Capital Budgeting: Techniques (NPV, IRR, Payback, PI) and Decision Rules (Basics) Questions

Q: Explain why NPV is considered superior to payback period (any three points) with a small table.

NPV is superior because it: - considers **time value of money** (discounts cash flows) - uses **cash flows over full project life** - directly measures **value addition** (₹) and supports wealth maximisation | Basis | Payback | **NPV** | |---|---|---| | TVM | ignored | **considered** | | Coverage | up to payback only | **all cash flows** | | Output | time | **₹ value** | Hence, NPV gives a better accept/reject decision.

Question 1

Define capital budgeting.

Accepted Answer

Capital budgeting is the process of evaluating and selecting **long-term investment projects** whose benefits extend over several years.

Question 2

What is initial outlay in a project?

Accepted Answer

Initial outlay is the cash investment at **time 0** (cost of asset + installation + working capital, if any).

Question 3

Define Net Present Value (NPV).

Accepted Answer

NPV is the excess of **present value of cash inflows** over **present value of cash outflows** of a project.

Question 4

What is IRR?

Accepted Answer

IRR is the discount rate at which a project’s **NPV becomes zero**.

Question 5

State one limitation of payback period.

Accepted Answer

Payback period ignores the **time value of money** (and also ignores cash flows after payback).

Question 6

Profitability Index (PI) is also called benefit-cost ratio.

Accepted Answer

True. PI = PV of benefits (inflows) / PV of costs (outflows).

Question 7

State decision rules for NPV, IRR and PI (brief) in a table.

Accepted Answer

Decision rules:

| Method | **Accept when** |
|---|---|
| **NPV** | NPV **> 0** |
| **IRR** | IRR **≥ cost of capital** |
| **PI** | PI **> 1** |

These rules indicate whether the project adds value.

Question 8

Compute payback period if initial outlay is ₹1,00,000 and annual cash inflow is ₹25,000.

Accepted Answer

Payback (equal inflows) = **Initial outlay / Annual inflow**

= 1,00,000 / 25,000 = **4 years**.

| Initial outlay | Annual inflow | **PB** |
|---:|---:|---:|
| 1,00,000 | 25,000 | **4 years** |

Question 9

Compute NPV: Initial outlay ₹1,00,000; inflows ₹40,000 for 3 years; discount rate 10% (use PV factors 0.909, 0.826, 0.751).

Accepted Answer

PV of inflows:

| Year | CF (₹) | PV factor | PV (₹) |
|---:|---:|---:|---:|
| 1 | 40,000 | 0.909 | 36,360 |
| 2 | 40,000 | 0.826 | 33,040 |
| 3 | 40,000 | 0.751 | 30,040 |
|  |  | **Total PV** | **99,440** |

NPV = Total PV − Initial outlay = 99,440 − 1,00,000 = **−560**.

Decision: **Reject** (NPV < 0).

Question 10

Explain why NPV is considered superior to payback period (any three points) with a small table.

Accepted Answer

NPV is superior because it:

- considers **time value of money** (discounts cash flows)
- uses **cash flows over full project life**
- directly measures **value addition** (₹) and supports wealth maximisation

| Basis | Payback | **NPV** |
|---|---|---|
| TVM | ignored | **considered** |
| Coverage | up to payback only | **all cash flows** |
| Output | time | **₹ value** |

Hence, NPV gives a better accept/reject decision.

Question 11

Compute Profitability Index (PI): PV of inflows = ₹1,20,000 and initial outlay (PV of outflows) = ₹1,00,000. State decision.

Accepted Answer

PI = **PV of inflows / PV of outflows**

= 1,20,000 / 1,00,000 = **1.20**.

Decision: **Accept** (PI > 1).

| PV inflows | PV outflows | **PI** |
|---:|---:|---:|
| 1,20,000 | 1,00,000 | **1.20** |

Question 12

Explain discounted payback period (DPB) and how it differs from simple payback (any three points) using a table.

Accepted Answer

Discounted Payback (DPB) is the time to recover initial outlay using **discounted (PV) cash inflows**.

| Basis | Simple payback | **Discounted payback** |
|---|---|---|
| TVM | ignored | **considered** |
| Cash flows used | actual inflows | **PV of inflows** |
| Result | shorter PB | DPB is usually **longer** |

Thus, DPB improves payback by considering time value of money.

Question 13

Explain capital budgeting process (exam-style) using a flowchart and conclude.

Accepted Answer

### Meaning
Capital budgeting is a structured process to select long-term projects that maximise **firm value**.

### Steps (flowchart)
Identify projects → Estimate **cash flows** → Assess **risk** → Choose discount rate (cost of capital) → Apply technique (**NPV/IRR/PI/PB**) → Select/Rank → Implement → Post-audit

| Step | Key output |
|---|---|
| Cash flow estimation | inflows/outflows by year |
| Evaluation | NPV/IRR/PI/PB results |
| Selection | accept/reject or ranking |

### Conclusion
A systematic process reduces decision errors and supports **wealth maximisation**.

Question 14

Explain IRR and how it is found by interpolation (exam-style) with a small working format.

Accepted Answer

### Meaning
**IRR** is the discount rate that makes **NPV = 0**.

### Interpolation idea (basic)
Compute NPV at two rates:
- at lower rate r1: NPV is **positive**
- at higher rate r2: NPV is **negative**

Then approximate IRR:
IRR ≈ r1 + [NPV1 / (NPV1 − NPV2)] × (r2 − r1)

| Rate | NPV sign |
|---:|---|
| r1 | **+** |
| r2 | **−** |

### Conclusion
Accept the project if **IRR ≥ cost of capital**.

Question 15

Differentiate between NPV and IRR (exam-style) and state which is preferred when they conflict (use a table).

Accepted Answer

### Difference

| Basis | **NPV** | **IRR** |
|---|---|---|
| Output | ₹ value added | % return |
| Reinvestment assumption (basic) | at cost of capital | at IRR |
| Use | accept/reject; ranking | accept/reject; ranking |

### Preference in conflict
For **mutually exclusive** projects with conflicting rankings, **NPV is generally preferred** because it measures absolute value addition and aligns with **wealth maximisation**.

### Conclusion
Use NPV as primary criterion; IRR can be used as a supporting indicator.

Method	Accept when
NPV	NPV > 0
IRR	IRR ≥ cost of capital
PI	PI > 1

Capital Budgeting: Techniques (NPV, IRR, Payback, PI) and Decision Rules (Basics)

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