CAPITAL BUDGETING

This unit introduces you to the concept of Capital Budgeting. A capital

expenditure is an expenditure on fixed assets and other long-term
infrastructure necessary for the implementation of projects. The assets
bought for the project are expected to generate cash flows. The appraisal of
capital projects is done in two steps. Firstly, we must determine the cash
flows that are expected to be generated by the project. Secondly, we must
estimate the cost of the funds (cost ofcapital ) that have been used in the
project. Finally, we subject the expected cash flows to certain appraisal
techniques.

Capital budgeting involves long-term decision making on the use of funds.

This implies the evaluation of investment opportunities, the essence of
which is the detailed consideration of expected future cash flows. A cash
flow may be defined as the receipt or expenditure of cash during an interval
of time. For the sake of simplicity, it is generally assumed that cash flows
occur at the end of each interval of time (usually at the end of each year).

It is a budget that deals with Capital Expenditure, for example the purchase
of plant and equipment, construction of a building .It is expenditure that is
not easily reversible due to the values committed. There are different types
of capital budgeting expenditures,e.g. Replacement projects and Expansion
projects.

So a detailed risk analysis needs to be done before the investment

introduction of new projects and regulatory projects. The investment in the
project is prescribed by the regulatory board on the safety issues.

Importance of capital budgeting.

You recall that the goal of financial management is to maximize the wealth
of shareholders by acquiring funds at the least possible cost and utilizing
them to obtain the highest possible return for the shareholders.

Capital budgeting techniques are used to make an appraisal of the

company’s investment projects, whereby assets are acquired in order to
carry out approved investment projects. It is expected that a project will
generate cash flows . In project appraisal, it is the project’s cash flows that
are subjected to a series of tests in order to find out whether the wealth of
the shareholders is being maximized by embarking on a particular project.
In making this appraisal, we utilize the discounted cash flow [DCF]
techniques, which are based on thetime value of money concept, as well as
other methods which are not based on the time value of money concept.

Incremental cash flows

In capital budgeting we should be careful not to include cash flows that are
not relevant to the decision under consideration. The relevant cash flows for
capital budgeting purposes are incremental cash flows. Cash flows for a
project are defined as the difference between the cash flows of the firm
without the project and the cash flows with the project :

Project CFt = CFt for the firm - CFt for the firm
with project without project

Cash flow versus Accounting income.

Accounting income may differ from the cash flows that we consider under
financial management. Income statements mix apples and oranges. For
example, accountants deduct costs, which are cash outflows, from revenues,
which may or may not be entirely cash inflows (some sales may be on
credit). At the same time, they do not deduct capital outlays, which are cash
outflows, but they also deduct depreciation, which is not a cash outflow. In
capital budgeting, it is critical that we base our decisions strictly on cash
flows, the actual dollars that flow into and out of the company during each
time period.

Study the following example.

Example
A company is considering investing in a project for which the following
information has been generated:
$
Initial capital outlay (600 000 )
Profit/loss for the year: Year 1 100 000
Year 2 150 000
Year 3 250 000
Year 4 300 000

The capital outlay was on plant and machinery which is expected to have an
economic life of four years with no scarp value.
In capital budgeting, we are concerned with "cash flows", not "profits or
losses". To turn these into cash flows, we add back the depreciation, which
is not a cash outlay. The profits are therefore adjusted as follows :

Annual depreciation = 600 000 / 4 = 150 000

Annual cash flows = profit + depreciation
Year 1 100 000 + 150 000 =250 000
Year 2 150 000 + 150 000 =300 000
Year 3 250 000 + 150 000 =350 000
Year 4 300 000 + 150 000 =450 000

Sunk Costs

Sunk costs are not incremental costs, so they should not be included in
capital budgeting. A sunk cost is an outlay that has already occurred (or
been committed). Since the outlay has already occurred, it is not affected by
the decision to accept or reject a project.

Opportunity Costs

An opportunity cost is the benefit lost or alternative foregone in making a

decision. For example, the use of a factory building to implement a project
may require that the other alternative uses to which the building could be
put have to be foregone, for example rentals to other users of the building.
Opportunity costs should be charged to the project as an additional cost.

Externalities

The effects of the project on other projects are called externalities.

Externalities may be positive or negative. For example, a project may result
in the production of a new product for the firm. If this results in the
reduction of the demand for the firm’s other products as some of the existing
customers shift to the new product ( this is known as “cannibalization”) ,
these reduced sales should be deducted from the new product sales [a
negative externality]. On the other hand, the new product may create sales
for other related existing products, and these should be attributed to the
new product [ a positive externality].

Types of Project Cashflows

Project cash flows are dividedinto three categories : the initial investment;
the annual cash flows; and the terminal cashflow.
The Initial investment [I0]

The initial investment is the net cash outlay on buying the capital, that is
the plant andequipment, buildings, and other infrastructure for the project.
The amount of the initialpayment and the way it is calculated is determined
by whether the project is a newinvestment project or a replacement project.

A new investment is when a totally new project is being analysed , or the

implementation ofthe project does not have any effect on the present cash
flows of the firm. If a newinvestment is being considered the initial
investment can be made up of the following:
1. Thecost of the assets and installation, and
2. Change in net working capital.
The cost of the assetsincluding installation costs is an outflow (-) including
any other opportunity costs.

Change in net working capital caused by the implementation of the project.

Normallyadditional inventories are required to support a new project, and
the new sales will alsogenerate additional accounts receivable. At the same
time, accounts payable and accrualsmay also spontaneously increase. If
there is a net increase, this is anoutflow (-). At the end of the project’s life,
the firm’s total working capital may revert toprior levels, the net increase in
net working capital is therefore recovered and becomes aninflow (+).

