Capital Investment Decisions,

Project Planning and Control

By Anuj Joshi
Anuj G Joshi
Note 1
Principles involved in estimation of Project Cash
Flows

Principle Description
1. Incremental
Approach
Cash Flows are to be estimated in incremental terms, i.e.
difference between the Cash Flows of the Firm without project
and with project.
2. Long Term
Funds Approach
Cash Flows should be assessed from the Total Long-Term Funds
view point, i.e. total of Debt, Preference and Equity Funds.
3. Exclusion of
Financing Costs
Since the Cost of Capital used for discounting purposes includes
the cost associated with Debt, Preference and Equity components
of Capital, Interest on Debt and Dividends (Equity and Preference)
are not considered as Cash Outflows /Expenses in the estimation.
Post Tax Concept Cash Flows are to be defined in post-tax terms. Also, the Cost of
Capital used for discounting should be computed in post-tax
terms.
Anuj G Joshi
Techniques of Project Evaluation
1. Simple Payback Period
2. Discounted Payback Period
3. Payback Reciprocal
4. Accounting or Average Rate of Return
5. Net Present Value (NPV) or Discounted Cash
Flow (DCF)
6. Profitability Index (PI) or Desirability Factor or
Benefit Cost Ratio
7. Internal Rate of Return (IRR) and Modified
Internal Rate of Return (MIRR)
Anuj G Joshi
Note 2
Procedure for computation for Simple Payback Period

a) Determine the Initial Investment (Cash Outflow) of the project.
b) Determine CFAT (Cash Inflows) from the project for various years.
c) Compute Payback period as under
i. Uniform CFAT per annum
Initial Investment
CFAT per annum
ii. Differential CFAT for various years
Compute cumulative CFAT at the end of every year
Determine the year in which cumulative CFAT exceeds Initial Investment
Payback period = Time at which cumulative CFAT = Initial Investment
(calculated on time proportion basis)
d) Accept if Payback Period is less than maximum or benchmark
period, else reject the project.
Anuj G Joshi
Note 3
Procedure for computation for Discounted Payback Period

a) Determine the Total Cash Outflow of the project (Initial Investment).
b) Determine the Cash Inflow After Taxes (CFAT) for each year.
c) Determine the PV factor for each year and compute Discounted CFAT
(DCFAT) for each year.
DCFAT = CFAT of each year X PV Factor for that year
d) Determine the cumulative DCFAT at the end of every year.
e) Determine the year in which cumulative DCFAT exceeds Initial
Investment.
f) Compute Discounted Payback Period as the time at which cumulative
DCFAT = Initial Investment. This is calculated on time proportion basis.
g) Accept if Discounted Payback Period less than maximum/benchmark
period, else reject the project.
Anuj G Joshi
Note 4
Payback Reciprocal

= Average Annual Cash Inflows (CFAT p.a.)
Initial Investment
Anuj G Joshi
Note 5
Procedure for computation of ARR

a) Determine Net Investment of the project.
Net Investment = Initial Investment Salvage Value
b) Determine PAT for each year
PAT = CFAT Depreciation
c) Determine total PAT for N years,
where N = Project Life
d) Compute Average PAT p.a.
= (Total PAT of all years)/N years
e) ARR = Average PAT p.a./Net Investment
Anuj G Joshi
Note 6
Procedure for computation of NPV or DCF

a) Determine the Total Cash Outflow of the project and the time
periods in which they occur.
b) Compute the Total Discounted Cash Outflow
= Outflow X PV factor
c) Determine the Total Cash Inflows of the project and the time
periods in which they arise
d) Compute the Total Discounted Cash Inflows
= Inflow X PV factor
e) Compute NPV
= Discounted Cash Inflows Discounted Cash Outflows
f) Accept project if NPV is positive, else reject.
Anuj G Joshi
Note 7
Desirability Factor

= Present Value of Operational Cash Inflows
Present Value of Net Investments

Accept project if PI is greater than 1, else reject.
Anuj G Joshi
Note 8
Procedure for computation of IRR

a) Determine the total cash outflow of the project and the time periods in
which they occur.
b) Determine the total cash inflows of the project and the time periods in
which they arise.
c) Compute NPV at an arbitrary discount rate, say 10%
d) Choose another discount rate and compute NPV. The second discount
rate is chosen in such a way that one of the NPVs is negative and the
other is positive. Suppose, NPV is positive at 10%, choose a higher
discount rate so as to get a negative NPV. In case NPV is negative at 10%,
choose a lower rate.
e) Compute the change in NPV over the two selected discount rates.
f) On proportion basis, compute the discount rate at which NPV is zero.
Anuj G Joshi
Note 9
Procedure for computation of Modified IRR

a) Determine the total Cash Outflows and Inflows of the project and the time
periods in which they occur.
b) Compute Terminal Value of all Cash Flows other than the Initial Investment.
For this purpose
Terminal Value of a Cash Flow
= Amount of Cash Flow X Reinvestment Factor
where,
Reinvestment Factor = (1+K)
n
[where, n = number of years balance remaining
in the project]
c) Compute Total of Terminal Values as computed under b. This is taken as the
Inflow from the project, to be compared with the Outflow i.e. the initial
investment.
d) Compute MIRR, i.e. Discount Rate such that PV of Terminal Value = Initial
Investment,
Note: For computing MIRR, the interpolation technique applicable to IRR may
be used.
Anuj G Joshi
Note 10
Comparison of two mutually exclusive projects
to be treated when they have Different Project
Durations

A. Equivalent Annual Flows Method
B. LCM Method
C. Terminal Value
Anuj G Joshi
A. Equivalent Annual Flows Method

Cash flows are converted into an equivalent
annual annuity called EAB i.e. Equivalent Annual
Benefit (in case of net inflow) or EAC i.e.
Equivalent Annual Cost (in case of net outflow)
i.e. Total Discounted Cash Flows
Total Discount Factor for the period
The amounts are then compared and decisions
drawn i.e. in case of cost comparison, proposal
with the lower Equivalent Annual Flow will be
selected, and in case of benefit comparison,
proposal with higher Annual Flow will be
selected.
Anuj G Joshi
Procedure for computation of Equivalent Annual Flows
Method

a) Compute the Initial Investment of each alternative
b) Determine the project lives of each alternative
c) Determine the Annuity Factor relating to the project
life of each alternative
d) Compute Equivalent Annual Investment (EAI)
= Initial Investment/Relevant Annuity Factor
e) Compute CFAT per annum or Cash outflows per
annum, of each alternative
f) Compute EAB = CFAT p.a. EAI
Compute EAC = Cash Outflows p.a. + EAI
g) Select Project with maximum EAB or minimum EAI, as
the case may be
Anuj G Joshi
B. LCM Method

Evaluate the alternatives over an interval equal to the
lowest common multiple of the lives of the alternatives
under consideration.
Example, Proposal A has 3 years and Proposal B has 5
years. Lowest common multiple period is 15 years,
during which period Machine A will be replaced 5
times and Machine B will be replaced 3 times. Cash
flows are extended to this period and computations
are made. The final results would then be on equal
platform i.e. equal years and hence would be
comparable.
This is similar to the Equivalent Annual Benefits / Costs
Method, discussed in Point A.
Anuj G Joshi
C. Terminal Value

Estimate the terminal value for the alternatives
at the end of a certain period i.e. product life.
In the above example, if the product can be
produced only for 3 years, the salvage value at
the end of the 3
rd
year should be considered
in the evaluation process.
Anuj G Joshi