thus, the NPV amount determines the incremental
value created by unde.
Chapter- III Techniques of Capital Budgeting
Concept, Significance, Nature and classification of capital budgeting decisions, cash flow computation- Incremental approach; Evaluation criteria- Pay Back Period, ARR, NPV, IRR and PI methods; capital rationing, Capital budgeting under risk and uncertainty.
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2. 5-2
Key Concepts and Skills
Be able to compute payback and discounted
payback and understand their shortcomings
Be able to compute the internal rate of return and
profitability index, understanding the strengths
and weaknesses of both approaches
Be able to compute net present value and
understand why it is the best decision criterion
3. 5-3
Chapter Outline
5.1 Why Use Net Present Value?
5.2 The Payback Period Method
5.3 The Discounted Payback Period Method
5.4 The Internal Rate of Return
5.5 Problems with the IRR Approach
5.6 The Profitability Index
5.7 The Practice of Capital Budgeting
4. 5-4
5.1 Why Use Net Present Value?
Accepting positive NPV projects benefits
shareholders.
NPV uses cash flows
NPV uses all the cash flows of the project
NPV discounts the cash flows properly
5. 5-5
The Net Present Value (NPV) Rule
Net Present Value (NPV) =
Total PV of future CF’s + Initial Investment
Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs
Minimum Acceptance Criteria: Accept if NPV > 0
Ranking Criteria: Choose the highest NPV
6. 5-6
Calculating NPV with Spreadsheets
Spreadsheets are an excellent way to compute
NPVs, especially when you have to compute
the cash flows as well.
Using the NPV function:
The first component is the required return entered
as a decimal.
The second component is the range of cash flows
beginning with year 1.
Add the initial investment after computing the
NPV.
7. 5-7
5.2 The Payback Period Method
How long does it take the project to “pay
back” its initial investment?
Payback Period = number of years to recover
initial costs
Minimum Acceptance Criteria:
Set by management
Ranking Criteria:
Set by management
8. 5-8
The Payback Period Method
Disadvantages:
Ignores the time value of money
Ignores cash flows after the payback period
Biased against long-term projects
Requires an arbitrary acceptance criteria
A project accepted based on the payback
criteria may not have a positive NPV
Advantages:
Easy to understand
Biased toward liquidity
9. 5-9
5.3 The Discounted Payback Period
How long does it take the project to “pay
back” its initial investment, taking the time
value of money into account?
Decision rule: Accept the project if it pays
back on a discounted basis within the specified
time.
By the time you have discounted the cash
flows, you might as well calculate the NPV.
10. 5-10
5.4 The Internal Rate of Return
IRR: the discount rate that sets NPV to zero
Minimum Acceptance Criteria:
Accept if the IRR exceeds the required return
Ranking Criteria:
Select alternative with the highest IRR
Reinvestment assumption:
All future cash flows are assumed to be
reinvested at the IRR
11. 5-11
Internal Rate of Return (IRR)
Disadvantages:
Does not distinguish between investing and
borrowing
IRR may not exist, or there may be multiple IRRs
Problems with mutually exclusive investments
Advantages:
Easy to understand and communicate
12. 5-12
IRR: Example
Consider the following project:
0 1 2 3
$50 $100 $150
-$200
The internal rate of return for this project is 19.44%
32
)1(
150$
)1(
100$
)1(
50$
2000
IRRIRRIRR
NPV
+
+
+
+
+
+−==
13. 5-13
NPV Payoff Profile
0% $100.00
4% $73.88
8% $51.11
12% $31.13
16% $13.52
20% ($2.08)
24% ($15.97)
28% ($28.38)
32% ($39.51)
36% ($49.54)
40% ($58.60)
44% ($66.82)
If we graph NPV versus the discount rate, we can see the IRR
as the x-axis intercept.
IRR = 19.44%
($100.00)
($50.00)
$0.00
$50.00
$100.00
$150.00
-1% 9% 19% 29% 39%
Discount rate
NPV
14. 5-14
Calculating IRR with Spreadsheets
You start with the same cash flows as you did
for the NPV.
You use the IRR function:
You first enter your range of cash flows, beginning
with the initial cash flow.
You can enter a guess, but it is not necessary.
The default format is a whole percent – you will
normally want to increase the decimal places to at
least two.
15. 5-15
5.5 Problems with IRR
Multiple IRRs
Are We Borrowing or Lending
The Scale Problem
The Timing Problem
16. 5-16
Mutually Exclusive vs. Independent
Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g., acquiring an
accounting system.
RANK all alternatives, and select the best one.
Independent Projects: accepting or rejecting one
project does not affect the decision of the other
projects.
