Capital budgeting

• Importance of capital budgeting

• Project classifications
• Capital budgeting decision rules
o Payback period
o Net present value
o Internal rate of return
o Modified internal rate of return
o Profitability index
Capital Budgeting

Capital budgeting is the process of acquiring the fixed assets or process of investment in capital
projects.
The process of capital budget includes the identification of the investment opportunity, estimation of
relevant cost and benefits of the identified projects, evaluation of the projects, approval and monitoring
of the projects.

IMPORTANCE OF CAPITAL BUDGETING

It is long lasting and is not easily revocable.

It involves substantial amount of funds.
Effective capital budgeting may increase the market share by improving both timing and quality of asset
acquisition.

CLASSIFICATION OF CAPITAL PROJECTS

Independent projects
Examples – installation of brick factory and installation of sugar mill

Dependent projects
Example – construction of dam and canal in irrigation project
Mutually exclusive projects
Example – labor intensive production process versus capital intensive production process, frock lift
versus conveyor belt, deep well versus canal irrigation
Replacement project
Expansion of the business
Diversification projects
RANKING THE INVESTMENT PROPOSAL

Ranking of the projects is essential to make a selection among independent projects. To rank the
proposals we apply different decision rules. We classify the decision rules into two categories--
discounted and non-discounted.
The Payback Period
The payback period is the expected number of years required to recover the investment of the project.

For the purpose of calculation of payback period, let us take the following examples.
Year Net Cash Flow (in Rs )
Project A Project B Project C Project D
0 -10,000 -10,000 -10,000 -10,000
1 3,000 1000 5000 1,500
2 3,000 2000 4000 2500
3 3,000 3000 3000 2,500
4 3,000 4000 2000 3000
5 3,000 5000 1000 4,500
In the case of project with equal annual cash flow, payback period is worked out by:
PB = (1)
Where,
I = investment cash outlay/project cost
CFA = annual cash flow
PB = payback period
In our example, Project A has equal annual cash flow stream. Payback period of this
project is:
PB = = 3.333 years
It means it takes 3.333 years to recover the investment made in Project A.
Cash flow streams of Project B, Project C, and Project D are not equal. In this case, first,
cumulative net cash flow is calculated. Net cumulative cash flows of these projects are
given in the following Table.
Year Net Cash Flow (in Rs )
Project A Project B Project C Project
D
0 -10,000 -10,000 -10,000 -10,000
1 -7000 -9000 -5000 -8,500
2 -4000 -7000 -1000 -6,000
 3 -1000 -4000 2000 -3,500
4 2000 0000 4000 -500
5 5000 5000 5000 4,000
The table shows that original investment in Project B is recovered at the end of the fourth
year. So, the payback period of this project is 4 years. Similarly, investment of Project C
is recovered after second year, but before the end of the third year. The exact payback
period of Project C and Project D is worked out by:
PB = NF - 1 + (2)
Where
NF-1 = year before full recovery of investment
IF = unrecovered cost at the beginning of the year of full recovery of investment
CFF = total cash flow during the year of full recovery of investment
In the second year of the Project C, the unrecovered investment is Rs 1,000 and in the
third year total cash flow is Rs 3,000. So, payback period of Project C is:
PB = 2 + = 2.333 years
Similarly, the payback period of Project D is:
PB = 4 + = 4.111 years
Decision rule

For decision making purpose, the maximum cost recovery time is established, and
payback period of the project is compared with this time.

As a decision rules, projects with the payback period less than the set recovery time is
acceptable and vice versa.

