Home » **CAPITAL BUDGETING I PRINCIPLES AND TECHNIQUES**

Profitability Index (PI) or Benefit-Cost Ratio (BIC Ratio)
Yet another time-adjusted capital budgeting technique is profitability index PI or benefit-cost ratio (B/c). It is similar to the NPY approach. The profitability index approach measures the present value of returns per rupee invested, while the NPY is based on the difference between the present value of future cash inflows and the present value of cas

Accept-reject Rule
The decision rule is that if the present value of the sum total of the compounded reinvested cash inflows (pvrs) is greater than the present value of the outflows (PVO) the proposed project is accepted otherwise not. Symbolically
PVTS > PVO accept
PVTS < rvo reject
The fi~ would be Indifferent if both

solutions
We would reinvest Rs 4,000 received at the end of the year I for 4 ye:vs at the rate of 6 per cent. Tile cash inflows in year 2 will be re-invested ‘for 3 years at 6 per cent, the cash inflows of year 3 for 2 years and so on. There win-be no reinvestment of cash. inflows received at the end of the fifth year. The total sum of these compounded cash inflows is then discounted back for 5 years at

The terminal value approach ( T v ) even more distinctly separates the timing of the cash inflows and outflows. The assumption behind the I V approach is that each ,cash inflow is reinvested in another asset at a sertain rate of return from the moment it is received until the termination of the project. Consider Example 10.8. Original outlay, Rs 10.000 life of the project, 5 years; Cash in lows, Rs 4,000 each f

Evolution of IRR
The IRR method is a theoretically correct technique to evaluate capital expenditure decisions. II has the advantages which are offered by the NPV criterion such as:.(j) it considers the time value of money. and (ii) it takes into ‘account the total cash inflows and outflows. In addition. the IRR is easier to understand. Business executives and non-technical people understand the concept o

Solution
1. The sum of cash-inflows of l Hitherto machines is Rs 93,000 which when divided by the economic life of the machine (5 rears). results in a ‘fake annuity’ of Rs 18.600.
2. Dividing the blini outlay of Rs by R, 18.600, we have ‘fake average pay hack period’ of 3.017 years.
3. In Table A-4. the factor closest 10 3.017 for ~ rears is 2.991 for a Me of 20 per cent.
4, Since Ihe actu

For a Mixed Stream or Cash Flows
Calculating the IRR for a mixed stream of cash flows is more tedious. In a mixed stream of Cash flows, the inflows in various years are uneven or unequal. One way to simplify the process is to use fake annuity’ as a starting point.P The following procedure is a useful guide to calculating IRR:
1. Calculate the average annual cash inflow 10 get a fake annuity
2. Determine

Solutions
(1) The pay back period is 3.214 (Rs 36,000/Rs 11,200) . .
(2) According to Table A-4. discount factors closest to 3.214 for 5 years are 3.274 (16 per Catt rate”b r interest) and 3.199 (17 per cent rate of interest). The actual value of IRR which lies between 16 per cent and 17 per cent can, now. be determined using Equations 10.11 and 10.12
Instead of using the direct method, we may find the act

computation
Unlike the NPV method, calculating the value of IRR is more difficult. The procedure will depend on whether the cash flows are annuity or mixed stream.
Annuities The following steps are taken in determining IRR for an annuity:
• Determine the pay back period of the proposed investment. .
• In Table A-4 (present value of an annuity) look for the pay back period that is equal to or closest to the

Accept-Reject Decision
The use or the IRR, as a criterion to accept capital investment decisions, involves a comparison of the actual IRR with the required rate of return- also known as the cut-off rate or hurdle rate. TIlt: project would qualify to be accepted if the IRR (r) exceeds the cut-off rate (k). I(the IRR and the required rare or return are equal, the- firm is indifferent as to whether to accept or