In a replacement project, some assets are replaced, and this may result in
the firm nolonger deriving any cash flows from the replaced assets but from
the new assets. Thefollowing factors make up the initial investment in a
replacement project:
 The cost of the new project + installation costs + changes in net
working capital. This isa cash outflow (-).
 The disposal value of the old assets. The implementation of the new
project results inthe old assets being disposed of. The funds that are
received at the disposal of the oldassets are an inflow (+).

Tax effects. Selling a fixed asset can result in tax effects. The tax savings or
taxpayable as a result of the disposal of the old assets must be incorporated
in the initialinvestment calculation.

Annual Cash Flows.

The annual cash flows are the result of revenues less expenses. Remember
we always use net incremental, relevant, after-tax cash flows. We therefore
need to incorporate tax effects in these cash flows. Let us do this now.
To convert before-tax cash flows into after-tax cash flows we use the
following procedure:
1. After-tax cash flow = Before-tax CF - Tax payable.
2. Tax payable = Taxable × tax rate.
3. Taxable CFs = Before-tax CF - Tax allowance.

In Zimbabwe, tax allowances e.g W&T and SIA are claimed in place of
depreciation charges, which are notrecognized for tax purposes.

The terminal cash flow

The terminal cash flow is the net after tax amount received by the firm when
a project is terminated. For a new investment the estimated terminal cash
flow might include the following : the estimated salvage value of the new
assets, the tax effects due to the disposal of the assets and the recovery of
the net working capital.

 The estimated salvage value of the new assets is the amount that is
expected to be received when the assets are sold at the termination of
the project. This is a cash inflow (+).
 The tax effects due to the disposal of the assets. This depends on
whether there is a net taxable recoupment (-) or scraping allowance
(+)
 Recovery of the net working capital. If there is a change in net working
capital when the project is implemented, we expect an opposite
change to occur at termination of the project. The change is usually
an inflow (+).

Thus, the terminal cash flow will be equal to:

Proceeds from sale of assets XXXX
Tax on recoupment (XXXX)
Recovery of working capital (XXXX)
Total (XXXX)

Practice Question

Thodes Bus Company is considering the replacement of one of its buses

with a new one.
It is estimated that the new bus will bring in extra revenues amounting to
$12 000 000 per year as well as savings in maintenance costs amounting to
$1 300 000 per year. The new bus is expected to cost $19 000 000 plus
shipping costs of $1 200 000. The bus is expected to operate for five years
and to have a salvage value of $5 000 000. There will be an increase of $100
000 per year in working capital resulting from the use of the new bus.

The old bus was bought four years ago and now has a market value of $300
000 and a zero book value.

The company elects to claim SIA on the bus using the current rates and has
a tax rate of 30% per year.

Calculate:
1. The initial investment.
2. The annual cash flows.
3. The terminal cash flow of the project.

Classification of Capital Projects

The effects of a capital budgeting decision continue over many years and
therefore, such a decision may not be easy to reverse. Capital budgeting
decisions also define the strategic direction of the firm because a decision to
move into new products, services or markets, for example, must be preceded
by a capital budgeting expenditure.

A company usually considers more than one project at a time. Based on this
notion, there
are basically two types of the projects: mutually exclusive or independent.

 Mutually exclusive projects cannot be carried out at the same time. If

project A and project B are mutually exclusive, for example, accepting
one of them means the rejection of the other. On the other hand,
 Independent projects, the acceptance of one may not necessarily mean
the rejection of other projects that may be under consideration.

Another issue related to the classification of projects is the types of

decisions. In investment appraisal there are two types of decision that we
face.
1. We either have to accept or reject decisions, for mutually exclusive
projects.
 2. We have to rank independent projects. Projects which are more
attractive according to the appraisal, are ranked higher than those
which are less attractive.

Steps in Investment Appraisal

We have seen that the first step in the appraisal of a capital expenditure
project is the determination of the project's net, after-tax cash flows. The
next step after this, is to determine the cost of the funds used in the project.
This is especially important if we are to use discounted cash flow techniques
in our appraisal.

In estimating the cost of funds, we need to consider the sources of those

funds, since the cost of funds is the return that is required by the suppliers
of both debt and equity capital that has been used to finance the project,
taking into account the risk of the project. In other words, it is the weighted
average cost of debt and equity.

The following example clarifies this.

Example
A firm requires $400m to finance its capital project. $300 of this will come
from the issue of new shares on which the investors require a return of 20%.
The balance will be borrowed at an interest rate of 18%.

Ignoring taxation, the weighted average cost of capital for this project would
be:
[(300 / 400) x 0.20] + [(100 /400) x 0.18] = 0.195 = 19.5%.

Project appraisal techniques

After we have got our cash flows as well as the cost of the funds used in the
project, we are now in a position to make an appraisal of the project. There
are various elements of the accounting system that are used including;
 Payback period.
 Discounted payback period.
 Net Present Value [NPV] method
 Internal Rate of Return [IRR] method.
 Modified Internal Rate of Return [MIRR] method.
 Profitability Index [PI].

We discuss each of these, including the problems associated with them, and
their merits and demerits in the following subsections.
The Payback method

The payback period tells us the number of years required to recover the
initial cash outlay from the project’s expected net cash flows (The payback
period, defined as the expected number of years required to recover the
original investment). It is the ratio of the initial cash outlay to the annual
net cash flows.

Example: payback period with equal annual cash flows .

A firm is considering a project whose expected net, after-tax cash flows are
as follows:
Initial Investment = $ 18 000.00
Annual cash flows = $ 5 600.00 per year for the next 5 years. What is the
payback period?

