Hi there, this is Imran here in this video you would learn about return on investment techniques such as net present value internal rate of return profitability index and payback period these are also called as Capital budgeting techniques the knowledge that you would acquire by learning capital budgeting techniques would be helpful for you in project management program management financial management and for students who are attending and via tasks if you’re preparing for PMP or prince2 it is very important for you to learn the Capital budgeting techniques because you may get a couple of questions in exams that you may need to answer with respect to decisions you make to choose between different projects and if you are a project manager and if you are not aware of capital budgeting techniques then I would say you must learn the capital budgeting techniques and the recently it could help you to make informed decisions when you’re faced with challenges with respect to the financial viability and business justification of projects capital budgeting techniques fall under the branch of financial management let me give you a brief overview of where does the capital budgeting technique fit into under financial management the financial management is primarily divided into 201 corporate finance to account in your control these are further divided into sub functions each function is a big subject in itself and would take hours if not days to learn about each function and our focus would be on capital budgeting, the reason why I am showing you the financial management overview is that it would help you to understand where exactly the capital budgeting technique fit into under financial management and if an organization decides to undertake a project it could usually do two studies one is technical feasibility and other is finish survival if the project is not technically feasible then there is no point in going ahead with the project and if the project is technically feasible and then the organization’s would conduct financial viability for the projects with the help of Capital budgeting okay so the point is what exactly is capital budgeting technique capital budgeting technique is a planning process it determines whether it is worth to take our invest organisations capsule into projects and it always works for the benefit of the firm by increasing its financial value and before we get started to learn about capital budgeting techniques it is very important for you to learn among the terms discounted cash flow and non discounted cash flow so the question is what is discounted cash flow and to explain this you must first understand the time has a money value discounted cash flow takes the time value of money into consideration for example the money in hand today it invested in the bank will earn let’s say 6% per annum so this six percent can be considered as a discounted cash flow and you need to remember one thing it’s not only about the interest rate it could also be the rate of return that an organization gets back if it invests the money in a business which could earn more than the interest rate and let’s say 8% rate of return is what we are getting by investing the capital in a business then this 8% rate of return should be considered as a discounted cash flow and this discounted cash flow is also called as opportunity cost of capital or sometimes it is referred as cost of capture and now let’s move on to non discounted cash flow now this is simple it does not take time value of money into consideration so therefore the interest or the rate of Britain is not taken into consideration now let’s see what is opportunity cost of cats what is opportunity cost of capital opportunity cost of capital is something that you would give up in order to get something else let me ask you this question what do you think is the opportunity cost for me for making this video if I’m not making this video for you then I would be spending this I’m going out with my friends or I would be spending

time with my one-and-a-half here please so the opportunity cost of making this video is the time lost spending with my kid or with my friends and it applies to everyone even you watching this video if you’re not watching this video then you would be doing something else and the opportunity costs for you would be that something else and then the big question comes why do people let go the opportunity cost the reason is because people think rational meaning you weigh the pros and cons of all mutually exclusive alternatives available you would choose the best alternative available at that point in time because people expect to achieve greater benefits choosing one alternative over the other mutually exclusive opportunity discounted cash flow is nothing but the opportunity cost of capital so when I say this houndred cash flow it also means that I’m referring to the opportunity cost of capital or just say cost attached now let’s look at these capital budgeting methods a net present value internal rate of return profitability index these capsule budgeting techniques would always consider the discounted cash flow without taking into consideration the opportunity cost of capsule or the discounted cash flow we cannot calculate the net present value or internal rate of return or profitable limits however payback period the opportunity cost of capsule is an optional mostly when calculating payback period the discounted cash flow is not considered now let’s look at the future value present value let’s understand the relationship between future value of money in present value for example let’s say you have 100 dollars in hand today then what would be the future value of that hundred dollars after one year similarly if you’re going to get $100 after one year for sure then what is the present value of that hundred dollars now you should be able to calculate the future value or the present value if one of the two information is available to us we can calculate using the formula FV is equal to P V multiplied by 1 plus K whole power M K in this formula is the discount rate in other words it is also the opportunity cost and n is the number of years now let’s look at calculating the future value and present value with some examples let’s first look at calculating the future value if you have $100 and if you invest that money in a bank today and Bank promised you who give you 8 percent per annum interest what would be the future value of that hundred dollars after first year fifth year and 15 Q now here $100 is the present value of the capsule and 8% is the opportunity cost of capsule now 8% means 8 500 that is equal to 0.08 and 1 plus K here is 1 plus 