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Capital Budgeting
L. T. Investment decision
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2Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Chapter Objectives
Understand the nature and importance of investment decisions.
Capital Budgeting Process
Distinguish between discounted cash flow (DCF) and non-discounted cash flow (non-DCF) techniques of investment
Explain the methods of calculating net present value (NPV) and
internal rate of return (IRR). Show the implications of net present value (NPV) and internal rate
of return (IRR).
Describe the non-DCF evaluation criteria: payback and accountingrate of return and discuss the reasons for their popularity inpractice and their pitfalls.
Illustrate the computation of the discounted payback. Describe the merits and demerits of the DCF and Non-DCF
investment criteria.
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3Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Nature of Investment
The investment decisions of a firm are generallyknown as the capital budgeting, or capitalexpenditure decisions.
The firms investment decisions would generally
include expansion, acquisition, modernisation andreplacement of the long-term assets. Sale of adivision or business (divestment) is also as aninvestment decision.
Decisions like the change in the methods of salesdistribution, or an advertisement campaign or aresearch and development programme have long-term implications for the firms expenditures andbenefits, and therefore, they should also beevaluated as investment decisions.
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4Financial Management, Ninth Edition I M Pandey
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Features of Investment in
Cap.Budgeting The exchange of current funds for futurebenefits on L. T. basis
Substantial funds are invested in long-term
assets. The future benefits will occur to the firm over
a series of years.
Difficult or expensive to reverse
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5Financial Management, Ninth Edition I M Pandey
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Importance of Capital Budgeting
Growth
Risk
Funding
Irreversibility
Complexity
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Steps involved in Capital Budging
Capital Budgeting Process
Identification of Investment Projects
Investment Criteria (DCF & Non DCF)
DCF Deciding on the basis of
(a) NPV (b) Benefit Cost Ratio
(c)IRR & MIRR
Non-DCF on the basis of
(a) Pay back period & (b)Ac Rate of Ret
Investment Appraisal
6Financial Management, Ninth Edition I M Pandey
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Capital Budgeting Process
Identification of Potential Investment
Opportunities.
Assembling of Investment proposals.
Decision Making
Preparing of Capital Budget & appropriations
Implementation
Performance Review
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8Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Mandatory Investments
New or Expansion Projects
Modernization Projects Project
Replacement Projects
Diversification Project
Research & Development projects
Contingent Investment Projects
Miscellaneous Project
Identification of Inv.Projects
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9Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Rules for Investment Decision
It should maximise the shareholders wealth.
It should consider all cash flows to determine the true profitability of
the project.
It should provide for an objective and unambiguous way of
separating good projects from bad projects. It should help ranking of projects according to their true profitability.
It should recognise the fact that bigger cash flows are preferable to
smaller ones and early cash flows are preferable to later ones.
It should help to choose among mutually exclusive projects that
project which maximises the shareholders wealth.
It should be a criterion which is applicable to any conceivable
investment project independent of others.
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10Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Investment Criteria
1. Discounted Cash Flow (DCF) Cri ter ia
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)/ Benefit Cost Ratio
2. Non-discounted Cash Flow Cri ter ia
Payback Period (PB)
Discounted Payback Period (DPB)
Accounting Rate of Return (ARR)
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11Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Net Present Value Method: Steps
Cash flows of the investment project should beforecasted based on realistic assumptions.
Appropriate discount rate should be identified to
discount the forecasted cash flows. Theappropriate discount rate is the projectsopportunity cost of capital.
Present value of cash flows should be
calculated using the opportunity cost of capitalas the discount rate.
The project should be accepted if NPV ispositive (i.e., NPV > 0).
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12Financial Management, Ninth Edition I M Pandey
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Net Present Value Method
Net present value should be found out by
subtracting present value of cash outflows
from present value of cash inflows. The
formula for the net present value can bewritten as follows:
31 202 3
0
1
NPV(1 ) (1 ) (1 ) (1 )
NPV(1 )
n
n
n
t
t
t
C CC CC
k k k k
CC
k
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13Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Calculating Net Present Value
Assume that ProjectXcosts Rs 2,500 nowand is expected to generate year-end cashinflows of Rs 900, Rs 800, Rs 700, Rs 600and Rs 500 in years 1 through 5. The
opportunity cost of the capital may beassumed to be 10 per cent.
