Capital Budgeting Tools: How to calculate Payback Period, NPV, IRR and PI ? - Executive MBA

I'm glad that I've found myself back on track for studying what has been going on in the class. Yesterday, I understood about Bonds and How to Calculate the Yield to Maturity of Bonds. You can read it here. Continuing from where I left in the last post last night, I have understood the basic concepts of Capital Budgeting Tools including Payback Period, Internal Rate of Return, Net Present Value and Profitability Index. In this post I'll be talking about all this and how you can use this to making investment decisions. Let's being...

What is Capital Budgeting ?

Before we actually deep dive into understanding how to use the tools to aid your investment decisions, it is important to first understand what Capital Budgeting actually is. So basically, capital budgeting is a process that is undertaken to understand whether the firm's investment in a new project, asset is actually worth or not. You may be investing in stocks and the capital budgeting can be one of the process that can help you understand where you should put your money.

Capital Budgeting Tools

Now that we've understood Capital Budgeting, let's look into the various tools available to help us plan our investment. I'll be talking about 4 basic tools that we've been taught in our Corporate Finance course as a part of the Executive MBA program at NMIMS Hyderabad. The four Capital Budgeting tools are:

1. Payback Period
2. Net Present Value
3. Internal Rate Of Return
4. Profitability Index

Capital Budgeting Tools Courtesy: businessjargons.com

Let's look into each of the tools to understand them better:

Payback Period

Payback Period is the most simplest Capital Budgeting tool. It considers the time you can get your invested money back. So say, there are a couple of project that require an initial investment or Rs 1000. Project A gives you Rs 500 each year for two years while Project B gives you Rs 200 each year for 5 years. So using Payback Period you can decide to put your money in Project A because that's where you are getting your money back the fastest. However this tool has a major drawback. The Payback period doesn't take into consideration the time value of money hence this isn't used widely (at least for high value business investments)

Net Present Value or NPV

Net Present Value or NPV is another tool that is used for Capital Budgeting. This is an advancement over the Payback Period as this takes into consideration the time value of money. So NPV is nothing but the a measurement to calculate the profit that will be generate after subtracting the present value of cash outflow from the present value of cash inflows over a period of time.

NPV = (PV) Cash Outflows - (PV) Cash Inflows

NPV helps in capital budgeting by providing us with the profit that will be generated keeping in mind the time value of cash inflows and outflows. So if there are multiple projects, then you should choose a project that has a positive NPV value because that would mean at the end of the time period, you would get your invested amount plus a profit. Hence take the project that has a positive NPV. 

Example: A company intends to invest Rs 200,000 in a project that would provide a steady cash flow of Rs 31,250 for a period of 6 years. If the discount rate is 10%, what is the NPV of the project. Should the company be investing in the project ?

Time line to calculate the NPV

Solution: The best way to solve any Corporate Finance question that involves time periods is to use time lines. I wish I understood this earlier in class, things would have been simpler. Anyways, Excel will help use get the NPV using the inbuilt formula = NPV(Rate, SUM of Cash Inflows)-Cash Outflow. Constructing the time line and applying the formula we get the answer as Rs -63,898. So since the NPV is negative, the company shouldn't invest in this project. The problems with NPV arises in estimating the future cash flows and also arriving at an appropriate discount rate.

Internal Rate of Return

Internal Rate of Return or IRR is another Capital Budgeting tool that takes into account the time value of money. In simple terms, IRR is the rate at which the NPV = 0. So you first find out the NPV rate of the investment. Then calculate the IRR when the NPV is 0. Now based on the IRR value you decide to accept / reject the project. 

If IRR <  Hurdle Rate --> Reject the Project

If IRR > Hurdle Rate  --> Accept the Project

Again, we have Excel Formula to help us calculate the IRR. So IRR formula basically takes the sum of all the cash inflow and outflows to provide you an answer. This is one way to calculate the IRR. Another way is to first calculate the NPV for the project and then use the Goal Seek feature (I'm in love with this feature since I learnt about this) and change the target NPV to 0 by varying the Discount Rate. So the discount rate at which NPV = 0 is the IRR.

Example: You plan to invest in a scheme where the initial invest is Rs 100. The scheme provides with Rs 30 annually over a period of 6 years. What is the IRR for the project ? Should you invest in the project if the hurdle rate is 12 % ?

Timeline to calculate the IRR

Solution: Plot the timeline and mention the cash inflows and outflows. Use the inbuilt IRR formula to get the answer. Using that we arrive at an IRR of 15.24%. Since this is greater than the hurdle rate of 12%, we should invest in this scheme. 

The problem with IRR arise when the cash flow is not steady. As in you initially invest in a project, get returns for a couple of years and then again invest some amount. So you see there is no steady cash flow - there are inflows, outflows etc. In that case, there can be multiple IRRs and deciding to invest in a project might become tougher. That's when you have a look at the NPV schedule. You accept a project if the hurdle rate is between the values when NPV = 0.

Profitability Index

Profitability Index is a great tool when it comes to choosing of projects. It basically is measures the value created per Rupee. As a manager let's say you have been provided a budget and you have 3 projects in front of you all with a positive NPV value, so which projects you should choose to maximise the profit ? This is where the Profitability index kicks in.

PI = NPV of project / Investment Amount

To choose the best combination of projects to invest in, we use Weighted Average Profitability Index or WAPI. Once you have the PI for the projects, these can be used as weights against the project to choose the best combination. In such cases what you do is basically for each project you calculate the weighted average. Example if a project's initial investment is Rs 20 and your total budget is Rs 50. The PI calculated is let's assume 0.6. Then the weighted average for this project would be (20/50) x 06 = 0.24. You calculate the weighted averages for all the projects in question, their combinations etc. The best combination is the one with the highest WAPI.

That's all I've understood about Capital Budgeting tools. I'm sure you will find this helpful in some way or the other. I've documented it so that I could go through it during my exams and can come back to this whenever needed. Enough of finance gyan tonight, will sign off now. 

Cya !