Capital Budgeting 1_1

7/28/2019 Capital Budgeting 1_1

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CAPITAL BUDGETING

Capital budgeting refers to the process where we makedecisions concerning investments in the long-termassets of the firm.

Capital budgeting is a decision situation where largefunds are committed (invested) in the initial stages of

the project and the returns are expected over a longerperiod of time usually more than one year and in casethis decision goes wrong, it can not be changed whichwill affect the future growth of the firm.

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FEATURES OF CAPITAL BUDGETING

1. Capital budgeting decisions have long-

term implications.

2. These decisions involve substantial

commitment of funds.

3. These decisions are irreversible and

require analysis of minute details.

4. These decisions determine and affect thefuture growth of the firm.


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Decision-making Criteria in Capital

Budgeting

How do we decide if acapital investment

project should beaccepted or rejected?

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To make decisions, we need:

Initial cash investment/outflows

Future cash benefits/inflows

Rate of return (why)

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A case study

Suppose ABC firm must decidewhether to purchase a new machine

for Rs. 1,00,000. This machine isexpected to generate annual cashinflows of Rs. 20,000, Rs. 50,000 and

Rs. 60,000 during next 3 years at 10%capitalisation rate. How do wedecide?

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Problems and constraints in cabital

budgeting

Time factor

Calculation of required rate ofreturn

Calculation of future benefits

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Capital budgeting process

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Evaluation consists of: Estimating relevant cash outflows and cash

inflows Estimating Appropriate rate of return

Comparing relevant cash outflows and cashinflows by any suitable technique to take thedecision:

1. Payback period2. Average rate of return3. Net present value4. Profitability index5. Internal rate of return

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Estimating relevant cash outflows and cash

inflows Estimating relevant cash outflows and cash inflows

depend upon the nature of investment decisions:

1. Single/Independent decisions2. Replacement decisions

3. Mutually Exclusive decisions

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Single/Independent decisionsCalculation of CO Cost of new plant

+ Installation expenses+ Other Capital expenditure

+ Additional working capital

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Single/Independent decisions Calculation of CI for subsequent years

Cash sales revenue

- Cash operating cost

= Cash inflows before tax (CFBT)

- Depreciation= Profits before tax/Taxable income

- Tax

= Profit after tax+ Depreciation

= Cash inf lows after tax (CFAT)

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Single/Independent decisionsCalculation of CI for TERMINAL CASH

FLOW:

Cash inflows after tax (CFAT) for last year+ Working capital released

+ Scrap value of the plant (if any).

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Case A cosmetic company is considering introducing a new

lotion. The manufacturing equipment will cost Rs.5,60,000. Working capital requirement is expected toincrease by Rs. 40,000. The expected life of the equipmentis 8 years. The company is thinking of selling the lotion atRs. 12 each pack. It is estimated that variable cost per pack

would be Rs. 6 and annual fixed cost Rs. 3,50,000. Thecompany expects to sell 1,00,000 packs of the lotion eachyear. Tax rate is 45% and straight-line depreciation isallowed for tax purpose. Calculate the cash flowsassumimg:

1. Working capital requirement remains same eachyear.

2. Working capital requirement increases by Rs. 5,000each year

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ANOTHER CASE

A manufacturing department of a firm estimates that 3,000units of a product can be sold annually at a unit cash saleprice of Rs. 14. The cash variable expenses will be Rs.9 perunit. It will also involve cash fixed cost of Rs. 5,000 yearly.The machine to manufacture the product is available at Rs.50,000. It expected useful life is 10 years. The installationcost would amount to Rs. 10,000. As a result of the

acquisition of the machine, the working capitalrequirement will increase by Rs. 40,000. The firm uses thestraight line method (SLM) of depreciation and is in the50% tax bracket. Your are required to compute the relevantcash flows associated with the acquisition of the machine,

assuming There is no salvage value The salvage value is Rs. 2,000 but for depreciation purpose:

a) It is ignoredb) it is considered

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Lets try..