In our case, if we assume the maximum cost recovery time to be 3 years, then, only
Project C is acceptable. If it is 5 years, then all projects are acceptable provided there is
no budget constraint.
For the purpose of ranking, the shorter the payback period, the better the project
principle is applied.
Evaluation
Payback period is very simple project evaluation technique.
In view of the threats of technological obsolescence of the projects, investors, these days,
pay more attention to the payback criterion.
In spite of its simplicity and popularity, it has certain drawbacks.
It does not consider all cash flows. It ignores the cash flows after the recovery of original
investment.
It does not take the time value of money into consideration while evaluating the projects.
As it ignores the time value of money it may lead to wrong decision.
The Discounted Payback Period
Discounted payback period is the time required to recover the original investment of the
project from the discounted cash flow.
Table 4: discounted cash flow of earlier cash flows at 10%
Year Project A (Rs) Project B Project C Project D
(Rs) (Rs) (Rs)
0 -10,000 -10,000 -10,000 -10,000
1 2,727 909 4,545 1,364
2 2,479 1,653 3,306 2,066
3 2,254 2,254 2,254 1,878
4 2,049 2,732 1,366 2,049
5 1,863 3,105 621 2,794
Year Project A Project B (Rs) Project C Project D
(Rs) (Rs) (Rs)
0 -10,000 -10,000 -10,000 -10,000
1 -7273 -9091 -5455 -8636
2 -4794 -7438 -2149 -6570
3 -2540 -5184 105 -4692
4 -491 -2452 1471 -2643
5 1372 653 2092 151
We work out the discounting payback period by following the same process that we
followed in calculation of regular payback period of projects with uneven cash flows. The
only difference is that in discounted payback period we use discounted cash flow whereas
in regular payback period we use undiscounted cash flow. Accordingly, in Equation 3,
instead of undiscounted cash flow, we use the discounted cash flow.
DPB = NF - 1 + (3)
Where
NF-1 = year before full recovery of original investment
IF = unrecovered cost at the beginning of the year of full recovery of original
investment
DCFF = total discounted cash flow during the year of full recovery of
original investment
Using Equation 3, the discounted payback period for each project is calculated below.
Discounted Payback for Project A is 4.26 yrs, for Project B is 4.79 yrs, for Project C is
2.05 yrs and for Project D is 4.95 yrs.
 This technique of evaluation of project considers the time value of the money and cost of
the capital. But it does not do away the major flaw—exclusion of cash flow after
recovery of the cost of the project—of regular payback period.
Net Present Value
Net present value of the project is the difference between present value of cash inflow
and outflow. Mathematically, it is given by:
NPV = - CF0 (5.a)
CF1, CF2 and CFn are expected net cash flow in the first, second and nth year, CF0 is
initial cash outlay, and k is cost of capital. We assume that k is given. The Equation 5.a is
restated as follow:
NPV = - CF0 (5.b)
Where
CFt = expected net cash flow at period t
CF0 = initial cash outlay/investment
n = project life, and
k = cost of capital/discounted rate

Let us illustrate how we can calculate the NPV for Project B, Project C, and Project D.
Table 8: Calculation of NPV of projects
Project B Project C Project D
Yea PVIF10%, Cash PV (Rs) Cash PV Cash PV
r t Flow Flow (Rs) Flow (Rs)
(Rs) (Rs) (Rs)
1 .9091 1,000 909 5,000 4,546 1,500 1,364
2 .8264 2,000 1,653 4,000 3,306 2,500 2,066
3 .7513 3,000 2,254 3,000 2,254 2,500 1,878
4 .6830 4,000 2,732 2,000 1,366 3,000 2,049
5 .6209 5,000 3,105 1,000 621 4,500 2,794
Total Present Value 10,653 12,09 10,15
3 1
Less Initial Investment 10,000 10,00 10,00
0 0
Net Present Value 653 2,093 151

The calculation of net present value for projects with even cash flows, such as for Project
A, is simple. It is worked out as follows:
Present value of the net cash flow
(Annual net cash flow)(PVIFA10, 5 years) =(Rs 3000)(3.7908) Rs 11,372
Less: Initial Investment 10,000
Net Present Value Rs 1,372
 The Decision and Ranking Rules
The following decision and ranking rules are followed in this method:
 If NPV is more than zero, accept the project.
 If NPV is less than zero, reject the project.
 Assign the higher rank to the project with the higher NPV and lower rank with
lower NPV.
According to these rules, all projects are acceptable provided that there is no budget
constraint and all projects are independent. Ranks of all these acceptable projects are
given in Table 9.
Table 9: Ranking of the projects
Project NPV Rank
Project A Rs 1,372 2
Project B 653 3
Project C 2,093 1
Project D 151 4
Merits
2. This method considers the time value of money.
3. This method takes account of all cash flows occurred during the project life
while making the decision.
4. This is based on the estimated cash flows of the project rather than on the
accounting income.
5. This method is consistent with the objective of maximizing the shareholders’
wealth.
Demerits
1 This method is based on the expected cash flow of the project which is very
difficult to forecast.
2 The corner stone of this method is discount rate. But it is difficult to determine
the appropriate discount rate.
3 In case of projects with unequal lives and budget constraints, much caution
have to be taken while applying the decision rules of this method.
4 Ranking of the projects is dependent on discount rate. The higher discount rate
has severe impact on the cash flow occurred in the later period of the project.
So, depending on the discount rate, the different ranks may be assigned to the
same independent projects.