2 3 4 5
1, 0.10 2, 0.10 3, 0.10
4, 0.10 5, 0.
Rs 900 Rs 800 Rs 700 Rs 600 Rs 500NPV Rs 2,500
(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)
NPV [Rs 900(PVF ) + Rs 800(PVF ) + Rs 700(PVF )
+ Rs 600(PVF ) + Rs 500(PVF
10)] Rs 2,500
NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683
+ Rs 500 0.620] Rs 2,500
NPV Rs 2,725 Rs 2,500 = + Rs 225
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14Financial Management, Ninth Edition I M Pandey
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Acceptance Rule
Accept the project when NPV is positive
NPV > 0
Reject the project when NPV is negative
NPV< 0 May or may not accept the project when NPV
is zero NPV = 0 (indifferent attitude)
The NPV method can be used to selectbetween mutually exclusive projects; the one
with the higher NPV should be selected.
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Why NPV positive is a tool ?
Year Amt O/s
at the beg
of year
Ret on
O/s @
10%
Total O/s
flows
Cash
Repment
at yr end
Balance
O/s
1 2725 # 272.50 2997.50 900 2097.50
2 2097.50 209.75 2307.25 800 1507.25
3 1507.25 150.73 1657.98 700 957.98
4 957.98 95.80 1053.78 600 453.78
5 453.78 45.38 499.16 500 (0.84)*
# initial-. Outlay + NPV
15Financial Management, Ninth Edition I M Pandey
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Considering initial outlay Rs2500/
Year Initial
amount
Ret on
O/s amt
@ 10%
Total O/s
flows
Repment Balance
1 2500 250 2750 900 18502 1850 185 2035 800 1235
3 1235 123.50 1358.50 700 658.50
4 658.50 65.85 724.35 600 124.35
5
* Amt Rs
124.35
363.20 is
12.45
Left after
136.80
Total repm
500
WhosePv= 225
(363.20)*
16Financial Management, Ninth Edition I M Pandey
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17Financial Management, Ninth Edition I M Pandey
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Importance of NPV Method
NPV is most acceptable investment rule for thefollowing reasons: Time value
Measure of true profitability
Value-additivity
Shareholder value
Limitations:
Involved cash flow estimation Discount rate difficult to determine
Mutually exclusive projects
Ranking of projects
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Understanding Value Additivity
Value of a Firm = P.v. of all existing Proj +
NPV of all on going future projs;
When a firm undertakes a proj with +ve NPV
its value increases & visa a versa, When firm Terminates an existing proj which
has - ve NPV, the value of the firm increases
by that amount.
In Case ofDivestment:-
If D Value of the firm ( Existing + NPV) the
decision is favorable ,18Financial Management, Ninth Edition I M Pandey
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Contd
In case ofAcquisition, If the acquisition price
is > NPV the acquiring firm is paying more
money than worth,
In case ofNew projects with +ve NPV thevalue of the firm will increase so long actual
cash inflows are in line with expectations
otherwise it will decrease
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Time Varying Discount Rate
In certain cases, r may not be uniform.
--- __ Initial investment
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21Financial Management, Ninth Edition I M Pandey
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Internal Rate of Return Method
The internal rate of return (IRR) is the rate that
equates the investment outlay with the present
value of cash inflow received after one period.
This also implies that the rate of return is thediscount rate which makes NPV = 0.
31 20 2 3
0
1
0
1
(1 ) (1 ) (1 ) (1 )
(1 )
0(1 )
n
n
n
t
t
t
n
t
t
t
C CC CC
r r r r
CCr
CC
r
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22Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Calculation of IRR
Uneven Cash Flows: Calculating IRR by Trialand Error The approach is to select any discount rate to
compute the present value of cash inflows. If thecalculated present value of the expected cash inflowis lower than the present value of cash outflows, alower rate should be tried. On the other hand, ahigher value should be tried if the present value of
inflows is higher than the present value of outflows.This process will be repeated unless the net presentvalue becomes zero.