A firm plans to buy an asset costing Rs.1,00,000 and expects CFBT to be Rs.30,000 p.a. Depreciation will be

charged @20% WDV. Tax rate is 30%.Estimated life is 4 years after which it

will be disposed off for Rs. 45,000. Your

are required to compute the relevantcash flows

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REPLACEMENT PROJECTS

Calculation of COCost of new plant

+ Installation expenses

+ Other Capital expenditure

+ Additional working capital Salvage value of old plant

+ Tax liability on account of

capital gain on sale of old plant /

Taxbenefit on account of capital loss onsale of old plant

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REPLACEMENT PROJECTS

Calculation of CI for subsequent years

(incremental basis i.e., new

old)Cash sales revenue (N-O)

- Cash operating cost (N-O)= Cash inflows before tax (CFBT)

- Depreciation (N-O)= Profits before tax/Taxable income- Tax= Profit after tax+ Depreciation (N-O)= Cash inflows after tax (CFAT) (N-O)

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Case A firm is currently using a machine which was purchased 2 years ago

for Rs. 70,000 and has a remaining useful life of 5 years. It isconsidering to replace the machine with a new one which will cost Rs.1,40,000. The cost of installation will amount to Rs. 10,000. Theincrease in working capital will be Rs. 20,000. The expected cashinflows before depreciation and taxes are as follows

Year Existing Machine New Machine

1 30,000 50,000 2 30,000 60,000 3 30,000 70,000 4 30,000 90,000 5 30,000 1,00,000

The firm uses SLM and is in 40% tax bracket. Calculate cash flowsassuming sale value of old machine is 1) 80,000

2) 60,0003) 50,0004) 30,000

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Lets try.. ABC Ltd. in considering an investment proposal for which the relevant

information is as follows Purchase price of the new asset Rs.I0,00,000 Installation costs 2,00,000 increase in working capital in year zero 2,50,000 Scrap value of the new asset after 4 years 3,50,000 Revenues from new asset (Annual) 21,50,000

Cash expenses on new asset (Annual) 9,50,000 Current Book value (old asset) 4,00,000 Present scrap value (old asset) 5,00,000 Revenue from old asset (Annual) 19,25,000 Cash expenses on old asset (Annual) 11,25,000

Planning period is 4 years. Depreciation on new asset: 92% the cost is to be depreciated in the

ratio of5:8:6:4 over 4 years. Existing asset is depreciated at a rate of Rs.1,00,000 p.a. Tax rate is 40%. Your are required to compute the relevantcash flows

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Mutually Exclusive

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2. DECISION CRITERIA

TECHNIQUES OF EVALUATION

Traditional or Time-adjusted orNon-discounting Discounted cash flows

1. Payback period 1. Net Present Value

2. Accounting Rate of 2. Profitability Index

Return 3. Internal Rate of Return


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Case A company is considering an investment proposal to instal new

milling controls. It will cost Rs. 50,000. The facility has a lifeexpectancy of 5 years and no salvage value. Company tax rate is

35%. The firm uses straight line depreciation. The estimated cashflows before depreciation and tax from the proposed investmentproposal are as follows:

Year Cashflows1 Rs. 10,0002 Rs. 10,692

3 Rs. 12,7694 Rs. 13,4625 Rs. 20,385

Compute the following: (a) Payback period.

(b) Average Rate of Return. (c) Net Present Value at 10% discount rate. (d) Profitability Index at 10% discount rate. (e) Internal Rate of Return

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TRADITIONAL OR NON-DISCOUNTING

TECHNIQUES

I . PAYBACK PERIOD:

The number of years required to recover

a projects cost,

or how long does it take to get thebusinesss money back?


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Is a 3.33 year payback period good? Is it acceptable?

Firms that use this method will

compare the payback calculation tosome standard set by the firm.

If our senior management had set a

cut-off of 5 years for projects likeours, what would be our decision?

Accept


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Unequal Cash inflowsPB ?

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0 1 2 3 4 5 86 7

(500) 100 150 200 100 150 100 50 150

Payback period = 3.5 years.