The Internal Rate of Return

The Internal rate of return (IRR) is the discount rate that makes the present value of
cash inflows equal to the present value of the cash outflows of the project. In the case of
project with conventional cash flow, this is the discount rate that equates the present
value of benefits with the investment outlay of the capital project. In other words, this is
the discount rate that results in the zero net present value of the project. Mathematically it
is worked out by solving the following Equation for k:

0 = - CF0 (9-6.a)
Model 9-6.a is restated as follows:
0 = - CF0 (9-6.b)
Equation 9-5-a and Equation 9-6.a are fundamentally the same. The only difference
is that in Equation 9-5.a, k is given and in Equation 9-6-a it is calculated. In both
Equations, k is discount rate. In Equation 9-5.a, k may give the NPV greater than or less
than zero but in Equation 9-6.a, k gives the NPV exactly equal to zero.
IRR can be worked out either by trial and error method or with the aid of financial
calculator or computer. You can use the inbuilt finance function of Microsoft Excel if
you have easy access to the computer. But, we will give emphasis on the trial and error
method.
Let us illustrate with our earlier example. First, let us calculate the IRR of Project
A. Project A's annual cash inflow is annuity. In the case of annuity, follow the following
steps:
1 Calculate the payback period. As calculated earlier payback period of Project A is
3.333 years.
2 Find out the discount rate for interpolation by looking at the Present Value Interest
Factor for Annuity Table for nth year, i.e., project life. In our case, n is 5. So, look
the table across 5 years and locate the PVIFA nearest to 3.333. This lies in between
15 and 16 percent rate. PVIFA at 15 percent and 16 percent are 3.3522 and 3.2743
respectively.
3 Find out the actual IRR using the following equation:
IRR = RL + × (RH - RL) (9-7.a)
Where
RL = lower discount rate
RH = higher discount rate
PVIFAL = present value interest factor for annuity at lower discount rate
PVIFAH = present value interest factor of annuity at higher discount rate
PB = payback period
Let us put the value of variables of the model 9-7.a.
IRR = 15 + × (16 - 15) = 15.24%
In the case of projects having unequal cash flow, follow the following steps to work out
IRR:
1. Sum up the annual cash flow and divide it by n to find out the fake annuity. Divide
the initial cash outlay by the fake annuity to find out the fake payback period. Let
us illustrate with Project B. Total cash inflow of Project B is Rs 15, 000. So, the
 fake annuity is Rs 3, 000. Initial cash outlay is Rs 10,000. Thus, the fake payback
period is 3.333 years.
2. Find out the discount rate for trial by looking at the Present Value Interest Factor
for Annuity Table for nth year. In our case, n is 5. So, look the table across 5 years
and locate the PVIFA nearest to 3.3333. This lies in between 15 percent and 16
percent discount rate. PVIFA at 15 percent is 3.3522 and 3.2743 at 16 percent.
PVIFA at 15 percent is closest to 3.3333.
2. Based on the pattern of cash flow, adjust the closest discount rate calculated
in step 2. If cash flow in earlier period of the project is greater than the
average cash flow of the project, try with the discount rate greater than the
discount rate calculated in step 2, and conversely try with discount rate less
than that of the discount rate worked out in step 2 if the cash flow in earlier
period is less than the average cash flow of the project. In our illustration,
average cash flow and payback period, based on the fake period, of Project
B and Project C are the same. But timing and magnitude of these projects
are different. Magnitude of cash flow of Project B in its earlier period is
smaller than the average cash flow but the magnitude of the cash flow of
Project C is greater in the same period. So, let us adjust the discount rate
calculated in step 2 by 3. Try with 18 percent discount rate for Project C and
12 percent for Project B. Net present value of both projects are negative.
Table 10: Present Value of Project B and Project C
T a b l e -91 0 Project B Project C
Year Cash PVIF12%, PV (Rs) Cash Flow PVIF18%, PV (Rs)
Flow (Rs) t (Rs) t