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23Financial Management, Ninth Edition I M Pandey
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Calculation of IRR
Level Cash Flows Let us assume that an investment would cost
Rs 20,000 and provide annual cash inflow ofRs 5,430 for 6 years.
The IRR of the investment can be found outas follows:
6,
6,
6,
NPV Rs 20,000 + Rs 5,430(PVAF ) = 0
Rs 20,000 Rs 5,430(PVAF )
Rs 20,000PVAF 3.683
Rs 5,430
r
r
r
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24Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
NPV Profile and IRR
A B C D E F G H
1 N P V P r o f i l e
2 C a s h F l o w
D i s c o u n t
r a t e N P V
3 - 2 0 0 0 0 0 % 1 2 , 5 8 0
4 5 4 3 0 5 % 7 , 5 6 1
5 5 4 3 0 1 0 % 3 , 6 4 9
6 5 4 3 0 1 5 % 5 5 0
7 5 4 3 0 1 6 % 0
8 5 4 3 0 2 0 % ( 1 , 9 4 2 )
9 5 4 3 0 2 5 % ( 3 , 9 7 4 )
F i g u r e 8 . 1 N P V P r o f i l e
I R
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25Financial Management, Ninth Edition I M Pandey
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Acceptance Rule
Accept the project when r> k.
Reject the project when r< k.
May accept the project when r= k.
In case of independent projects, IRR and NPV
rules will give the same results if the firm has
no shortage of funds.
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26Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Evaluation of IRR Method
IRR method has following merits: Time value
Profitability measure
Acceptance rule Shareholder value
IRR method may suffer from: Multiple rates
Misleading when Cash flows are NonConventional
Mutually exclusive projects Difficul to dicide
Value additivity
Fails to decide between Investing or Borrowing
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Modified Internal Rate Of Return (MIRR)
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Contd;
Advantage of MIRR :
Can take care of Non conventional Cash flows,
Problem of multiple rate is eliminated.
In MIRR Proj in flows are reinvested at the rate ofcost of capital which is a realistic rate where as in
case IRR the same is reinvested at projects IRR
which is estimated one of . Hence MIRR is superior.
In case of Projects of same size NPV & MIRR leadsto same decision.
In case
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29Financial Management, Ninth Edition I M Pandey
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Profitability Index
Profitability indexis the ratio of the present
value of cash inflows, at the required rate of
return, to the initial cash outflow of the
investment.
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30Financial Management, Ninth Edition I M Pandey
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Profitability Index
The initial cash outlay of a project is Rs 100,000and it can generate cash inflow of Rs 40,000,Rs 30,000, Rs 50,000 and Rs 20,000 in year 1through 4. Assume a 10 per cent rate of
discount. To Calculate PV of cash inflows at 10 per cent disct. rate then the ratio.
.1235.11,00,000Rs
1,12,350RsPI
12,350Rs=100,000Rs112,350RsNPV
0.6820,000Rs+0.75150,000Rs+0.82630,000Rs+0.90940,000Rs=
20,000(PVFRs+)50,000(PVFRs+)30,000(PVFRs+)40,000(PVFRsPV 0.14,0.103,0.102,0.101,
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31Financial Management, Ninth Edition I M Pandey
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Acceptance Rule
The following are the PI acceptance rules: Accept the project when PI is greater than one.
PI > 1
Reject the project when PI is less than one.PI < 1
May accept the project when PI is equal to one.PI = 1
The project with positive NPV will have PI
greater than one. PI less than means that theprojects NPV is negative.
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32Financial Management, Ninth Edition I M Pandey
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Evaluation of PI Method
It recognises the time value of money.
It is consistent with the shareholder valuemaximisation principle. A project with PI greater thanone will have positive NPV and if accepted, it willincrease shareholders wealth.
In the PI method, since the present value of cashinflows is divided by the initial cash outflow, it is arelative measure of a projects profitability.
Like NPV method, PI criterion also requires
calculation of cash flows and estimate of the discountrate. In practice, estimation of cash flows anddiscount rate pose problems.