Solution
The payback period = 18 000 / 5 600 = 3.2 years.

Example: payback period with unequal annual cash flows .

A project has the following expected annual net, after-tax cash flows :

Year Expected Net Cash flow Cumulative Cash Flow

0 ($ 18 000) ($ 18 000)
1 $ 4 000 ($ 14 000)
2 $ 6 000 ($ 8 000)
3 $ 6 000 ($ 2 000)
4 $ 4 000 $ 2 000
5 $ 4 000 $ 600

In this example, you can see that the payback period falls between 3 years
and 4 years. Toget the actual payback period, we use the following formula:

Payback = Year before full recovery + [unrecovered cost at start of year / cash
flowduring year]

Therefore the payback period = 3 + [ 2 000 / 4 000 ] = 3.5 years.

Decision criteria of Payback period

A company might have a standing policy that all projects must recover their
full cost within a certain period of time. If the payback for a particular
project falls within this stipulated period, then the project is acceptable.

If, for example, the company policy payback was 3 years, then the project
would be accepted. In this sense therefore, the payback period may be said
to be a rough measure of the risk associated with the project. The longer the
payback, the greater the risk, therefore the less acceptable a project is.

In the case of mutually exclusive projects, those with longer paybacks are
eliminated in favour of those with shorter paybacks. As for independent
projects, those with shorter paybacks would be ranked higher than those
with longer paybacks.

Criticism of payback period

 The regular payback does not take into account the time value of
money, assuming that cash flows received in the future are just as
good as cash flows received today. In this sense it does not take into
account the cost of capital. A project may be financed by both debt
and equity and we need to factor in the cost of obtaining these funds,
using an appropriate discount rate.
 It suffers from “Fish-bait criteria” i.e. (the size of the fish matters, not
just catching something). It focuses only on the covering the initial
investment than profitability.
 it ignores cash flows beyond the payback period, as is evident from
the above examples.

Discounted Payback Method

It is a refinement of the payback method and seeks to overcome the

problems of the time value of money before calculated.

To overcome the problems of the regular payback, the expected cash flows
are discounted at the project’s cost of capital. The discounted payback
period is therefore the number of years required to recover the investment
from discounted cash flows .

Example

A project has the following net after tax cash flows;

Year 0 1 2 3 4
Cash flows -1000 500 400 300 100

Calculate the discounted payback period if the cost of capital is 10%.

Solution

Year 0 1 2 3 4
Cash flows -1000 500 400 300 100
Discounted -1000 500
=454.55
400
=330.5
300
=225.39
100
=68.30
1.1 (1.1)^2 (1.1)^3 (1.1)^4
Cash flows
Cumulative -1000 -545.45 -214.89 10.5 78.8
cash flow

Discounted Payback Period=2 years + 214.89/225.39

= 2.95 years

The discounted payback shows the break-even year after covering the cost of
debt and equity.

General critique of payback methods

The payback provides information on how long funds will be tied up in a

project.Therefore, the shorter the payback, the greater the project’s liquidity.
Since cash flows expected in the distant future are generally riskier than
near-term cash flows, the payback can be used as a crude measure of risk.
The company that is cash poor may find the method useful in gauging the
early recovery of funds invested.

The proper measure of risk, however, is the standard deviation of expected

cash flows, which takes into account the dispersion of the possible cash
flows. The payback measures only the magnitude and timing of the expected
cash flows relative to the original investment. It cannot therefore, be
considered an adequate indicator of risk. It is more appropriately treated as a
constraint to be satisfied rather than a measure of profitability.

The payback discriminates against longer term projects, which may turn out
to be more profitable for the shareholders, by ignoring the cash flows after
the payback period. This is demonstrated for you in the following example.

Example
The cash flows for projects X and Y are as follows :

Project X Project Y
Year 0 (10 000) (10 000)
Year 1 1 000 5 000
Year 2 2 000 3 000
Year 3 3 000 2 000
Year 4 4 000 1 000
Year 5 8 000 500

The payback period for project X is 4 years whereas that for Y is 3 years. If
these projects were mutually exclusive, Y would be accepted and X rejected.
Project Y is, however, a shorter-term project than X in that the cash flows of
X show a rising trend and those for Y are decline drastically after the
payback period.

The Net Present Value (NPV)

It is the difference between the present value of the initial cash outlay and
the present value of the cash inflows of project discounted at the cost of the
capital.

The steps to be followed in evaluating a project using the NPV method are as
follows :

 Find the present value [PV] of each period’s cash flow, including both
inflows and outflows, discounted at the project’s cost of capital,
 Sum the PVs to find the NPV.
 If the NPV is positive, accept the project and if the NPV is negative,
reject the project.
 For two or more projects, accept the project with the highest NPV, if
the projects are mutually exclusive. If the projects are independent,
accept the project with the highest NPV first and rank them
accordingly.

The NPV is found by the following formula :

𝑪𝑭
NPV=∑𝒏𝒕=𝟏 ((𝟏+𝒕)𝒕) – I0

Where I0=Initial cash outlay

t=time of periods 1,2,3,4 ……n

 n=number of periods

Example

Using the information from the example on discounted payback period

calculate the Net Present Value of the project.

Solution
𝐶𝐹
Given that ; NPV=∑𝑛𝑡=1 ((1+𝑡)𝑡) – I0

500 400 300 100

NPV=∑(((1.1)1 +(1.1)^2 +(1.1)^3 +(1.1)^4 )-1000)

=$1078.82-$1000

=$78.82

This investment has a total value or present value of future cash flows of
$1078.82. Since the investment is acquired at a cost of $1000(the initial
outlay). The investment company is giving up $1000 of its wealth in
exchange of an investment worth $1078.82. This means the investors wealth
has increased by a margin of $78.82.

