1. Investment decisions

2.  Capital budgeting decisions
 Evaluation criteria DCF –NPV-IRR
 Reinvestment assumption
 Modified IRR
 Investment decision under inflation
 Complex investment decisions
 Investment decisions under capital rationing

3.  Is the process of making investment
decisions in capital expenditures
 A capital expenditure may be defined as an
expenditure the benefits of which are
expected to be received over a period of time
exceeding one year.
 The main characteristic of capital
expenditure is that expenditure is incurred at
one point of time where as benefits of
expenditure are realized at different points
of time in future.

4.  Cost of acquisition of permanent assets
land & buildings, Plant & machinery,
goodwill etc
 Cost of addition, expansion, improvement
or alteration in the fixed assets
 Cost of replacement of permanent assets
 Research and development project cost

5.  According to CharlesT.Horngreen “ capital
budgeting is long term planning for making
finance proposed capital outlays”.

6.  Large investments
 Long – term commitment of funds
 Irreversible in nature
 Long – term effect on profitability
 Difficulties of investment decisions
 National importance

7.  Identification of investment proposals
 Screening the proposals
 Evaluation of various proposals
 Fixing priorities
 Final approval and preparation of capital
expenditure budget
 Implementing proposal
 Performance review

8.  Accept or reject decisions
 Mutually Exclusive project decisions
 Capital rationing decisions

9.  Traditional or Non-discounted methods
 (i) Pay back period
 (ii) Accounting rate of return
 Modern or Discounted Cash flow
 (i) Net present value
 (ii) Internal rate of return
 (iii) Profitability index

10.  A project costs Rs.1,00,000 and yields an
annual cash inflow of Rs.20,000 for 8
years. Calculate its payback.
 Pay back period = Initial investment /
Annual cash flows
 1,00,000/20,000 = 5 years

11.  Accept less than cut off point or standard
point
 Reject if the pay back period is greater
than cut off point or standard point

12.  XYZ ltd is considering two projects. Each
projects requires an investment of
Rs.10,000. The firm’s cost of capital is 10%.
The net cash inflows from investments in
two projects X and Y are as follows:
 The company has fixed 3 years PBP as cut
off point. State which project should be
accepted?

13. Years Cash flows Cumulative cash flows
1 5,000 5,000
2 4,000 9,000
3 3,000 12,000
4 1,000
5 -
Years 1 2 3 4 5
X 5,000 4,000 3,000 1,000 -
Y 1,000 2,000 3,000 4,000 5,000

14.  2+ 10,000 – 9,000 / 3,000 = 2+ 0.33
 2.33 years

15.  This method takes into consideration the
time value of money and attempts to
calculate the return on investments by
introducing the factor of time element.
 The net present values of all inflows and
outflows of cash occurring during the
during the entire life of the project is
determined separately for each year by
discounting these flows cost of capital or
pre-determined rate.

16.  Accept when it is positive
 Reject when it is negative

17.  NPV = Present value of cash inflows –
Present value of cash outflows
 No project is acceptable unless the yield is
10%. Cash inflows of a certain project
along with cash outflows are given below:
 The salvage value at the end of 5th year is
40,000. Calculate NPV
Years 0 1 2 3 4 5
Cash flow 1,50,000 30,000 - - - -
Cash flow - 20,000 30,000 60,000 80,000 30,000

18.  Calculation of present value of cash
outflows
Years Cash flow PV factor @
10%
Pv of cash flow
0 1,50,000 1 1,50,000
1 30,000 0.909 27,270
Total 1,77,270

19. Years Cash flow PV factor @ 10% Pv of cash inflows
1 20,000 0.909 18,180
2 30,000 0.826 24,780
3 60,000 0.751 45,060
4 80,000 0.683 54,640
5 30,000 0.621 18,630
5 40,000(scrap value) 0.621 24,840
Total 1,86,130

20. NPV = 1,86,130 – 1,77,270 = 8,860
2. From the following information calculate
the net present value of the two projects
and suggest which of the two projects
should be accepted assuming a discount
rate of 10%.

21.  The profits before depreciation and after
taxes (cash flows) are as follows:
Particulars year1 year2 year3 year4 year5
Project X 5,000 10,000 10,000 3,000 2,000
ProjectY 20,000 10,000 5,000 3,000 2,000

22. Particulars Project X ProjectY
Initial investment 20,000 30,000
Estimated life 5 years 5 years
Scrap value 1,000 2,000

23.  It is e net present valuknown as time
adjusted rate of return, discounted cash flow,
yield method. The cash flows of a project are
discounted at a suitable rate by trial and
error method.
 It equates the net present value so calculated
to the amount of the investment.
 Since the discount rate is determined
internally, this method is called as internal
rate of return

24.  Initial outlay / Annual cash flow
 Problem:
 Initial outlay : 50,000
 Life of the asset : 5 years
 Estimated annual cash flow: 12,500
 Calculate the internal rate of return.
 50,000/12,500 = 4
 Decision rule :
 Accept if the IRR is greater than cost of
capital
 Reject if the IRR is lesser than cost of capital