0.08 that is 1 point zero eight now you can see this on the screen here 1 plus K value K value and present run now let’s use the formula and calculate the future value moons now that we know the present value 1 plus K value and the N value it’s easy to calculate the future value future value after 1 year is $100 multiplied by 1 point 0 H to the power of 1 and that gives you 108 dollars in future value after five years is $100 multiplied by 1 point zero eight to the power of five and if you do the calculations it will give you one hundred and forty six dollars and similarly we can calculate the future value 100 dollars for any period of time using the formula it could be for 15 years or any number of years and for 15 years we are getting the value is three hundred and seventeen dollars now I would request you after you watch this video come back to the video again pause the video on the screen take a pen and paper in hand and do the calculations this would help you to get prepared for the examinations and do this for all the examples in this

video that I show for calculations now let’s look at how to calculate the present value let’s say you have three scenarios where you are going to get hundred dollars after one year five years in fifteen years then what would be the value of one hundred dollars today now we have the formula through which we can calculate the future value we would use the same formula to calculate the present value the formula is present value is equal to future value divided by one plus K to the power of n here the future value is $100 and the opportunity cost of capsule is given as eight dollars eight percent sorry now using the formula we can calculate the present value the present value of $100 to be received after one year would be 100 divided by one point zero eight and that would give you 93 dollars and similarly we can calculate the present value of $100 to be received after five years or 15 years and for that matter any period of time as long as we know the future value in the discount rates now on the screen I’ve just done the calculations for the present value for present value for one year present value for five years present value for 15 years now you can just pause the screen and you can do the calculations or you can come back and do the calculations now that we have learned how to calculate the present value and future value it is just a cakewalk for you to calculate the net present value and before we learn how to calculate the net present value let’s look at the few important points that we need to keep in mind and remember in order to calculate the net present value net present value is determined by subtracting present value of all cash outflows from the present value of all cash inflows meaning you would need to take into consideration all the cash inflows for a project and calculate their present value and we need to sum up all the present values and from the sum of all present values you will need to subtract the cash outflows and that would give you the net present value I know you’re confused a little bit here but do not worry this would become clear when you look at an example in the next coming slide and this is very important to remember once we calculate the net present value it should always be positive for the project being accepted if the net present value is negative that means the project is not enhancing a viable now let’s get into the nitty-gritty of calculating the net present value here is an example a sum of $400,000 is invested in an IT project and below we have the cash inflows to the project up to a period of five years and the opportunity cost of capsule is given as eight-person all we need to do is calculate the net present value and bases the net present value decide if the project is worth undertaking or do we need to reject the project see in this example the $400,000 is spent out right initially fit is called a cash outflow and coming to the revenue from the project at the end of first year the project generates $70,000 and at the end of second year the project generous $120,000 and at the end of third year it generates one $40,000 and for fourth year it generates one $40,000 and at the end of fifth year it generates $40,000 now that we know how to calculate the present value we need to calculate the present value for year one that is for $70,000 in for year two that is 120 thousand dollars in for a 3-1 $40,000 and year for again one $40,000 in for efi same $40,000 now once we get the present value for the EO one two three four five we need to sum them up and subscribe to $400,000 and that gives us the net present value information and if the net present value is positive you should accept the project and if it is negative you should check the hose I have done the calculations here I got all the present value details for all the ears and when I sum them up I got the total value of all caps in close as four hundred eight

thousand nine hundred and fifty nine dollars and for us to calculate the net present value we have to subtract the cash outflows from the cash inflation remember the cash outflows for this example was four hundred thousand dollars that was spent initially so that becomes cash outflow now that we have the cash inflow for all the cash inflow of all present values which is four hundred eight thousand nine fifty nine dollars we need to subtract four hundred thousand dollars from this announce and that would give us eight thousand nine hundred and fifty nine dollars and since this net present value is positive this project in the accepted now let’s look at another example the same example I would say what we have done is we have just changed the opportunity cost of the capsule from eight percent to fifteen percent now this was eight percent in the previous example and this is fifteen version in this example and let’s see if the project is still financially viable and won’t remain the same the time period remains the same it’s only just the opportunity cost that has changed from 8 percent per annum to 15 percent per annum now let’s look if this project is still financially viable or not I’ve done the calculations on the screen we know the formula for present value now using the present value formula we would calculate the present value for year 1 year 2 year 3 year 4 and year 5 that uses these values here on the screen now if I sum them up I get three hundred and forty three thousand five hundred and ninety one dollars and the cash outflow which we’ve done initially is four hundred thousand dollars now if I subtract four hundred thousand dollars from three hundred and forty three five ninety one dollars I get the net present