It can be safely said that: the NPV is the amount by which the investors
wealth increases or decreases as a result of an investment. The decision rule
is:

1. Invest: if NPV >0,

2. Do not invest: if NPV <0

It should be noted that positive NPV investments are wealth increasing

whilst negative NPV investments are wealth decreasing.

Example: Calculating NPV with Constant Cash flows

A project is expected to generate net cash flows of $600.00 per year for the
next three years. The initial investment in the project is $ 1000.00 and the
cost of capital is 10%.

Solution

Since this is an annuity, the NPV will be found as follows :

NPV = [ 600.00 ( PVIFA10%,3years ) ] - 1 000.00
= [ 600.00 ( 2.487 ) ] - 1 000.00.
= $ 492.00.

Rationale for the NPV

An NPV of zero signifies that the project’s cash flows are exactly sufficient to
repay the invested capital and to provide the required rate of return
demanded by the providers of the capital used on the project [both equity
and debt ].

If the NPV is positive, the project’s cash flows are generating more than the
required rate of return [RRR]. Since the return to bond holders [the
providers of debt capital] is fixed [ the interest on debt], the extra return
accrues solely to the firm’s stock holders [the providers of equity capital,]
who receive their return [dividend] only after the bond holder have been
paid their fixed amount. It therefore follows that if a firm takes on a zero-
NPV project, the position of the shareholders remains unchanged. The firm
only becomes larger to the extent of the size of the project, but the wealth of
the shareholders, that is the price of the company’s shares, remains
constant.

If the firm takes on a positive-NPV project, the position of the shareholders

is improved by the amount of the NPV. Thus, if the firm takes on the project,
the wealth of the shareholders is increased directly by the NPV amount,
thus enhancing the share price of the firm.

Practice Question
A project has an initial cash outlay of $800000. The life of the project is 4
years; residual value of the asset in 4 years is $90000. Expected revenue per
year is $650000. $450000 of the capital required is borrowed at 15% after
tax amount. The balance is raised through the issue of new shares at a
required rate 18%. Evaluate if the project is worth investing in or not.
(-$55622.09) NPV=Reject the project

Internal Rate of Return (IRR)

The IRR is the yield or rate of return generated by the project’s internal
cash flows. It is an internally generated rate of return. It can also be defined
as a discount rate that makes the present value of the future after tax cash
flows of a project equal to the initial outlay. It yields an NPV of zero (NPV=0).
𝑪𝑭𝒕
NPV=∑𝒏𝒕=𝟏 (𝟏+𝑰𝑹𝑹)𝒕 − 𝑰𝟎 = 𝟎
 𝑛
𝐶𝐹𝑡
∑ =𝐼
(1 + 𝐼𝑅𝑅)𝑡
𝑡=1

At the IRR,NPV=0

Therefore IRR is a rate of return generated by the internal cash flows of a

project.

Decision Rules for IRR

It is such that: Accept the project: if IRR >Required Rate of Return

: Reject the project: if IRR < Required Rate of Return

The Required Rate of Return is equivalent to the Weighted Average Cost of

Capital.

How do we find the IRR?

We find the IRR using the Iterative Methods- specifically Estimation by

Interpolation

Example

An investment with an initial outlay of $12000 returns a constant after tax

cash flows of $24000 per annum for 10 years. What is the IRR for the
project?

Solution
𝐶𝐹𝑡
Given that ; ∑𝑛𝑡=1 (1+𝐼𝑅𝑅)𝑡 = 𝐼

𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹10

I=(1+𝐼𝑅𝑅)^1 +(1+𝐼𝑅𝑅)^2 +(1+𝐼𝑅𝑅)^3 +............(1+𝐼𝑅𝑅)^10

24000 24000 24000 24000

120000=(1+𝐼𝑅𝑅)^1 +(1+𝐼𝑅𝑅)^2 +(1+𝐼𝑅𝑅)^3 +............(1+𝐼𝑅𝑅)^10

Let’s try to make IRR the subject of the formulae and see if we can win.[we
can’t ]….lol

Also notice that the pattern of the payments is in the form of an annuity.

Let’s employ our knowledge of annuities then.

120000= R×PVIFAn,%
 (1+𝐼𝑅𝑅)10 −1
=24000×𝐼𝑅𝑅(1+𝐼𝑅𝑅)^10

Even so , we cannot make IRR subject by mere algebraic manipulation. So

we use trial and error then we interpolate.

Formulas for estimation of the value of IRR

If Z is to the left of both X and Y we use:

𝑧−𝑥
IRR =a-(𝑥−𝑦)(b-a)

If Z is between X and Y we use:

𝑥−𝑧
IRR =a+(𝑥−𝑦)(b-a)

If Z is to the right of both X and Y we use:

𝑥−𝑧
IRR =b+(𝑥−𝑦)(b-a)

Where: Z=initial outlay or investment initial outlay (PV)

a=is the lower discount rate

b=is the higher discount rate

x=is the Present Value associated with the lower discount rate

y= is the Present Value associated with the higher discount rate

The relationship between the Present Value and a Discount Rate;

To reduce the Present Value you increase the discount rate (an inverse
relationship) and vice versa.

Finding IRR by trial and error then Interpolation

You can just try any percentage and calculate the PVs so that you compare
with the I0.