25.  Initial investment : 60,000
 Life of the asset : 4 years
 Estimated net annual cash flows:
 1 year : 15,000
 2 year : 20,000
 3 year : 30,000
 4 year : 20,000
 Calculate internal rate of return

26. Years Cash flows Discount rate @
14%
PV cashflows
1 15,000 0.877 13,155
2 20,000 0.769 15,380
3 30,000 0.674 20,220
4 20,000 0.592 11,840
Total 60,595

27. Years Cash flows Discount rate @
15%
PV cashflows
1 15,000 0.869 13,035
2 20,000 0.756 15,120
3 30,000 0.657 19,710
4 20,000 0.571 11,420
TOTAL 59,285

28.  IRR = LDR + (Initial investment – cash flows of
lower discount rate /( Initial investment – cash
flows of lower discount rate +Initial
investment -cash flows of higher discount
rate ) * (HDR –LDR)
 14%+ 595/595+715 * (15%-14%) = 14.45%

29.  It is also called as Benefit cost ratio, it is
the relationship between present value of
cash inflows and the present value of cash
outflows.
 PI = PV of cash inflows/ PV of Outflows
 Decision rule:
 Accept when it is greater than 1
 Reject if it is lesser than 1

30.  Differences between the NPV and IRR
 The net present value method and the
Internal rate of return method are similar
in the sense that both are modern
techniques of capital budgeting and both
take into account the time value of money.
 There are certain basic differences
between these two methods of capital
budgeting.

31.  Conflicting ranking: is conflict in ranking of a
given project by NPV or IRR resulting from
differences in magnitude or timing of cash
flows.
 Differences in ranking by the these two
methods will arise in case of mutually
exclusive projects.
 The differences can be illustrated under the
following heads:

32.  Size disparity problem
 Time disparity problem
 Unequal expected lives
 Size disparity problem:This arises when the
initial investment in projects under
consideration that is mutually exclusive
projects is different.The cash outlay of some
projects is larger than that of others. In such a
situation the NPV and IRR will give a different
ranking.

33.  A and B are mutually exclusive investments
involving different outlays:

Particulars Project A Project B Project B-A
Cash outtlays (5,000) (7,500) (2,500)
Cash inflows at
the end of year 1
6,250 9,150 2,900
IRR% 25 22 16
Cost of capital 10
NPV 681.25 817.35

34.  The mutually exclusive proposals may differ
on the basis of the pattern of cash flows
generated, although their initial investment
may be the same.This may be called the time
disparity problem.
 It may be the conflict arising because of
conflict in ranking of proposals by NPV and
IRR which have different cash flow patterns.
In such cases NPV method would give
superior results than IRR.

35.  Another situation in which the IRR and the
NPV methods would give conflicting ranking
to mutually exclusive projects is when the
projects have different expected lives.
 The conflict in the ranking by the two
methods in such cases may be resolved by
adopting a modified procedure.
 There are two approaches to do this(i)
Common time horizon (ii) equivalent annual
value or cost

36.  Common time horizon:This approach makes
a comparison between projects that extends
over multiples of the each.
 Equivalent annual value: Evaluates unequal
lived projects that converts the net present
value of unequal lived mutually exclusive
projects into an equivalent (in NPV terms)
annual amount.

37.  The conflict between these two methods is
mainly due to different assumptions with
regard to reinvestment rate on funds
released from the proposal.
 The assumption underlying the IRR method
seems to be incorrect and deficient.
 The IRR method implicitly assumes that the
cash flows generated by the projects will be
reinvested at the internal rate of return I,e the
same rate as the proposal itself offers.

38.  With the NPV method the assumption is that
funds released can be reinvested at the rate
equal to the cost of capital I,e required rate of
return.
 The assumption of the NPV method is
considered to be theoretically superior
because it has the virtue of having a rate
which is consistently be applied to all
investment proposals.

39.  In contrast to NPV method,The IRR method
assumes a high reinvestment rate of
investment proposals having a high IRR and a
low investment proposals having a low IRR.
 The implicit reinvestment rate will differ
depending upon the cash flow stream for
each investment proposal.
 It is the rate at which interim cash flows can
be invested.

40.  Both NPV and IRR will show similar results in
the following cases:
 (i) Independent investment proposals which
do not compete with one another and which
may be either accepted or rejected on the
basis of a minimum required rate of return.
 (ii) Conventional investment proposals which
involve cash outflows or outlays in the initial
period followed by a series of cash inflows.

41.  The reason why they provide similar results is
on the basis of decision making.
 Under NPV method proposal is accepted with
NPV positive, where as under IRR method it is
accepted if the internal rate of return is
higher than the cut off rate.
 The projects which have positive NPV will
have internal rate of return higher than the
required rate of return.