1 1,000 .8929 892.90 5,000 .8475 4237.50

2 2,000 .7972 1594.40 4,000 .7182 2872.80
3 3,000 .7118 2135.40 3,000 .6086 1825.80
4 4,000 .6355 2542.00 2,000 .5158 1031.60
5 5,000 .5674 2837.00 1,000 .4371 437.10
Total 10,001.7 10404.80
0
Less: Initial Investment 10,000 10,000
Net Present Value 1.70 404.80
3. The step 3 shows the direction of IRR. In other words, IRR of Project B
and Project C should be higher than 12 percent (approximately) and 18
percent respectively. As we know the relation between discount rate and
present value is inverse. Try with higher discount rate to decrease the
present value of cash flow. Let us try with 14 percent for Project B, and 22
percent for Project C.
Table 11: Present Value of Project B and Project C

Project B Project C
Year
5. Step 3 and step 4 show that IRR for Project B lies in between 14 percent and 12
percent, and for Project C, it lies in between 18 percent and 22 percent. So, let us
find out IRR using interpolation:
IRR = RL + × (RH - RL) (9-7.b)
IRR for Project B:
IRR = 12 + × (14 - 12) = 12.006 = 12%
IRR for Project C:
IRR = 18 + × (22 - 18) = 20.33%
For Project D, fake annuity is Rs 2,800 and fake payback period is 3.5714. This is
closest to the PVIFA at 12%. Cash flow of this project in its earlier life is smaller than in
latter life. So, the pattern of cash flow suggests that IRR should lie below 12%. So, let us
try with 12% and 10% and interpolate to find out the IRR for Project D.