For the problem above;

Try with 10%

(1.10)10 −1
PV (10%) =10%=(0.1(1.10)^10)*24000

=147469.61
This is not the same with Z of $120 000 ,it is greater than Z so let’s
increase the discount rate to get a r PV that is slightly lower or the same as
Z

Try with 18%

(1.18)10 −1
PV (18%) =18%=(0.18(1.18)^10)*24000

=107858.07

This is also not equal to Z of $120000. We have to look for another discount
rate which will equalize the PV to Z,but this may take us forever so we resort
to interpolation to find an estimate of this IRR.

The next step is to compare the relationship of X, Y and Z ,so that we knw
which formula to use for our interpolation.

If we compare the 2values (a= 10%) ⇛X=147469.61 and (b=18 %) ⇛( Y=

107858.07) with Z= 120 000 ,we can see that our Z figure lies between the
two figures X and Y so we construct a table.

a% IRR b%
X Z Y
10% IRR 18%
147469.61 120000 107858.07

So our Z is between X and Y so the formulae to use is the formulae #2

Graphical line representation

Y Z X

107 858.120 000 147 469.61

𝑥−𝑧
So IRR =a+ (𝑥−𝑦)(b-a)

147469.61−120000
= 0.1+ (147469.61−107858.07)(0.18-0.10)
 27469.61
= 0.1+ (39611.54)(0.08)

=0.1+0.693474931*0.08

=15.5%

Example

An investment has an initial capital outflow of $600000 and is going to

generate the following successive yearly cash flows of $50000, $70000,
$150000, $200000, $250000 and $300000. If theinvestor RRR is 14%.
Determine whether the project is worthwhile using the IRR method.

Solution

Use the same methods above.

Example

A company is trying to decide whether to buy a machine for $ 80 000.00.

The machine will save the company costs of $ 20 000 per year for five years
and have a resale value of $ 10 000 at the end of that period. What is the
IRR? (Ignoring tax effects ).

Solution

The IRR is found by trial and error [interpolation] if one is not using a
financial calculator.We apply different discount rates to the cash flows until
we get one which produces an NPV of zero.

Try 9%:

Year Cash flow x PVIF = present value

0 (80000) x 1.000 = (80000)
1 –5 20 000 x 3.890= 77 800
5 10 000 x 0.650 = 6 500
NPV = 4 300

Since this is a positive NPV, we try a higher discount rate, say 12% , to get a
negative NPV:
 NPV = [20 000 (3605) + 10 000 (0.567) ] - 80 000
= - 2 230.

Since the NPV is negative, the required discount rate lies somewhere
between 12 % and 9%, as shown in the following diagram, known as the
NPV profile of the project :

NPV Profile for the project

NPV ($)
IRR = 10.98%

$ 4 300

0 9% 10.98% 12% Discount Rate (%)

-$ 2 230

The IRR is the discount rate that will result in a zero NPV, therefore lies
somewherebetween 9% and 12%. It is found by the following formula :

IRR = A + [(a / a + b)][(B – A)]

Where A = the lower discount rate which produces a positive NPV,

a = the NPV resulting from a discount rate of A%,
B = the higher discount rate which produces a negative NPV,
b = the NPV resulting from a discount rate of B%.

NB. We treat the –NPV as a positive in the formulae.

Thus, in this example, the IRR is equal to 10.98%, which is approximately

11%.

The decision rule for the IRR is that we should accept the project if the IRR
is greater thanthe RRR, that is the cost of capital. If the IRR is less than the
RRR, then the project shouldbe rejected. If we are comparing two mutually
exclusive projects, we would take the onewith the higher IRR.
Rationale for the IRR

The IRR is the return that is expected to be generated by the project's net
cash flows, assuming that all the cash flows are reinvested into the project.
If the IRR exceeds the cost of the funds used to finance the project [the
RRR], a surplus remains after paying for the funds, and this surplus belongs
to the firm’s shareholders. Therefore, taking on a project whose RRR exceeds
the cost of capital increases the shareholders’ wealth.

The decision criterion is therefore that if the project's internal rate of return
exceeds the required rate of return, the project should be accepted.

The decision criteria for independent projects is to take those projects with a
higher IRR first. If the projects are mutually exclusive, we take on those
projects with a higher IRR and reject those with a lower IRR.

Conflict between the NPV and the IRR

There may be a conflict between the decision resulting from an NPV analysis
and that resulting from an IRR analysis. This conflict arises when the
projects are mutuallyexclusive rather than independent.

For independent projects, the NPV and the IRR always lead to the same
accept / rejectdecision, that is if NPV says accept, IRR also says accept. The
criterion for acceptance isthat the project’s cost of capital [RRR] is less than
[to the left of] the IRR. Whenever theproject’s cost of capital is less than the
IRR, its NPV is positive, therefore the project isacceptable using both
methods. Both methods reject the project if the cost of capital isgreater than
the IRR.

If IRR >Cost of Capital(RRR), then NPV >0

If two projects, A and B are mutually exclusive, we can choose either A or B,

or we canreject both, but we cannot accept both projects.

Let us suppose we had two projects, A and B.

PROJECT A PROJECT B
NPV $100 000 $150 000
IRR 20% 18%

You can see that project A has a lower NPV than project B, but it has a
higher IRR. Thisconflict between A and B is illustrated as below :
Conflict between projects

NPV($)
Cross-over rate
IRRb
IRRa
NPVb

NPVa

RRR Discount Rate (%)

NPV profile (A)

NPV profile (B)

According to the NPV method, project B should be accepted and A rejected.

But accordingto the IRR project A should be accepted and B rejected.As long
as the cost of capital [RRR] is greater than the cross-over rate, the NPV of
projectA is greater than the NPV of project B and the IRR for project A is
greater than the IRRfor project B.

