Capital BudgetingCapital Budgeting

Vrushali M. PalodkarVrushali M. Palodkar Roll No : 31Roll No : 31

Capital BudgetingCapital Budgeting:: While long-term investment decisions may take less of a typical finance manager’s time than working capital decisions, capital budgeting decisions affect the business for years to come, and are critical to strategic success and survival.

Steps to capital budgetingSteps to capital budgeting

1.1. Estimate CFs (inflows & outflows).Estimate CFs (inflows & outflows).

2.2. Assess riskiness of CFs.Assess riskiness of CFs.

3.3. Determine the appropriate cost of capital.Determine the appropriate cost of capital.

4.4. Find IRR.Find IRR.

5.5. Accept if IRR > WACC.Accept if IRR > WACC.

Internal Rate of Return (IRR)Internal Rate of Return (IRR)

IRRIRR: : the return on the firm’s the return on the firm’s invested capital. invested capital. IRR is simply IRR is simply the rate of return that the firm the rate of return that the firm earns on its capital budgeting earns on its capital budgeting projects.projects.

Advantages of IRRAdvantages of IRR

It takes into account the time value of money.It takes into account the time value of money. It considers cash flows throughout the project’s life.It considers cash flows throughout the project’s life. It does not use the concept of required rate of return or the It does not use the concept of required rate of return or the

cost of capital, it itself provide a rate of return which is cost of capital, it itself provide a rate of return which is indicative of profitability.indicative of profitability.

It gives more psychological satisfaction to the user, since it It gives more psychological satisfaction to the user, since it is calculated by the method of trial and error.is calculated by the method of trial and error.

It is consistent with the objective of shareholders welth It is consistent with the objective of shareholders welth maximization.maximization.

Limitations of IRRLimitations of IRR

It is difficult to understand and to calculate since it It is difficult to understand and to calculate since it involves tedious calculations.involves tedious calculations.

It implies that profit can be reinvested at internal It implies that profit can be reinvested at internal rate of return, which is not logical.rate of return, which is not logical.

It produces multipal rate of return which can be It produces multipal rate of return which can be confusing.confusing.

It may not give fruitful results in case of unequal It may not give fruitful results in case of unequal projects life, unequal cash outflows, and projects life, unequal cash outflows, and difference in the timing of cash flows.difference in the timing of cash flows.

Internal Rate of Return (IRR)Internal Rate of Return (IRR)

IRR= L1+IRR= L1+ NPVL1NPVL1

NPVL1-NPVL2NPVL1-NPVL2

×(L2-L1)

ExampleExample From the following find out IRR.From the following find out IRR.

YearYear 00 11 22 33 44 55

Project XProject X 200200 3535 8080 9090 7575 2020

Project YProject Y 200200 218218 1010 1010 44 33

L1=10% and L2=20%

NPV of Project XNPV of Project XYearYear CICI PVPV PV.CIPV.CI

11 3535 0.9090.909 31.81531.815

22 8080 0.8260.826 66.0866.08

33 9090 0.7510.751 67.5967.59

44 7575 0.6830.683 51.22551.225

55 2020 0.6210.621 12.4512.45

CI = 229.128CI = 229.128

(-)Outflow = 200.000(-)Outflow = 200.000

NPVL1 = 29.13NPVL1 = 29.13

L1=10%

NPV of Project XNPV of Project XYearYear CICI PVPV PV.CIPV.CI

11 3535 0.8330.833 29.15529.155

22 8080 0.6940.694 55.5255.52

33 9090 0.5780.578 52.0252.02

44 7575 0.4820.482 36.1536.15

55 2020 0.4010.401 8.028.02

CI = 180.86CI = 180.86

(-)Outflow = 200.000(-)Outflow = 200.000

NPVL1 = 19.14NPVL1 = 19.14

L1=20%

IRR = L1+IRR = L1+ NPVL1NPVL1

NPVL1-NPVL2NPVL1-NPVL2×(L2-L1)

=10% + IRR = 10% +IRR = 10% + 29.1329.13

29.13-(-19.14).(20%-10%)

= 16.03%

NPV of Project YNPV of Project YYearYear CICI PVPV PV.CIPV.CI

11 218218 0.9090.909 198.162198.162

22 1010 0.8260.826 8.268.26

33 1010 0.7510.751 7.517.51

44 44 0.6830.683 2.7322.732

55 33 0.6210.621 1.8631.863

CI = 218.527CI = 218.527

(-)Outflow = 200.000(-)Outflow = 200.000

NPVL1 = 18.527NPVL1 = 18.527

L1=10%

NPV of Project YNPV of Project YYearYear CICI PVPV PV.CIPV.CI

11 218218 0.8330.833 181.594181.594

22 1010 0.6940.694 69.469.4

33 1010 0.5780.578 59.859.8

44 44 0.4820.482 1.9241.924

55 33 0.4010.401 1.2031.203

CI = 313.921CI = 313.921

(-)Outflow = 200.000(-)Outflow = 200.000

NPVL1 = 113.921NPVL1 = 113.921

L1=20%

IRR = L1+IRR = L1+ NPVL1NPVL1

NPVL1-NPVL2NPVL1-NPVL2×(L2-L1)

=10% + IRR = 10% +IRR = 10% + 18.52718.527

18.527-113.921.(20%-10%)

= 18.82%

IRRIRR

Decision RuleDecision Rule::

If IRR is greater than or equal If IRR is greater than or equal to the required rate of return, to the required rate of return, ACCEPTACCEPT..

If IRR is less than the required If IRR is less than the required rate of return, rate of return, REJECTREJECT..

ConclusionConclusion

IRR method can be used to make good IRR method can be used to make good decisions about capital budgeting decisions about capital budgeting investments.investments.

ReferanceReferance

Financial ManagementFinancial Management

-R. M. Shrivastava-R. M. Shrivastava www.google.com

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