Table 12: Present value of project D

Ye Cash Flow PVIF10%, t PV @ PVIF12%, t PV @
ar (Rs) 10% (Rs) 12% (Rs)
1 1,500 .9091 1,363.65 .8929 1,339.35
2 2,500 .8264 2,066.00 .7972 1,993.00
3 2,500 .7513 1,878.25 .7118 1,779.50
4 3,000 .6830 2,049.00 .6355 1,906.50
5 4,500 .6209 2,794.05 .5674 2,553.30
Total Present Value 10,150.95 9,571.65
Less Initial Investment 10,000 10,000
Net Present Value 150.95 (428.35)
IRR for Project D:
IRR = 10 + × (12 - 10) = 10.521 = 10.52%
The decision and ranking rules. Cost of capital works as the corner stone in accepting
and rejecting the projects under considerations. The project with the IRR exceeding the
cost of capital contributes to the wealth of shareholders and vice versa. So, based on this
rationale, following decision and ranking rules are followed in this method:
 If IRR is greater than the cost of capital, k, accept the project.
 If IRR is less than k, reject the project.
According to these rules, given the 10 percent cost of capital and absence of the
budget constraint, all projects are accepted.
 Ranks of the projects given in Table 9-12 and Table 9-10 do not differ each other.
But sometime, NPV method and IRR method give conflicting rankings for mutually
exclusive projects.
Merits
1. Like NPV method does, it takes the time value of the money and all cash flow
of the project into consideration.
2. It is based on the cash flow not on accounting profits of the project.
3. It is consistent with the value maximization decision criterion. Investing in the
project whose IRR exceeds the cost of capital increases the shareholders
wealth. And on the other hands, investing in the project whose IRR is less than
the cost of the fund destroys the value. That is why investment is made only in
those projects which IRR exceeds the cost of funds.
4. Though it is difficult to work out the IRR of the project, it is easy to understand
and communicate to the management and investors in term of percent rather
than in term of money.
Demerits
1. In spite of the advantages stated earlier, we encounter the problems with
IRR when cash flows are not conventional and when two or more projects
are compared each other. In unconventional cash flow cases, the problem
of multiple rate arises. In reality, cash outflow is not always followed by
cash inflows. Series of cash inflows may be followed by cash outflow. In
such a case there is a possibility of multiple IRR. So, this approach might
not be usable for projects with unconventional cash flows.
2. In the case of independent project, IRR and NPV give the same decision. But in
the case of mutually exclusive projects, IRR gives the conflicting decision. This
is due to the difference in the assumption of reinvestment rate. NPV assumes
that fund will be reinvested at cost of capital whereas IRR assumes that fund
will be reinvested at project rate of return.
Net Present Value and Internal Rate of Return: A Comparison
NPV and IRR techniques are similar in some respect and different in some ones. First,
both are discounted cash flow method. So, they focus on the magnitude and timing of the
cash flows of the project. Second, both methods accommodate the difference in project
risk easily. This is done by adjusting the project’s required rate of returns. Finally, subject
to some important exceptions, both NPV and IRR give the same accept-reject decision
for independent projects. As stated earlier, IRR is a discount rate which makes the present
value of the cash outflow equal the present value of the cash inflows. So, the IRR greater
than the required rate of return yields the positive NPV and the IRR less than the required
rate of return results in the negative NPV. Thus, except in some cases like substantial
difference in initial investment and timing of cash inflows, both NPV and IRR yield the
same decision.
 In spite of similarities stated in the foregoing paragraph, there are several important
differences between NPV and IRR. First, NPV is absolute measurement and IRR is
relative measurement of the project worth. NPV shows the project worth in monetary
term whereas IRR does in term of rate of return on investment. Theoretically, NPV shows
how much the market value of the firm will rise if project is accepted and IRR shows
what rate of return will the project yield if it is accepted. This difference can create the
conflict between NPV and IRR in ranking the mutually exclusive projects. This problem
comes across if there are substantial differences in the magnitude of investment and
significant difference in the timing of project cash flows. This is due to the assumption
of different reinvestment rate of return. Second, NPV and IRR are different with respect
to the assumption of reinvestment rate. NPV assumes that cash inflows are reinvested at
required rate of return and IRR assumes that they will be reinvested at project rate of
return.
 NPV Profiles and Crossover Rate
N P V p r o file
It is a g ra p h th a t p lo ts NPVa profile is a graph that plots a projects
NPV against the cost of capital rates. Let us
p ro je c ts N P V a g a in st illustrate
th e how we prepare NPV profiles of the project with hypothetical project X and
c o s t o f ca p ita l ra te s
Project Y. Net cash flows of these projects are given in Table 9.13.
Year Project X Project Y
T a b le 9 .1 3
N e t c a sh flo w s
(Rs) (Rs)
0 - 10,000 - 10,000
1 1,000 5,000
2 3,000 4,000
3 4,000 3,000
4 5,000 3,000
5 6,000 2,500
T a b le 9 . 1Table
4 9.14: NPV of Project X and Project Y at different cost of capital.
N e t p re s e n t v a lu e
Cost of NPV Project NPV Project
Capital X (Rs) Y (Rs)
0 9000.00 7500.00
5 5943.49 5408.46
9 4,138.68 4,138.68
10 3534.28 3706.53
15 1609.89 2303.15
20 54.01 1132.01
NPV profiles of Project X and Project Y are shown in Figure 9.1. We plot the cost of
capital on horizontal axis and NPV on vertical axis. NPV of a project at IRR is equal to
zero. So, the point where NPV profile crosses the horizontal axis indicates the IRR of a
project. In Figure 9.1, NPV profile of Project X crosses the horizontal axis at 20 percent.
Similarly, NPV profile of project Y crosses at 26 percent. These horizontal intercepts are
equal to IRR of the project X and project Y. Thus, NPV profiles can be used to work out
the IRR of the projects and be a valuable tool for project analysis.
Net Present Value X Y
F ig u r e 9 .1 (Rs )
N P V p ro file s a n d cro ss
o v e r ra te 10000.00 Project X
8000.00
Crossover rate = 9%
6000.00