Therefore for IRR greater than the cross-over rate, the two methods lead
tothe selection of the same project. However, if the cost of capital [RRR] is
less than thecross-over rate, a conflict arises. The NPV ranks project B
higher but the IRR ranks Ahigher.

Why conflicts arise

Conflicts arise for two reasons :

 When project size [scale] differences exist, that is when the initial
capital outlay on oneproject is greater than that on the other.
 When timing differences exist, that is the timing of the cash flows
from the twoprojects differs such that most cash flows from one
project come in the early years andmost of the cash flows from the
other project come in the later years.

You may be wondering ‘How can I deal with such a conflict ?” Let us study
the next example for the answer.
Example :Resolving conflict between NPV and IRR

The following two projects aremutually exclusive:

Project A Project B
Year 0 (10200) (35250)
Year 1 6 000 18 000
Year 2 5 000 15 000
Year 3 3 000 15 000

The company’s cost of capital is 16%.

At this rate of discount the NPV for A is $610.00and the NPV for B is $ 1
026. The IRR for A is 20% and the IRR for B is 18%. Therefore,using the
NPV method, B is preferred to A but using the IRR, A is preferred to B.

In actual fact, B is better if we consider the differential [orincremental] cash

flows thatwould occur from the adoption of B rather than A. If we discount
these incremental cashflows at 16% we find that the present value of the
incremental benefits from project Bexceed the present value of the
incremental costs, that is, the NPV of the differential cashflow is positive.

Therefore, it is worth spending the extra capital on project B and also

theIRR of the differential cash flows exceed the cost of capital [16%].

Year Project A Project B Difference PVIF (16%) PV of Differential CF

0 (10 200) (35 250) (25 050) 1.000 (25 050)
1 6 000 18 000 12 000 0.862 10 344
2 5 000 15 000 10 000 0.743 7 430
3 3 000 15 000 12 000 0.641 7 692
NPV = 416

The IRR of the differential cash flows is 18%.

Why the NPV is regarded as superior to the IRR

We have seen that the cost of capital is the weighted average between the
cost of debt andthe cost of equity. When a project generates cash flows, they
must be paid out to the debtholders and equity holders, who on average
require a return which is equal to the cost ofcapital [the discount rate, or the
RRR].
We have also seen that there are two sources of funds for the firm, debt and
equity.However, in the case of equity, we have internally generated equity,
that is retainedearnings, and new equity. Thus, the cash flows of the project
can be paid out as dividendsafter we have paid interest on debt.
Alternatively, the cash flows can be retained and usedas a substitute for
outside sources of funds, after paying out the interest on debt capital.

Now, suppose that the cost of capital ( RRR, or WACC ) is 18%. This means
that byretaining all the cash flows, we are saving the firm the cost of
obtaining outside sources offunds at a cost of 18%. We can, therefore say
that the value of the cash flows to the firm is18%. As you can see, this value
is an opportunity cost. In other words, it is the requiredrate of return, which
the shareholders would obtain on alternative investments of similarrisk if we
had paid them their dividend instead of retaining the cash flows.

The NPV is regarded as superior to the IRR due to the assumptions they
both make aboutthe treatment of the project’s cash flows. The IRR assumes
that the cash flows arereinvested at the IRR itself. Obviously, the IRR will
vary from project to project,depending on the cash flows of each particular
project. As we have seen, a project is onlyacceptable if the IRR is greater
than the RRR.

Now, if a firm can get funds from outside at the same cost as the RRR,
which is also thediscount rate that is applied to projects, the appropriate
reinvestment rate would be theopportunity cost of capital, that is the RRR.
The NPV assumes that the cash flows from theproject are reinvested at the
RRR, which is built into the NPV method. Thus, whenevaluating mutually
exclusive projects, especially those with timing and scale differences,the NPV
should be used rather than the IRR.

Problems with IRR

The use of IRR in appraising projects is fraught with problems. Firstly, the
IRR ignores therelative size of the projects, as shown in the following
example:

Project A Project B
Year 0 (350 000) (35 000)
Year 1 – 6 100 000 10 000
Project A is 10 times bigger than project B, therefore more profitable, but
both have thesame IRR of 18%.

Secondly, the IRR is not effective when it comes to unconventional cash

flows.

Let’s study thefollowingexampleinvolving two projects.

PROJECT A PROJECT B
Cash flows ($) Cash flows ($)
YEAR
0 (100 000) (120000)
1 (50000) 50 000
2 60 000 80 000
3 90 000 (50000)
4 80 000 20 000

Project B is not a conventional project. As you can see, we have an outflow

in year 0 whichis followed by two inflows before we get another outflow in
year 3, which is followed byanother outflow in year 4. If the cash flows from
the project are not conventional [out flowsfollowed by inflows, as in project
A], there may be more than one IRR.

The equation for the IRR is a polynomial of n degrees, therefore it has n

different roots orsolutions. All except one of the roots are imaginary
numbers when the cash flows arenormal, therefore in the normal case only
one value of IRR appears. For non-conventionalcash flows, there are
multiple real roots, hence multiple IRRs. In the case of project B,there would
be two internal rates of return.

Thus, the IRR is inferior to the NPV method.

The Modified Internal rate of return [MIRR]

In spite of the strong academic preference for the NPV over the IRR, surveys
have shown that the IRR is by far the preferred method of investment
appraisal. The IRR is easier to understand as it looks at percentages rather
than absolute figures. In order to take into account the objections regarding
the re-investment assumption, we can modify the IRR by assuming that the
cash flows are re invested at the required rate of return before calculating
the IRR.
The modified internal rate of return (MIRR) is given by the following formula:

MIRR = PV Costs = TV / (1 + MIRR)

Where: TV = the future value of the inflows reinvested at the cost of capital
[known as the terminal value ]
MIRR=the discount rate that forces the present value of the terminal value
to equal the present value of the costs is the.