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Problem:
If the expected cash flows of a Proj are :
Yr 0 1 2 3 4 5
-100000 20000 30000 40000 50000 30000
Considering Cost of Capital as 12% calculate
(i) NPV, (ii) IRR (iii) MIRR & ( iv) BCR
Ans: (i) 19060 (ii) 18.69 % (iii) 15.97 % (iv) 1.19
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34Financial Management, Ninth Edition I M Pandey
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Payback
Payback is the number of years required to recover the
original cash outlay invested in a project.
If the project generates constant annual cash inflows,
the payback period can be computed by dividing cash
outlay by the annual cash inflow.
Assume that a project requires an outlay of Rs 50,000
and yields annual cash inflow of Rs 12,500 for 7 years.
To find The payback period for the project
0Initial InvestmentPayback = =Annual Cash Inflow
C
C
Rs 50,000PB = = 4 years
Rs 12,000
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35Financial Management, Ninth Edition I M Pandey
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Payback
Unequal cash flows In case of unequal cash
inflows, the payback period can be found out by
adding up the cash inflows until the total is
equal to the initial cash outlay. Suppose that a project requires a cash outlay of
Rs 20,000, and generates cash inflows of
Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000
during the next 4 years. What is the projectspayback?
3 years + 12 (1,000/3,000) months
3 years + 4 months
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36Financial Management, Ninth Edition I M Pandey
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Acceptance Rule
The project would be accepted if its paybackperiod is less than the maximum orstandardpaybackperiod set by management.
As a ranking method, it gives highest rankingto the project, which has the shortest paybackperiod and lowest ranking to the project withhighest payback period.
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37Financial Management, Ninth Edition I M Pandey
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Evaluation of Payback
Certain virtues: Simplicity
Cost effective
Short-term effects
Risk shield Liquidity
Serious limitations: Cash flows after payback
Time effects on Cash flows ignored Cash flow patterns (Magnitude & Timing)
Administrative difficult in finding Maxm.P.B Period
Inconsistent with shareholder value
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38Financial Management, Ninth Edition I M Pandey
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Payback Reciprocal and the Rate of
Return The reciprocal of payback will be a closeapproximation of the internal rate of return if
the following two conditions are satisfied:
The life of the project is large or at least twice thepayback period.
The project generates equal annual cash inflows.
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39Financial Management, Ninth Edition I M Pandey
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Discounted Payback Period
The discounted payback period is the number of
periods taken in recovering the investment outlay on the
present value basis.
The discounted payback period still fails to consider the
cash flows occurring after the payback period.
3 DISCOUNTED PAYBACK ILLUSTRATED
Cash F lows
(Rs)
C0 C1 C2 C3 C4
Simple
PB
Discounted
PB
NPV at
10%
P -4,000 3,000 1,000 1,000 1,000 2 yrs
PV of cas h flows -4,000 2,727 826 751 683 2.6 yrs 987
Q -4,000 0 4,000 1,000 2,000 2 yrs
PV of cas h flows -4,000 0 3,304 751 1,366 2.9 yrs 1,421
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40Financial Management, Ninth Edition I M Pandey
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Accounting Rate of Return Method
The accounting rate of return is the ratio of the
average after-tax profit divided by the average
investment. The average investment would be
equal to half of the original investment if it weredepreciated constantly.
A variation of the ARR method is to divide
average earnings after taxes by the original cost
of the project instead of the average cost.
Average incomeARR =
Average investment
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41Financial Management, Ninth Edition I M Pandey
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Acceptance Rule
This method will accept all those projectswhose ARR is higher than the minimum rateestablished by the management and rejectthose projects which have ARR less than theminimum rate.
This method would rank a project as numberone if it has highest ARR and lowest rankwould be assigned to the project with lowest
ARR.
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42Financial Management, Ninth Edition I M Pandey
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Evaluation of ARR Method
The ARR method may claim some merits
Simplicity
Accounting data
Accounting profitability Serious shortcoming
Cash flows ignored
Time value ignored
Arbitrary cut-off
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43Financial Management, Ninth Edition I M Pandey
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Conventional and Non-conventional
Cash FlowsA conventional investment has cash flows thepattern of an initial cash outlay followed by cashinflows. Conventional projects have only onechange in the sign of cash flows; for example,the initial outflow followed by inflows,i.e., + + +.