4000.00 Project Y
2000.00

0.00 IRRy = 26%

-2000.00 0 5 10 15 20 25 30 35

-4000.00
Discount Rates
IRRx = 20%
 Figure 9.1 shows that NPV of both Project X and Project Y decreases as
the cost of capital increases. But Project Y has higher NPV at higher cost of capital and
lower NPV at lower cost of capital. Similarly, Project X has higher NPV at lower cost of
capital. In Figure 9.1, NPV of both Project X and Project Y are equal at 9 percent
(approximately) cost of capital. This rate is known as crossover rate. Thus, crossover
rate is that discount rate where NPVs of two projects are equal. NPV of Project X is
C ro sso v er rate
greater
It is th a t d isc o u n t ra te than the NPV of Project Y below the crossover rate. Conversely, NPV of Project
w h e re N P V s o f tw o
X is greater than that of Project X above this rate. Notice that NPV of Project X has
p ro je c ts a re e q u a l.
steeper slop. This shows that NPV of Project X is more sensitive to changes in the cost of
capital than Project Y.
Modified Internal Rate of Return
M o d ifie d in t e rn a l r aAs te stated earlier, we come across the two problems—conflicting decision and multiple
o f r e t u rn
It is th e d isc o u n t ra tereturns
at in IRR method. Modified internal rate of return (MIRR) does away these
w h ic h p re se n t v a lu e o f
p ro je c t's c o st is e q u aproblems
l to by shifting the assumption of reinvestment rate of cash flows from internal rate
th e p re s e n t v a lu e o fofits return to cost of capital, and converting the cash flows into terminal value. It is the
te rm in a l v a lu e .
discount rate at which present value of project's cost is equal to the present value of its
terminal value. The terminal value is the sum of the future value of cash inflows
compounded at cost of funds. Mathematically, it is given by the following equation:
= (9-8)
Where
COFt = cash outflow or investment in the project for tth year
k = cost of capital
n = project life
CIFt = cash inflows for tth year
In Equation 9-8, left side is present value of the investment outlay of the project and right
side is the present value of terminal value. Numerator of right side of the equation is the
compounded value of cash inflows of the project at cost of capital. In order to calculate
MIRR, Equation 9.8 is solved for it. Follow the flowing steps to work out MIRR:
1. Work out the terminal value of cash inflows at cost of capital. Here, we assume that
cost of capital is given.
2. Calculate the present value of cash outflows. In the case of a project with
conventional cash flow, initial outlay represents the present value of investment.
3. Solve the Equation 9-8 for MIRR.
Let us illustrate these steps with Project B.
Step 1: Calculation of Terminal Value of Cash Inflows
Use the numerator of right hand side of Equation 9-8 to work out the terminal
value. Thus, the Equation for calculating the terminal value is :
TV = CIFt (1 + k)n - t (9-8.a)
In our example, n is 4, and k is 10 percent. We do not have the cash inflow at the
beginning of the project.
T a b le 9 .1 5
T e r m in a l V a lu e o f
P r o je c t B
 Year (t) Cash Inflows FVIF10%,n-t FV10%,n-t (Rs)
(Rs)
1 1000 (1+.1)5-1=1.4641 1464.10
5-2
2 2000 (1+.1) =1.3310 2662.00
5-3
3 3000 (1+.1) =1.2100 3630.00
5-4
4 4000 (1+.1) =1.100 4400.00
5-5
5 5000 (1+.1) =1.000 5000.00
Total 17,156.10
Step 2: Calculation of PV of Cash Outflow
We use the left hand side of Equation 9-8 to calculate the present value of cash
outflows. So, we use the following Equation to work out the present value of outflows of
the project:
PV = (9-8.b)
In our case, we invest Rs 10,000 at t=0 and we do not have any investment in the
years to come. So, the present value of the cash outflows of the project is:
PV = = Rs. 10,000
PV of the outflow of the project is equal to Rs 10, 000. Thus, in the case of the
project with conventional cash flows, cost of the project/initial cash outlay presents the
represents value of the cash outflows. In such a case we need not to bother about its
calculation.
Step 3: Solution of Equation for MIRR