value as – fifty-six thousand four hundred and eight dollars and the net present value has become negative here so we should not accept this project because this project is not financially viable now look at the note on this page below though we have the same inflow and outflow of cash when compared to the previous example the net present value has changed from positive to negative when the opportunity costs of captain has increased from eight percent fifteen version now what does they say they say that net present value is very much dependent on the discount rate or the opportunity cost of capsule now with this example we complete the net present value and now let’s move on to the eternal rate of return calculations now generally speaking the higher the project’s internal rate of return the better and it’s more desirable to undertake the project’s internal rate of return is the calculations by which we would be able to tell how much rate of return are we getting from the project so higher the internal rate of return the better for the project IRR which is also called as internal rate of return can also be used through ranked projects now IRR is nothing but the discount rate at which the net present value becomes sheer I’ll make it clear in a moment let’s say you have to choose between two projects where the net present value of the project is say and you are asked to choose one of the projects then you would need to choose the project which has the higher internal rate of return now you may get a couple of questions in exams asking you to choose between two different projects they may give you the net present value details internal rate of return it is and they would ask you to choose what project among the three projects then you would need to choose the project which has highest internal rate of return and remember this point the project’s internal rate of return should be greater than because the project’s internal rate of return is greater than opportunity cost you should always accept the cross and if the project’s internal rate of return is less than the opportunity cost you should reject the project because if the internal rate of return is less than opportunity cost the project is not financially viable and it is better to invest the money in a different project where we have a better instrument now let’s look at the relationship between internal rate of return opportunity cost and the net present value if IRR is greater than the opportunity cost then the net present value will always be positive and if IRR is less than opportunity cost then the net present

value will always be negative as said earlier as long as the net present value is positive the project is financially viable in the moment the net present value goes to negative the project is not energy divided right now let’s see an example and calculate the internal rate of return for a project the project let’s say the project cost is thousand dollars in the panel span is five years and it generates $200 at the end of year one $300 at the end of year two $300 at the end of year three $400 in the year four and $500 in the vo hi the opportunity cost is given here as twelve receipts and now we are asked to calculate if the project is financially viable or not faces the internal riddle now let’s look at the solution first we need to calculate the net present value of the project then adjust the opportunity cost until we get the net present value regime the opportunity cost at which the net present value becomes 0 would be the internal rate of return so we will tackle this solution with the following in mind if the NPV positive that means at 12% opportunity cost the net present value is positive so we need to increase the opportunity cost above to a person and see where does the net present value become 0 once we find out the rate at which the net present value becomes 0 we need to consider that rate has insulin later now I will show you how the calculations are done let’s see the excel sheet which is attached in this bitch and you get a period as to how the internal rate of return is calculated so we know the formula to calculate the present value and using the formula I have just automated this in the Excel report and let me show you how it is done now we have all the future values here for year 1 year 3 a 3 year 4 5 we know what the discounted rate is its whole person that’s given in the example here I have calculated the present value for year 1 year 2 year 3 year 4 and year 5 now I got cash inflow for all present values as 1169 dollars I know the cash outflow is $1,000 so I calculated the net present value which is 1 system in dollars now for us to calculate the internal rate of return what we are doing is we need to adjust the discount rate as I said the internal rate of return is nothing but the discount rate at which the net present value becomes 0 now at 12% then at present values 1 system in dollars so let’s increase the 12% to 13% and let’s see what would be the net present value so it dropped to 136 let’s look at code in version 321 or $5 let’s see 15 versus $75 so net present value is dropping as we increase the discount rate now let’s look at 17% laters sorry 17% is harmful it’s $18 let’s see 18% so it went to negative fruit should be in between 70 and 80 so let’s look at some in point five right it’s five point five so let’s see seventeen point six it’s two point eight 17.7 now it is close to zero zero point two four if I make it seven point eight invention it so at 17 point seven percent discount rate then it present value becomes zero now this would be the internal rate of return because at seventeen percent discount rate the net present value have become zero so this would be considered as the internal rate of now let’s go on and let’s look at the profitability index before we move on to profitability next let’s just look at this twelve percent discount rate the net present value is one season in dollars in at 17.7% let us become zero point two four close to zero so the IRR is seventeen / 17 point seven percent for this project which is a pretty good internal rate of return let’s get on to profitability next what is profitability index it is