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TRY.. Delhi Machinery Manufacturing Company wants to replace

the manual oprations by new machine. There are twoalternative models X and Y of the new machine. UsingPayback period, suggest the most profitable investment.

Ignore taxation.X Y

Initial Investment (Rs.) 9,000 18,000Estimated life of the machine (Years) 4 5

Estimated savings in cost (Rs.) 500 800Estimated savings in Wages (Rs.) 6000 8000Additional cost of maintenance (Rs.) 800 1000Additional cost of supervision (Rs.) 1200 1800

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Critical evaluationStrengths of Payback:

1. Easy to calculate and understand.

2. It serves the purpose of FM as it is based oncash flow analysis.

3. Provides an indication of a projects risk.Project with shorter PB will be less risky

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Critical evaluationDrawbacks of Payback Period:

1.The payback period does not indicate whether the

project should be accepted or rejected. Forexample, we dont know whether 4.56 years is agood payback period, or not.

2. Cash flows that occur after the end of the payback

time are ignored in the calculation of paybackperiod. Yet, these latter cash flows may besignificant in making the decision.

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Example(500) 150 150 150 150 150 (300) 0 0

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0 1 2 3 4 5 86 7

This project is clearly unprofitable, but we

would accept it based on a 4-year payback

criterion!


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Discounted Payback

Discounts the cash flows at thefirms required rate of return.

Payback period is calculated usingthese discounted net cashflows.Problems:

Di d P b k


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Discounted Payback

0 1 2 3 4 5

(500) 250 250 250 250 250

Discounted

Year Cash Flow CF (14%)

0 -500 -500.00

1 250 219.30

Di t d P b k


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Discounted Payback

0 1 2 3 4 5

(500) 250 250 250 250 250

Discounted


0 -500 -500.00

1 250 219.30 1 year

280.70

Di t d P b k


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Discounted Payback

0 1 2 3 4 5

(500) 250 250 250 250 250

Discounted


0 -500 -500.00

1 250 219.30 1 year

280.70

2 250 192.38

Di t d P b k


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Discounted Payback

0 1 2 3 4 5

(500) 250 250 250 250 250

Discounted


0 -500 -500.00

1 250 219.30 1 year

280.70

2 250 192.38 2 years

88.32

Di t d P b k


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Discounted Payback

0 1 2 3 4 5

(500) 250 250 250 250 250

Discounted


0 -500 -500.00

1 250 219.30 1 year

280.70

2 250 192.38 2 years

88.32

3 250 168.75


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Di t d P b k


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Discounted Payback

0 1 2 3 4 5

(500) 250 250 250 250 250

Discounted


0 -500 -500.00

1 250 219.30 1 year

280.70

2 250 192.38 2 years

88.32

3 250 168.75 .52 years

The Discounted

Payback

is 2.52 years


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II . ACCOUNTING RATE OF RETURN (OR) AVERAGERATE OF RETURN (ARR)

# ARR is a measure based on accounting profits ratherthan the cash flows. The ARR may be defined as the annualized

net income earned on the average funds invested in a project.

COMPUTATION OF ARR:

Average Annual profit (after tax)

ARR = x 100

Average Investment in the Project


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Critical evaluation Merits

1). Easy to understand. Necessary information tocalculate average rate of return are available easy.

2). This method takes into account all the profitsduring the life time of the project, whereas pay backperiod ignores the profits accruing after the pay backperiod

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Critical evaluation Demerits

1). Ignores the time value of money.2). Does not use cash flow so it does not serve the

purpose of FM.3) ARR method does not consider the sizeof investment for each project. It may be time that thecompeting ARR of two projects may be the same but

they may require different average investments.

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DISCOUNTED CASH FLOWS OR TIME

ADJUSTED TECHNIQUES

These are based upon the fact that the cash flows occurring at

different point of time are not having same economic worth i.e.,TVM


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Time Value of MoneyWhich would you prefer -- $10,000 todayor $10,000 in5 years?

Obviously, $10,000 today.

A dollar received today is worth more than a dollarreceived tomorrow This is because a dollar received today can be invested to

earn interest

Uncertainty Preference for present consumption

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How can one compare amounts in

different time periods? One can adjust values from different time periods

using an interest rate.