The following example illustrates this.

Example: Calculating the MIRR

Suppose we have the following time line for a particular project with a cost
of capital of 10%

Timeline: Modified Internal Rate of Retrun

0 1 2 3 4

(1000) 500 400 300 100 100.00

330.00
484.00
665.50
1 579.50
PV[TV]= 1000[I0] @ MIRR = 12.1%

To calculate the MIRR you take the following steps.

Step 1: Find the terminal value [TV] . This is the total of the future values of
all the cash flows reinvested, that is compounded, at the cost of capital
[RRR], 10%. The TV =$ 1 579.50.

Step 2:Find the discount rate that will give a present value of $1 000 on a
future value of$1 579.50, the IRR. This is found by trial and error in the
normal way. This discount rate is12.1%, which is the MIRR for the project.

Since the MIRR is greater than the cost of capital, 10%, the project is
acceptable. Theconventional IRR for this project would have been 14.5%.

Revising NPV Analysis for Inflation.

In the absence of inflation, the real rate is equal to the nominal [quoted] rate
of interest.The cost of capital, that is the RRR, includes an inflation
premium because investorsalways try to protect themselves against a
decline in their purchasing power by includingan adjustment for inflation in
the required rate of return. The cost of capital is a nominalrate in that it
takes into account the expected rate of inflation. On the other hand, cash
flowsare usually real cash flows in that they do not include inflation effects.

As inflation increases so does the minimum return required by an investor.

It is, thereforeimportant to adjust the cash flows before we discount them at
the nominal rate, whichalready contains an inflation premium. Alternatively,
we should convert the nominal rateinto a real rate before we discount the
cash flows.

To convert a nominal interest rate to a real rate, we use the following

formula :

(1 + nominal rate) = (1 + real rate) (1 + inflation rate)

Let us say for example, the required [quoted ] rate of return is 20% under
the current andanticipated conditions and the rate of inflation is currently
running at 10% per year, we cansolve for R [ the real rate ] as follows :

(1 + 0.20 ) = ( 1 + R ) ( 1 + 0.10 )

Therefore R = 0.091 or 9.1%.

This means that a return of 20% will protect the shareholders against the
loss of purchasingpower and also provide a real return of 9.1%.

In dealing with inflation, we should always:

 discount nominal cash flows using a nominal discount rate; and

 discount real cash flows using a real discount rate.

If the information is mixed, that is real cash flows with nominal rates, or
nominal cashflows with real rates, we should :
 change nominal cash flows to real cash flows, or
 change real cash flows to nominal cash flows,
 change nominal rates to real rates, or
  change real rates to nominal rates,

,so that nominal cash flows are discounted at nominal rates or real cash
flows are discountedat real rates.

Example: Discounting real cash flows at a real rate of return

The following nominal cash flows must first be converted to real cash flows
before beingdiscounted at the real rate of 9.1%.
Year Nominal CF Real CF
0 ( 15 000 ) ( 15 000 )
1 9 000 9 000 / ( 1.10 ) = 8 182
2 8 000 8 000 / ( 1.10 )2 = 6 612
3 7 000 7 000 / ( 1.10 )3 = 5 259

Discounted cash flows at the real rate of 9.1%:

Year Discounted cash flow
0 (15000)
1 8 182 / ( 1.091 ) = 7 500
2 6 612 / ( 1.091 )2= 5 555
3 7 000 / ( 1.091 )3= 4 050
NPV = 2 105
This is the NPV of the project after taking into account the effects of
inflation.

The Accounting Rate of Return

The accounting rate of return (ARR) is based on the return on investment

ratio (ROI). The ROI is the ratio between the operating income for the year
(from the income statement) and the total assets employed (from the balance
sheet). It is a measure of the effectiveness with which the company is
utilizing its assets to generate profits. Since management is often evaluated
on the basis of this ratio, it is also an appropriate measure of the likely
performance of a project. When applied to projects, the ratio is known as the
ARR. Using this ratio, a project can be evaluated on the basis of an
appropriate ARR. A project with a good ARR will in turn contribute positively
to the firm’s overall ROI.

(𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐜𝐫𝐞𝐦𝐞𝐧𝐭𝐚𝐥 𝐧𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞)

𝑨𝑹𝑹 =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
Where:
1. Average incremental net income is the expected annual average
increase innet income if the project is accepted. This is equal to

Total net Income from the project/Project economic life

However, as we have discussed before, when we are analyzing project cash

flows, we must first deduct depreciation and other non-cash flow items from
the netincome.
2. Average investment = Cost of the investment

Example
A firm is considering a project with an expected economic life of fiveyears.
The following data also relate to the project:
Capital outlay: $ 200 000
Residual value: nil (assuming straight line depreciation)
Expected Annual Net Income :
Year Expected Net Income ($)
1 60 000
2 80 000
3 76 000
4 58 000
Total 274 000

The project’s ARR is calculated as follows :

1. Total net income = 274 000.
2. Average net income = 274 000 / 5 years = 54 800 per year.
3. Depreciation per year = 200 000 / 5 year = 40 000 per year
4. Average investment = 200 000 / 2 = 100 000
5. Average net cash flow = 54 800 – $ 40 000 = 14 800

ARR = Average net cash flow/Average investment

= 14 800 / 100 000 = 0.148, or 14.8%.