Anon-conventional investment, on the otherhand, has cash outflows mingled with cashinflows throughout the life of the project. Non-conventional investments have more than onechange in the signs of cash flows; for example,
+ + + ++ +.
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44Financial Management, Ninth Edition I M Pandey
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NPV Versus IRR
Conventional Independent Projects:
In case of conventional investments, which are
economically independentof each other, NPV
and IRR methods result in same accept-or-rejectdecision ifthe firm is not constrained for funds in
accepting allprofitable projects.
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45Financial Management, Ninth Edition I M Pandey
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NPV Versus IRR
Cash Flows (Rs)
Project C0 C1 IRR NPV at 10%
X -100 120 20% 9
Y 100 -120 20% -9
Lending and borrowing-type projects:
Project with initial outflow followed by inflows is
a lending type project, and project with initial
inflow followed by outflows is a lending typeproject, Both are conventional projects.
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46Financial Management, Ninth Edition I M Pandey
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Problem of Multiple IRRs
A project may have
both lending and
borrowing features
together. IRR method,when used to evaluate
such non-conventional
investment can yield
multiple internal ratesof return because of
more than one change
of signs in cash flows.
NPV Rs 63
-750
-500
-250
0
250
0 50 100 150 200 250
Discount Rate (%)
NPV (Rs)
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47Financial Management, Ninth Edition I M Pandey
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Case of Ranking Mutually Exclusive
Projects Investment projects are said to be mutually exclusivewhen only one investment could be accepted andothers would have to be excluded.
Two independent projects may also be mutually
exclusive if a financial constraint is imposed. The NPV and IRR rules give conflicting ranking to the
projects under the following conditions: The cash flow pattern of the projects may differ. That is, the
cash flows of one project may increase over time, while those
of others may decrease orvice-versa. The cash outlays of the projects may differ.
The projects may have different expected lives.
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48Financial Management, Ninth Edition I M Pandey
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Timing of Cash Flows
Cash F lows (Rs) NPV
Project C0 C1 C2 C3 at 9% IRR
M
1,680 1,400 700 140 301 23%
N 1,680 140 840 1,510 321 17%
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49Financial Management, Ninth Edition I M Pandey
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Scale of Investment
Cash F low (Rs) NPV
Project C0 C1 at 10% IRR
A -1,000 1,500 364 50%
B-100,000 120,000 9,080 20%
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50Financial Management, Ninth Edition I M Pandey
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Project Life SpanCash Flows(Rs)
Project C0 C1 C2 C3 C4 C5 NPV at 10% IRR
X
10,000 12,000
908 20%Y 10,000 0 0 0 0 20,120 2,495 15%
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51Financial Management, Ninth Edition I M Pandey
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Reinvestment Assumption
The IRR method is assumed to imply that the
cash flows generated by the project can be
reinvested at its internal rate of return, whereas
the NPV method is thought to assume that thecash flows are reinvested at the opportunity
cost of capital.
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52Financial Management, Ninth Edition I M Pandey
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Modified Internal Rate of Return
(MIRR) The modified internal rate of return (MIRR)is the compound average annual rate that is
calculated with a reinvestment rate different
than the projects IRR. The modified internalrate of return (MIRR) is the compound
average annual rate that is calculated with a
reinvestment rate different than the projects
IRR.
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53Financial Management, Ninth Edition I M Pandey
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Varying Opportunity Cost of Capital
There is no problem in using NPV method
when the opportunity cost of capital varies
over time.
If the opportunity cost of capital varies overtime, the use of the IRR rule creates
problems, as there is not a unique benchmark
opportunity cost of capital to compare with
IRR.
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NPV Versus PI
A conflict may arise between the two methods
if a choice between mutually exclusive projects
has to be made. Follow NPV method:
Project C Project D
PV of cash inflows 100,000 50,000
Initial cash outflow 50,000 20,000
NPV 50,000 30,000
PI 2.00 2.50