Two techniques:

1. Compounding Technique

2. Discounting Technique

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. NET PRESENT VALUE (NPV) METHOD The NPV of an investment proposal may be defined as

the sum of the present values of all the cash inflowsless the sum of present values of all the cash outflows

associated with the proposal. The decision rule is Accept the proposal if its NPV is

positive and reject the proposal if the NPV is negative.

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Case XYZ Company is considering replacement of its existing

machine by a new machine, which is expected to cost Rs.1,60,000. The new machine will have a life of 5 years and willyield annual cash revenue of Rs. 2,50,000 and incur annualcash expenses of Rs. 1,30,000. The estimated salvage valueof the new machine is nil. The existing machine has a book

value of Rs. 40,000 and can be sold for Rs. 20,000 today. Itis good for next 5 years and is estimated to generate annualcash revenue Rs. 2,00,000 and to involve annual cashexpenses of Rs. 1,40,000. Its salvage value after 5 years iszero. Corporate tax rate is 40%. Depreciation rate is 25% on

WDV method. The companys opportunity cost of capital

is 20%. Ignore taxes on profit or loss on sale of machine.Advice whether the company should replace the machineor not.

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Non conventional caseMachine A costs Rs. 1,00,000 payable immediately. Machine Bcosts Rs. 1,20,000 half payable immediately and half payable inone years time. The cash inflows expected are as follows:

Year (at end) Machine A Machine B

1 Rs. 20,000 2 60,000 Rs. 60,000 3 40,000 60,000; 4 30,000 80,000; 5 20,000

At 7% opportunity cost, which machine should be selected on the

basis of NPV?

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Try this.

ABC Ltd. is in the business of manufacturing X product. It has aplant on a piece of landwhich was purchased 10 years ago for 10lakhs. The firm now plans to set up another plant on the sameland(50% of the existing plant). Capital Expenditure for settingup new plant (incurred in the beginning of the year):

Year 1 Cost of land Rs. 5,00,000Land Development 17,00,000

Payment for purchase of Machine 20,00,000Year 2 Final payment for Land Development 15,00,000Final payment to Machine supplier 70,00,000

The machine has an estimated useful life of5years and thecompany follows SL method of depreciation. The informationregarding sales and operational expenses is as follows

Year 1 2 3 4 5Sales (Rs. lacs) 25 30 35 40 45Expenses (Rs. lacs) 5 7 10 12 15

If the companys rate of discount is15% and the tax rate is 50%,should the above proposal be accepted assuming no depreciationon land.

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Critical evaluation - merits

1 It recognizes the time value of money.

2. The NPV technique considers the entirecash flow stream and all the cash inflows andoutflows.

3. It serves the purpose of FM as it is based

on cash flow analysis.4. This method is particularly useful for theselection of Mutually Exclusive projects(mostly the case with the companies) .5. It represents the net contribution of aproposal towards the wealth of the firm and istherefore, in full conformity with theobjective of maximization of the wealth ofthe shareholders.

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Critical evaluation - demeritsi) It involves difficult calculations .ii) The NPV technique requires thepredetermination of the required rate of return, k,

which itself is a difficult job. If the value of the kis not correctly taken, then the whole exercise ofthe NPV may give wrong results.

iii) The decision under the NPV technique isbased on a value which is an absolute measure. Itignores the difference in initial outflows, size ofdifferent proposals etc. while evaluating mutuallyexclusive proposals.

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I I PROFITABILITY INDEX METHOD


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I I . PROFITABILITY INDEX METHOD:

This technique is a variant of the NPV technique and is also

known as BENEFIT - COST RATIO or PRESENT VALUE INDEX.

Total present value of cash inflows

PI =

Total present value of cash outflows.

Accept the project if its PI is more than 1 and reject

the proposal if the PI is less than 1.