As stated earlier, MIRR is the discount rate that makes the present value of cash
outflows equal with the present value of terminal value of the cash inflows of the
projects. It is given by
PVCOF = (9-8.c)
In our example, present value of cash outflow (PVCOF) is Rs 10,000, and terminal
value of cash inflow (TVCIF) is Rs 17,156.10. Thus, put the value of PVCOF and TVCIF in
Equation (9-8.c) and solve for MIRR.
10,000 =
Taking the log,
Log10,000+5Log(1+MIRR)=Log17,156.10
5 Log(1+MIRR)=Log17,156.10-Log10,000
5 Log (1+MIRR)=4.2344-4.000
Log (1+MIRR)=.2344/5
(1+MIRR)=Antilog.0469
(1+MIRR)=1.1140
MIRR=1.1140-1=.114 , i.e, 11.4%
Decision rules. We follow the same decision rule of regular IRR in MIRR also. In other
words, if MIRR is greater than the required rate of return, project is accepted and if it is
 less than that, it is rejected in the case of independent projects. In the case of mutually
exclusive projects, the acceptable project with higher MIRR is preferred to the project
with lower MIRR.
Merits
1. MIRR is based on the assumption that cash inflows are reinvested at cost of
capital. This assumption is more realistic than the assumption of regular IRR.
So, MIRR is better indicator of profitability of the project.
2. MIRR solves the problem of multiple returns. As stated earlier multiple return
problem arises due to the unconventional cash flows of the project. But MIRR
solves this problem by converting the unconventional cash flow into
conventional cash flows through the process of present value of cash outflow
and terminal value of cash inflows of the project.
Demerits
1. NPV and MIRR of mutually exclusive projects give the same decision
provided the size and life of the projects are equal. But NPV and MIRR give
the conflicting decision when projects differ in size measured in term of
investment.
2. It is a little bit intricate to understand the calculation process of MIRR. Since,
first, cash outflows and inflows are converted into the present value and
terminal value respectively and then based on the present value of the outflows
and terminal value of cash inflows, MIRR is calculated.
Profitability Index (PI)
P r o fita b ilit y in d eThis
x is the measurement of relative profitability of the project. It shows the present value
It is th e m e a s u re m e n t o f
re la tiv e p ro fita b ilityper
o f rupee of initial investment of the project. It is given by the following equation.
th e p ro je c t
PI = (9.9)
Equation (9.9) can be restated as follows:
(9.9.a)
Here, CFt, CF0, k, and n signify as in Equation (9.5.a)
Let us illustrate how we can calculate PI for project A, B, C and D and rank these
independent projects.
Project A: = = 1.1372
Project B: = = 1.0653
Project C: = = 1.2093
Project D: = = 1.0151
The decision and ranking rules. The PI equal to 1 indicates the zero NPV. Similarly the
PI greater than 1 implies positive NPV of the project. Conversely, the PI less than 1,
shows the negative NPV. Applying the same rationale of NPV, we make a decision under
PI method. The following decision and ranking rules are followed in this method:
 If PI > 1, accept the project.
  If PI < 1, reject the project.
 Assign the higher rank to the project with the higher PI and lower rank with lower
PI.
In our case, all projects are with PI greater than 1. So, provided the absence of
budget constraint and independent projects, we can accept all projects. In the case of
mutually exclusive projects, we select the project with the highest PI. In our case, project
C is with the higher PI. So, we select project C. Ranks of all projects under consideration
are given in Table 9.15.
T a b le 9 .1 6 Project PI Rank
R a n k in g o f th e p ro je c ts
Project A 1.1372 2
Project B 1.0653 3
Project C 1.2093 1
Project D 1.0151 4
Notice that both NPV and PI methods yield the same decision and assign the same rank
to the projects.
This method also has the same merits and demerits of NPV method. But in addition
to the merits of NPV, it has one more advantages. It shows the relative profitability of the
project. As stated earlier, it indicates the NPV per rupee of initial cash outlay.