Must exceed a MINIMUM acceptance criteria
17. 5-17
Multiple IRRs
There are two IRRs for this project:
0 1 2 3
$200
$800
-
$200
-
$8
00
($100.00)
($50.00)
$0.00
$50.00
$100.00
-50% 0% 50% 100% 150% 200%
Discount rate
NPV
100% = IRR2
0% = IRR1
Which one should
we use?
18. 5-18
Modified IRR
Calculate the net present value of all cash
outflows using the borrowing rate.
Calculate the net future value of all cash
inflows using the investing rate.
Find the rate of return that equates these
values.
Benefits: single answer and specific rates for
borrowing and reinvestment
19. 5-19
The Scale Problem
Would you rather make 100% or 50% on your
investments?
What if the 100% return is on a $1
investment, while the 50% return is on a
$1,000 investment?
20. 5-20
The Timing Problem
0 1 2 3
$10,000 $1,000
$1,000
-
$10,000
Project A
0 1 2 3
$1,000 $1,000
$12,000
-
$10,00
0
Project B
22. 5-22
Calculating the Crossover Rate
Compute the IRR for either project “A-B” or “B-A”
Year Project A Project B Project A-B Project B-A
0 ($10,000) ($10,000) $0 $0
1 $10,000 $1,000 $9,000 ($9,000)
2 $1,000 $1,000 $0 $0
3 $1,000 $12,000 ($11,000) $11,000
($3,000.00)
($2,000.00)
($1,000.00)
$0.00
$1,000.00
$2,000.00
$3,000.00
0% 5% 10% 15% 20%
Discount rate
NPV
A-B
B-A
10.55% = IRR
23. 5-23
NPV versus IRR
NPV and IRR will generally give the same
decision.
Exceptions:
Non-conventional cash flows – cash flow signs
change more than once
Mutually exclusive projects
Initial investments are substantially different
Timing of cash flows is substantially different
24. 5-24
5.6 The Profitability Index (PI)
Minimum Acceptance Criteria:
Accept if PI > 1
Ranking Criteria:
Select alternative with highest PI
InvestentInitial
FlowsCashFutureofPVTotal
PI =
25. 5-25
The Profitability Index
Disadvantages:
Problems with mutually exclusive investments
Advantages:
May be useful when available investment funds
are limited
Easy to understand and communicate
Correct decision when evaluating independent
projects
26. 5-26
5.7 The Practice of Capital Budgeting
Varies by industry:
Some firms may use payback, while others choose
an alternative approach.
The most frequently used technique for large
corporations is either IRR or NPV.
27. 5-27
Example of Investment Rules
Compute the IRR, NPV, PI, and payback period
for the following two projects. Assume the
required return is 10%.
Year Project A Project B
0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150
28. 5-28
Example of Investment Rules
Project A Project B
CF0 -$200.00 -$150.00
PV0 of CF1-3 $241.92 $240.80
NPV = $41.92 $90.80
IRR = 0%, 100% 36.19%
PI = 1.2096 1.6053
29. 5-29
Example of Investment Rules
Payback Period:
Project A Project B
Time CF Cum. CF CF Cum. CF
0 -200 -200 -150 -150
1 200 0 50 -100
2 800 800 100 0
3 -800 0 150 150
Payback period for project B = 2 years.
Payback period for project A = 1 or 3 years?
30. 5-30
NPV and IRR Relationship
Discount rate NPV for A NPV for B
-10% -87.52 234.77
0% 0.00 150.00
20% 59.26 47.92
40% 59.48 -8.60
60% 42.19 -43.07
80% 20.85 -65.64
100% 0.00 -81.25
120% -18.93 -92.52
32. 5-32
Summary – Discounted Cash Flow
Net present value
Difference between market value and cost
Accept the project if the NPV is positive
Has no serious problems
Preferred decision criterion
Internal rate of return
Discount rate that makes NPV = 0
Take the project if the IRR is greater than the required return
Same decision as NPV with conventional cash flows
IRR is unreliable with non-conventional cash flows or mutually exclusive
projects
Profitability Index
Benefit-cost ratio
Take investment if PI > 1
Cannot be used to rank mutually exclusive projects
May be used to rank projects in the presence of capital rationing
33. 5-33
Summary – Payback Criteria
Payback period
Length of time until initial investment is recovered
Take the project if it pays back in some specified period
Does not account for time value of money, and there is an
arbitrary cutoff period
Discounted payback period
Length of time until initial investment is recovered on a
discounted basis
Take the project if it pays back in some specified period
There is an arbitrary cutoff period
34. 5-34
Quick Quiz
Consider an investment that costs $100,000 and has a
cash inflow of $25,000 every year for 5 years. The
required return is 9%, and payback cutoff is 4 years.
What is the payback period?
What is the discounted payback period?
What is the NPV?
What is the IRR?
Should we accept the project?
What method should be the primary decision rule?
When is the IRR rule unreliable?