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Calculation of IRR1) When CI are equal

2) When CI are unequal

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IRR- When CI are equal

A firm is evaluating a proposalcosting Rs. 1,00,000 and havingannual inflows of Rs. 25,000

occurring at the end of each of nextsix years. Calculate the IRR of theproposal

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Step 1 Calculate PB period = CO / Equal CI

The payback period in the given case is 4 years.

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Step 3 In order to make aprecise estimate ofthe IRR, find outthe NPV of the

project for boththese rates. OneNPV will bepositive and otherwill be negative.

At 12%, NPV=25,000X 4.111 1,00,000

= Rs. +2,775.

At 13%, NPV=

25,000X 3.998 1,00,000

= Rs. -50.

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Try this.A project costs Rs. 36,000 and is

expected to generate cash

inflows of Rs. 11,200 annually for5 years. Calculate IRR

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IRR- When CI are unequalA firm is evaluating a proposal

costing Rs. 50,000 and having

annual inflows of Rs. 10,000;10,450; 11,800; 12,250; 16,750

occurring at the end of each of next5 years. Calculate the IRR of theproposal

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Self assessment


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Self assessment A company is considering as to which of two mutually exclusive

projects it should undertake. The Finance Director thinks that

the project with the higher NPV should be chosen whereas theManaging Director thinks that the one with the higher IRRshould be~ undertaken especially as both projects have the sameinitial outlay and length of life. The company anticipates a cost ofcapital of 10% and the net after-tax cash flows of the projects areas follows:(Figures in Rs. 000)

Year 0 1 2 3 4 5 Project X (200) 35 80 90 75 20 Project Y (200) 218 10 10 4 3Required:a) Calculate the NPV and IRR of each project.

b) State, with reasons, which project you would recommended.

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T i l


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Typical caseA share of the face value of Rs. 100 has current

market price of Rs. 480. Annual expected dividendis 30%. During the fifth year, the shareholder isexpecting a bonus in the ratio of 1:5. Dividend rateis expected to be maintained on the expandedcapital base. The shareholder intends to retain theshare till the end of the eighth year. At that timethe value of share is expected to be Rs. 1,000.

Additional expenses at the time of purchase andsale are estimated at5% on the market price. There

is no tax on dividend income and capital gain. Theshareholder expects a minimum return of15% perannum. Should he buy the share

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2. Reinvestment rate assumption The IRR criterion implicitly assumes that the cash flow

generated by the projects will be reinvested at theinternal rate of return, that is, the same rate as the

proposal itself offers. With the NPV method, theassumption is that the funds released can bereinvested at a rate equal to the cost of capital, that is,the required rate of return.

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The crucial factor is which assumption is


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correct?

The assumption of the NPV method is consideredto be superior theoretically because it has the

virtue of having a rate which can consistently be

applied to all investment proposals.

In contrast to the NPV method, the IRR methodassumes a high reinvestment rate for investment

proposals having a high IRR and a low investmentrate for investment proposals having a low IRR

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Therefore it becomes importantto incorporate consistent

reinvestment rate in IRR. ButHOW ?????

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Th M difi d I t l R t f R t


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The Modified Internal Rate of Return

Modified Internal Rate of Return or MIRR is the

investor's required rate of return which equates theInitial Cost Outlay with the present value of futurevalue of cash inflows

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Conti The modified IRR

(MIRR) is the averageannual rate of returnthat will be earned on aninvestment if the cash

flows are reinvested atthe specified rate ofreturn (usually, theWACC)

To calculate the MIRR,

first find the total futurevalue of the cash flows atthe reinvestment rate,and then apply theformula:

MIRRFVCF

IO

N 1

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The MIRR: An ExampleAssume that your company is investigating a newlabor-saving machine that will cost $10,000. Themachine is expected to provide cost savings each

year as shown in the following timeline:

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0 1 2 3 4 5

2000 2500 3000 3500 4000-10,000


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Conclusion This is the amount that

you will have accumulatedby the end of the life of theinvestment

Now, find the averageannual rate of return

Since the MIRR is greaterthan the WACC, this

project is acceptable

MIRR 1834256

10000

1 12899%5.

.

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3. Multiple Rates of Return If a project has more than one rate of return, howwould you make an accept/reject decision?

