Capital Investment Decisions / Term Loans
(Should We Build the Factory? NPV, IRR, Payback & How Banks Fund Projects!)
A company wants to build a ₹20 crore factory. Will the investment pay off? This chapter covers the 4 methods to evaluate projects — NPV, IRR (time value methods) and Payback Period, ARR (non-time value). Plus term loans, DPG, project appraisal, infrastructure finance, and loan syndication.
Banky Appraises a BIG Project! 🏗️💰
A borrower wants ₹20 crore term loan for a cement factory. Banky must decide: Will the project generate enough cash to repay? What’s the NPV? IRR? DSCR? This chapter teaches Banky to evaluate ANY investment!
Investment Appraisal + Term Loans
📖 Part 1 — 2 Discounted Cash Flow Methods (Time Value)
NPV (Net Present Value): Discount ALL future cash flows to present → subtract initial cost. NPV > 0 = ACCEPT. NPV < 0 = REJECT. For mutually exclusive projects → choose HIGHEST positive NPV. Assumes certainty + no inflation.
IRR (Internal Rate of Return): Find the rate where PV of cash flows = initial investment. IRR > Cost of Capital = ACCEPT. IRR < Cost of Capital = REJECT. Found by trial & error. IRR is MORE widely used than NPV because businesspeople think in terms of "rates of return."
NPV vs IRR: Both give same accept/reject decision. For mutually exclusive, NPV ranking is more reliable. Both use time value of money (discounted cash flows).
📋 Part 2 — 2 Non-Discounted Methods (NO Time Value)
Payback Period: How many years to get your money back? Simply add cash flows till they equal initial investment. Shorter = better. Limitations: (1) ignores time value, (2) arbitrary cutoff, (3) ignores cash flows AFTER payback, (4) may bias toward risky projects.
ARR (Accounting Rate of Return): Uses ACCOUNTING profit (after depreciation), not cash flows. Average investment = (Cost − Scrap) ÷ 2. Limitations: ignores time value, uses profits not cash flows, arbitrary cutoff.
Key distinction: NPV & IRR = DISCOUNTED (use time value) = scientific. Payback & ARR = NON-DISCOUNTED (ignore time value) = simpler but less accurate. Only IRR uses time value of money among the exam choices (not Payback, not ARR)!
🏦 Part 3 — Term Loans, DPG & Project Appraisal
Term Loans: For fixed assets (land, building, machinery). Repaid per schedule (not on demand like WC). DSCR is the KEY ratio (not current ratio!). Each loan has own repayment schedule. EMI suits salaried borrowers. Bullet repayment = all at end.
WCTL (Working Capital Term Loan): Exceptional — term loan for CURRENT assets when borrower can’t bring NWC. Maintains current ratio.
DPG (Deferred Payment Guarantee): Bank guarantees buyer’s deferred payments to supplier. NON-FUND based (becomes fund-based on default). Appraisal same as term loan.
Project Appraisal (3 parts): (1) Managerial: Promoter credentials, stake, key persons. (2) Technical: Location, products, tech, infrastructure, raw materials, marketing. (3) Economic: NPV, IRR, Break-even, Sensitivity analysis.
Increase repayment period of existing TL → DSCR INCREASES (denominator spreads over more years = lower per-year burden). DPG is NOT a source of funds for buying fixed assets (it’s a guarantee, not money).
Syndication: Sharing large loans among multiple banks. Lead bank arranges. Charges syndication fee. Risk sharing.
Infrastructure: Transport, Energy, Water, Communication, Social/Commercial. Features: LONG implementation, gestation, payback. HIGH D/E ratio. Does NOT “reduce risk for lender” — that’s FALSE!
Exam-Ready Points
🎯 Must Remember!
- NPV > 0 = Accept. NPV < 0 = Reject. Highest NPV = best among mutually exclusive.
- IRR > Cost of Capital = Accept. IRR uses time value. Found by trial & error.
- IRR is MORE widely used than NPV (people think in rates of return).
- Payback: No time value. Arbitrary cutoff. Ignores post-payback cash flows. Simple.
- ARR: Uses accounting profit (not cash flows). Average investment = (Cost−Scrap)/2.
- Only IRR (and NPV) use time value — NOT Payback, NOT ARR. KEY exam distinction!
- DSCR = Key ratio for term loans. Current ratio = key for working capital.
- Increase TL repayment period → DSCR INCREASES (burden spread over more years).
- EMI suits salaried borrowers. Farmers = match cropping pattern. Industry = monthly/quarterly.
- DPG = Non-fund based guarantee. NOT a source of funds. Appraisal = same as term loan.
- WCTL = Term loan for current assets (exceptional). When borrower can’t bring NWC.
- Project appraisal: Managerial + Technical + Economic (NPV, IRR, Break-even, Sensitivity).
- Infrastructure: Long implementation, high D/E. Does NOT reduce lender’s risk!
- Syndication: Multiple banks share large loans. Lead bank charges syndication fee.
📝 Past Exam Questions
Last-Minute Flash Cards
⚡ Module C • Chapter 7 (Unit 25) Done!
- 4 Methods: NPV & IRR (time value ✅) vs Payback & ARR (no time value ❌).
- NPV > 0 = accept. IRR > Cost of Capital = accept. IRR more widely used.
- Term Loans: For fixed assets. DSCR = key ratio. ↑ Period = ↑ DSCR.
- DPG = guarantee (non-fund). NOT a source of funds. Appraisal = same as TL.
- Project Appraisal: Managerial + Technical + Economic. Infrastructure = long + high D/E.
- EMI = salaried borrowers. Syndication = multiple banks share large loans.
Banky says: “NPV & IRR = scientific! Payback & ARR = simple! DSCR = term loan’s best friend! DPG ≠ source of funds! Now I can appraise ANY project!” 🎉🏗️📊
Next: Chapter 26 — Equipment Leasing / Lease Financing! 💪