also again our decision-making criteria to choose projects now it is a ratio by which we can tell how many dollars can be earned in return for each dollar spends for you to be able to calculate the profitability index you should know the present value of all cash inflows and cash outflows and then divide the cash inflows with cash outflows and you should be able to get the profitable day image I will show you how to calculate the profitability index in an example now you need to remember this you should accept the project if the profitability index is greater than one and you should reject if it is less than one again the higher the profitability for a project it is more desirable to undertake the project and let’s look at the relationship between net present value and profitable index if net present value is greater than 0 then the profitability index is greater than 1 if the net present value is less than 0 then the profitability index is less than 1 and remember this point this is very important profitability index can never be negative it would always be greater than 0 the reason being is not subtracting the cash outflows from hash enclosure we’re just dividing the cash inflows in the cash outflows so therefore the profitability index can never be negative it would always be greater than zero and the ideal profitability net should always be greater than one and anything less than one for profitability index the project is not financially viable now let’s look at the example for profitability index in this example an investment of $25,000 is invested in a project which is giving you a series of cash inflows that’s here it’s giving you $5,000 at the end of year $100,000 enough a to $10,000 at end of year 3 again $10,000 at end of year four and $3,000 in the VF 5 and if the required rate of return is 12 percent what is the profitability index the profitability index is calculated by dividing the present value of all cash inflows by present value of all cash outflows so first we need to calculate the present value of all years all the years here and sum them up and divide it with the cash outflow let’s see the excel sheet in which I have automated using the formula to calculate a profitable English all right we know the formula for present value now we know all the future values you know the years of one two three four five I know the discount rate is 12% I have automated the formula here so we calculate the present value for you one calculate the present value for here to present value for year three per year for input year five I got the individual present values for year one two three four five now if I sum them up I get twenty six thousand eight hundred fourteen dollars now in this example the cash inflow for all the present values is twenty-six thousand eight hundred and fourteen dollars but we have been given twenty five thousand dollars as cash outflows all we need to do is divide twenty six thousand eight hundred fourteen dollars with twenty five thousand dollars and that would give you the profitable business here is the profitability on points is M so the profitability index for this project is one point zero seven as I said earlier if the profitability index is greater than one we can accept the project now if we change the profitability index the discount rate the profit it would affect the profitable index if I increase this it becomes third one four zero four see as I increase the opportunity cost the profitability index went down so we have a direct relationship between the discount rate and the property the difference that’s about the profitability index now let’s move on to the payback period now what is payback period it is the length of time required for an investment to recover its initial

cash or growth for example if you invest thousand dollars in a project and it generates five hundred dollars every year for a period of five years then what is the payback period I would say the payback period would be three years because it takes two years to recover the thousand dollars we invested in the project initiative so the payback period is two years and generally speaking organizations do not consider time value of money in a back idiot and again it depends on the organization’s you’re working for however if you want to take the time value of money into consideration for calculating payback period you may do so and here is the important point good projects will not only have a good internal rate of return or the net present length but they also have early payback periods so if you’ve given a couple of projects with good internal rate of return and in a present value choose the project which has early payback period if the internal rate of return hundred present values are the same for the projects you should go with the project that has the early day back period now let’s look at the example that’s on the screen and I think with that this video would come to an end in this example an investment of $25,000 in IT projects you a series of cash inflows has described below it in the first year $5,000 in the second year $9,000 in the third and fourth years $10,000 and in the fifth year it gives you $3,000 so what would be the payback period for this project the solution is simple we need to calculate the time it takes to earn $25,000 since we are not given the discount rate we need to just calculate this payback period without considering the opportunity cost so in the end of first year we got $5,000 and at the end of second year we got $9,000 so the total amount we got at the end of second year is $14,000 it’s just the cumulative of all the revenue that we get at the end of the ears okay so at the end of third year it becomes one four thousand dollars since we need to get back with twenty five thousand dollars let’s see if I calculate this the cumulative of four years it would become thirty four thousand dollars since we are concentrating only on 25 thousand dollars let’s break the fourth year the venue in two month wise revenue and that would be ten thousand divided by Club and that is eight hundred and thirty three dollars per month so for three years one month we would earn about 24,000 plus eight hundred and thirty three dollars and that would be twenty-four thousand eight hundred and thirty dollars close to 25 thousand dollars and in three years two months fine we would earn about twenty five thousand 666 dollars so we can say that the payback period is in between three years one month and three years two months for this project okay so that’s about the payback period payback period is easy to calculate all we just need to do is just calculate the amount at what period of time we would be able to recover the initial investments right so let’s have a quick recap in this video we learned about the capital budgeting techniques learn what is discounted cash flow and non discounted cash flow we learned how to calculate the future value present value we learn how to calculate the net present value internal rate of return payback period and profitable index and with this we end this video tutorial if you find this tutorial informative please subscribe and thumbs