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Investment Classification


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Simple Investment

Def: Initial cash flowsare negative, and onlyone sign change occursin the net cash flows

series. Example: -$100, $250,

$300 (-, +, +)

ROR: A unique ROR

Non simple Investment

Def: Initial cash flowsare negative, but morethan one sign changesin the remaining cashflow series.

Example: -$100, $300, -$120 (-, +, -)

ROR: A possibility ofmultiple RORs

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Multiple Rates of Return Problem

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Find the rate(s) of return:

2$2,300 $1,320( ) $1, 000

1 (1 )

0

PW ii i

CO $1,000

CI $2,300

CO $1,320


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Let Then,

Solving for yields,

or

Solving for yields

or 20%

xi

PW ii i

x x

x

x x

i

i

1

1

000300

1

320

1

000 300 320

0

10 11 10 12

10%

2

2

.

( ) $1,$2,

( )

$1,

( )

$1, $2, $1,

/ /


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Plot for Investment with Multiple Rates of Return

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Why use MIRR versus IRR?


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Why use MIRR versus IRR?

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MIRR correctly assumes reinvestmentat opportunity cost = WACC and alsoavoids the problem of multiple IRRs.

Managers like rate of returncomparisons, so when there are nonnormal CFs and more than one IRR,MIRR is better than IRR


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Net Present Value(NPV) A

Snapshot The Net Present Value (NPV) or Net Present

Worth (NPW) of a investment proposal, is definedas the sum of the present values (PVs) of the

individual cash Inflows less the sum of presentvalue of all the cash outflows associated with theproposal

The decision rule is

Accept the proposal if itsNPV is positive and reject the proposal if the NPVis negative.

Internal Rate of Return(IRR)


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The IRR of a proposal is defined as the discountrate which produces a zero NPV, i.e., the IRR is thediscount rate which will equate the present value

of cash inflows with the present value of cashoutflows

It is also known as Marginal Rate of Return or

Time Adjusted Rate of Return If IRR > Cost of Capital, then the project is

accepted, If IRR < Cost of Capital, then project isRejected

Internal Rate of Return(IRR)A Snapshot


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Similarities between NPV and IRR

Both NPV and IRR will gave the same result (i.e.t d j ti ) di i t t


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acceptance and rejection) regarding an investmentproposal in the following cases:

When project involving conventional cash flows Independent Investment Proposals, i.e. , acceptance of

which does not preclude the acceptance of the others(Single Machine)

Reason for the same results is, NPV will be positiveonly when the actual return on investment is morethan the cut-off rate (required rate of return/ cost ofcapital), whereas IRR support projects in whose case

the IRR is more than the cut-off rate

Consider the following case


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Consider the following case

(Already discussed) Following information regarding Machine A is availableand suggest that machine will be purchased or not on the

basis of NPV method and IRR method:Cash Outflow Rs. 50,000Cost of Capital 10%

Year CFAT PVF@10 %1 Rs. 10,000 .9092 Rs. 10,450 .8263 Rs. 11,800 .7514 Rs. 12,250 .683

5 Rs. 16,750 .621

NPV (-4648) Reject the proposalIRR (6.58%) Reject the proposal


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The big Q?

Will the two methods always give the same

answer?

No, unfortunately not


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Dissimilarities between NPV and

IRR

In certain situations NPV and IRR gives contradictoryl h h if NPV h d fi d l


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results such that if NPV methods find one proposalacceptable, while IRR favors the other

This sort of problems will be faced in mutuallyexclusive projects

The problem of the conflicting results can be classifieddue to the following differences in the projects

Size Disparity problem Time Disparity problem

Unequal expected lives


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Size Disparity Problem It arises when the initial investment in mutuallyexclusive projects are different

Particulars Project A Project BCash Outlays (Rs. 5000) (Rs 7500)