The ARR can alternatively be calculated on the basis of the total investment
rather thanthe average investment as follows:

ARR = 14 800 / 200 000 = 0.074, or 7.4%.

A major criticism of the ARR is that it ignores the time value of money and is
thereforeinferior to other methods which are based on discounting
techniques. If the ARR iscalculated purely on the basis of accounting
income, without adjusting for depreciation andother non-cash flow items, it
becomes even less suitable to apply to project appraisal.

Capital rationing.

Capital rationing is a situation in which the firm does not have adequate
funds for all itsviable projects.

Single period capital rationing is where capital is limited for the current
period only butwill be freely available in the future.

Multi-period capital rationing is where capital will belimited for several

periods.

Divisible projects are those that can be undertaken completely or in

fractions. This alsomeans that the NPV is divisible. Indivisible projects are
those which must be undertakencompletely or not at all because it is not
possible to invest in a fraction of the project.

Profitability index (PI)

The profitability index is the ratio between the present value and the cash
outlay on theproject. The PI is a measure of the present value per dollar of
capital invested. A projectshould be accepted if the PI is greater than 1. If we
have capital rationing, projects shouldbe ranked according to their PIs.

Formula:

Profitability Index = Present Value of Future Cash Flows

Initial Investment Required

= 1+ Net Present Value

Initial Investment Required

Profitability index is actually a modification of the net present value method.

While present value is an absolute measure (i.e. it gives as the total dollar
figure for a project), the profibality index is a relative measure (i.e. it gives as
the figure as a ratio).
The Decision Rule is to Accept a project if the profitability index is greater
than 1, stay indifferent if the profitability index is zero and don't accept a
project if the profitability index is below 1.

Profitability index is sometimes called benefit-cost ratio too and is useful in

capital rationing since it helps in ranking projects based on their per dollar
return.

Example: Capital rationing with divisible projects

A company has available $250 000 for investment in the forthcoming period
at a cost ofcapital of 25%. The following six projects are under
consideration.

PROJECT REQUIRED INVESTMENT PV @ 25%

1 $50 000 $90 000
2 $70 000 $100 000
3 $40 000 $70 000
4 $100 000 $160 000
5 $90 000 $120 000
6 $80 000 $95 000

The first step is to rank the projects according to the PI.

PROJECT PROFITABILITY INDEX RANKING

1 1.8 1
2 1.4286 4
3 1.75 2
4 1.6 3
5 1.33 5
6 1.1875 6

The next step is to allocate the available funds according to the PI.

PROJECT INVESTMENT CUMULATIVE INVESTMENT

1 50 000 50 000
3 40 000 90 000
4 100 000 190 000
5 90 000 280 000
6 80 000 360 000

The company should take projects 1, 3, and 4. These would require $190
000. The balanceof$60 000 (i.e. $250 000 - $190 000), will then be invested
in a fraction of project 5. Thisfraction will be 67% (i.e. $60 000 / $90 000).
Project 6 cannot be undertaken this year.

If the projects are not divisible, then both 5 and 6 will be shelved for this
year and thefunds left over, $60 000, should be placed in other investments,
such as money marketsecurities.

Practice Questions
1. Discuss the conflict between NPV and IRR.
2. Distinguish between single and multi-period capital rationing.
3. Explain how the profitability index (PI) is used in appraising projects.

Sensitivity analysis

Sensitivity analysis is a way of determining how sensitive the project's NPV

is to the manyvariables that may affect it. We know that the NPV is
calculated on the basis of estimates,such as expected revenues and
expected expenses. Expected revenues are in turn based onexpected sales
levels in units and expected selling price per unit. On the other
hand,expected expenses also depend on expected variable costs per unit,
such as the cost of laborand materials.

Sensitivity analysis is based on asking "what if " questions regarding these

input variables.
For example, we could calculate the NPV using different estimates of
material cost per unitto measure how sensitive the NPV would be to
estimation errors regarding this variable. Ifour estimate of the expected cost
of materials is wrong, then our estimate of the project'scash flows will also
be inaccurate.

In sensitivity analysis we would want to find out what would happen to the
estimate of the
NPV under different assumptions regarding each input variable. We then
determine theinput variables to which the NPV is most sensitive and put
more resources and effort inestimating those input variables. We then put
more attention to controlling those variablesonce the project has been
implemented.

Some of the drawbacks of sensitivity analysis are as follows:

 1. It assumes that we can alter each input variable in isolation from
others. However, mostinput variables are interrelated. For example,
changing the selling price per unit mayalso affect the number of units
sold.
2. It ignores the probability distribution of each input variable. Since
each variable isbeing estimated, it would have its own probability
distribution.

The following example will show you how the concept of sensitivity analysis
can beapplied:

Example
A project requires an initial investment of $570 000 and provides annual net
cash flows of$220 000 each for a period of 5 years. The cost of capital is
24%.

1. Calculate the NPV of the project.

Solution
NPV = R×PVIFA – I0
NPV = ( 220 000 x 2.7454 ) - 570 000 = $33 988.

2. Suppose the variable cost per unit increases by 10%, resulting in the
decrease of20% in the estimated net annual cash flows. Will the project still
be acceptable?

Solution
New cash flow estimate = 220 000 ( 1 - 0.20 ) = $176 000.
NPV = ( 176 000 x 2.7454 ) - 570 000 = -$86 809.60.

3. By how much should the annual cash flows decline before the NPV falls
to zero?

Solution

Let the annual cash flow be equal to a, therefore:

0 = 2.7454a - 220 000
220 000 = 2.7454a
a = 80 134.04.

This means that annual cash flows should fall to $80 134.04 for the NPV
tofall to zero, that is by 63.58% from the current estimate.