Cash Inflow at

the end of year

6250 9150

Cost of Capital 10%

NPV @10% 681.25 817.35

IRR 25% 22%

Time Disparity Problem


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This problem arises when the cash

flow pattern of mutually exclusiveprojects is different. i.e., most ofthe cash flows from one projectcome in the early years, while mostof the cash flows from the other

project come in the later years

Example already discussed


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Example already discussed A company is considering as to which of two mutually

exclusive projects it should undertake. The FinanceDirector thinks that the project with the higher NPVshould be chosen whereas the Managing Directorthinks that the one with the higher IRR should beundertaken especially as both projects have the sameinitial outlay and length of life. The companyanticipates a cost of capital of 10% and the net after-tax cash flows of the projects are as follows:(Figures in Rs. 000)

Year 0 1 2 3 4 5 Project X (200) 35 80 90 75 20 Project Y (200) 218 10 10 4 3

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Proposals having unequal lives If a firm is evaluating two mutually exclusive proposals

having unequal lives, then the decision may be takenin normal course on the basis of NPV of the two

proposals. The proposal with the higher NPV will beselected. The difference in economic lives may not beof much importance, unless they can be repeatedindefinitely.

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Example


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A firm is evaluating the following two proposals @15% discountrate

Year X Y 0 24,000 44,000

1 14,000 16,000

2 14,000 16,000

3 14,000 16,000

4 16,000

5 16,000

Evaluate the proposal if:

1) They are one off investment2) They can be repeated indefinitely.

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This is done by Equivalent Annuity Method (EAM).

The equivalent annuity is defined as the amount ofannuity for n years, which has a present valuesdiscounted at r percent per annum equivalent to thegiven amount.

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In our case, The project X has the NPV of Rs. 7,962.

Considering this to be the present value of annuityof three years at discount rate of 15%, the annuity

amount can be calculated asX/1.15+ X/(1.15)(1.15)+ X/(1.15)(1.15)(1.15)=7962

Annuity Amount (X) = Rs.7,962/2.283

= Rs.3,488.

Similarly, for project Y,

Annuity Amount (Y) = Rs.9,632/3.352

= Rs.2,873.

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Interpretation


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ProjectXProject X is giving NPV of Rs. 7,962 after

a period of every three years. This can also beconsidered as an annuity of Rs. 3,488 for threeyears; and with replacement every three years, thiscan be considered as a perpetuity of Rs.3,488

forever. Project Y: Project Y is giving NPV of Rs. 9,632 after

a period of every five years. This can also beconsidered as an annuity of Rs. 2,873 for five years;and with replacement every five years, this can beconsidered as a perpetuity of Rs. 2,873 forever.

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Question is To select between the NPV of Rs. 7,962 (Project X)

every three years or the NPV of Rs. 9,632 (Project Y)every five years. Now, in the light of the above, the

same can be expressed as a choice between aperpetuity of Rs. 3,488 (Project X) and Rs. 2,873(Project Y). The choice now, is obvious and the firmwill like to select project X only.

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Conclusion


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To conclude, the two methods would give similar accept-reject decisions in the case of independent conventional

investments. They would, however, rank mutually exclusiveprojects differently in the case of the (i) size-disparityproblem, (ii) time-disparity problem, and (iii) unequalservice life of projects.

The ranking by the NPV decision criterion would be

theoretically correct as it is consistent with the goal ofmaximization of shareholders wealth. Further, thereinvestment rate of funds released by the project is basedon assumptions which can be consistently applied. The IRRcan, of course, be modified by adopting the incrementalapproach to resolve the conflict in ranking. But it involves

additional computation. Another deficiency of the IRR isthat it may be indeterminate and give multiple rates in thecase of a non-conventional cash flow pattern. In sum,therefore, the NPV emerges as a superior evaluationtechnique.

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CAPITAL BUDGETING PRACTICES IN INDIA

1 Capital budgeting decisions are undertaken at the


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1. Capital budgeting decisions are undertaken at the

top management level and are planned in

advance. The Corporates follow mostly top-downapproach in this regard.

2. Discounted cash flow techniques are more

popular now.3. High growth firms use IRR more frequently

whereas Payback period is more widely used by

small firms.

4. PI technique is used more by public sector units

than by private sector units.

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Capital Budgeting 1_1