BAC204 BUSINESS FINANCE 11

LESSON 1

Capital Budgeting

Meaning
The term Capital Budgeting refers to the long-term planning for proposed capital
outlays or expenditure for the purpose of maximizing return on investments. It is the
process of evaluating and selecting long-term investments consistent with the firm’s goal
of shareholder wealth maximization. It is a crucial process in any organization because
huge amounts of funds could easily go down the drain where an investment is not planned
optimally. In a dynamic and competitive environment, efficient asset allocation of capital
resources is a very important function of financial management. The Function involves
organizations decisions to invest in long term physical assets such as plant and equipment,
industrial buildings, motor vehicles among others. The capital expenditure may be :
Cost of mechanization, automation and replacement.
(2) Cost of acquisition of fixed assets, e.g., land, building and machinery etc.
(3) Investment on research and development.
(4) Cost of development and expansion of existing and new projects.
DEFINITION OF CAPITAL BUDGETING
Capital Budget is also known as "Investment Decision Making or Capital Expenditure
Decisions" or "Planning Capital Expenditure" etc. According to Pandey(2005), investment
decisions are decisions that influence a firm’s growth in the long term, affect the risk of
the firm, involve commitment of large amounts of funds, are irreversible or reversible at
substantial loss, and are among the most difficulty decisions to make. Normally such
decisions where investment of money and expected benefits arising therefrom are spread
over more than one year, it includes both raising of long-term funds as well as their
utilization. Charles T. Horngnen has defined capital budgeting as "Capital Budgeting is
long-term planning for making decisions and financing proposed capital outlays."
In other words, capital budgeting is the decision making process by which a firm
evaluates the purchase of major fixed assets including building, machinery and equipment.
According to Hamption, John. J., "Capital budgeting is concerned with the firm's formal
process for the acquisition and investment of capital."
 From the above definitions, it may be concluded that capital budgeting relates to the
evaluation of several alternative capital projects for the purpose of assessing those which
have the highest rate of return on investment.
Importance of Capital Budgeting
Capital budgeting is important because of the following reasons :
(l) Capital budgeting decisions involve long-term implication for the firm, and
influence its risk complexion.
(2) Capital budgeting involves commitment of large amount of funds.
(3) Capital decisions are required for assessment of future events which are
uncertain.
(4) Wrong sale forecast ; may lead to over or under investment of resources.
(5) In most cases, capital budgeting decisions are irreversible. This is because it is
very difficult to find a market for the capital goods. The only alternative available
is to scrap the asset, and incur heavy loss.
(6) Capital budgeting ensures the selection of right source of finance at the right time.
It improves timing and quality of assets.
(7) Many firms fail, because they have too much or too little capital equipment. Asset
expansion involves substantial expenditures and befor a firm spends a large
amount of money, it must make financial plans.
(8) Investment decision taken by individual concern is of national importance
because it determines employment, economic activities and economic growth.
Objectives of Capital Budgeting
The following are the important objectives of capital budgeting :
(1) To ensure the selection of the possible profitable capital projects.

(2) To ensure the effective control of capital expenditure in order to achieve by

forecasting the long-term financial requirements.
(3) To make estimation of capital expenditure during the budget period and to see
that the benefits and costs may be measured in terms of cash flow.
(4) Determining the required quantum takes place as per authorization and sanctions.
(5) To facilitate co-ordination of inter-departmental project funds among the
competing capital projects.
(6) To ensure maximization of profit by allocating the available investible funds.
Principles or Factors of Capital Budgeting Decisions
A decision regarding investment or a capital budgeting decision involves the
following principles or factors :
(1) A careful estimate of the amount to be invested.

(2) Creative search for profitable opportunities.

(3) A careful estimates of revenues to be earned and costs to be incurred in future in
respect of the project under consideration.
(4) A listing and consideration of non-monetary factors influencing the decisions.
(5) Evaluation of various proposals in order of priority having regard to the amount
available for investment.
(6) Proposals should be controlled in order to avoid costly delays and cost over-runs.
(7) Evaluation of actual results achieved against those budget.
(8) Care should be taken to think all the implication of long range capital investment
and working capital requirements.
(9) It should recognize the fact that bigger benefits are preferable to smaller ones and
early benefits are preferable to latter benefits.
Capital Budgeting Process
The following procedure may be considered in the process of capital budgeting
decisions :
(1) Identification of profitable investment proposals.

(2) Screening and selection of right proposals.

(3) Evaluation of measures of investment worth on the basis of profitability and
uncertainty or risk.
(4) Establishing priorities, i.e., uneconomical or unprofitable proposals may be
rejected.
(5) Final approval and preparation of capital expenditure budget.
(6) Implementing proposal, i.e., project execution.
(7) Review the performance of projects.
Types of Capital Expenditure
Capital Expenditure can be of two types :
(l) Capital expenditure that increases revenue.
(2) Capital expenditure that reduces costs.
 (1) Capital Expenditure Increases Revenue : It is the expenditure which brings
more revenue to the firm either by expanding the existing production facilities or
development of new production line.
(2) Capital Expenditure Reduces Costs : Such a capital expenditure reduces the
cost of present product and thereby increases the profitability of existing operations. It can
be done by replacement of old machine by a new one.
Types of Capital Budgeting Proposals
A firm may have several investment proposals for its consideration. It may adopt
after considering the merits and demerits of each one of them. For this purpose capital
expenditure proposals may be classified into :
(1) Independent Pmposals : These proposals are said be to economically
independent which are accepted or rejected on the basis of minimum return on investment
required. Independent proposals do not depend upon each other.
(2) Dependent Proposals or Contingent Proposals : In this case, when the
acceptance of one proposal is contingent upon the acceptance of other proposals, it is
called as "Dependent or Contingent Proposals." For example, construction of new
building on account of installation of new plant and machinery.
(3) Mutually Exclusive Proposals : Mutually Exclusive Proposals refer to the
acceptance of one proposal results in the automatic rejection of the other proposal. Then
the two investments are mutually exclusive. In other words, one can be rejected and the
other can be accepted. It is easier for a firm to take capital budgeting decisions on such
projects.
(4) Accept/Reject Vs Ranking Decisions: The accept /Reject approach
involves evaluating capital expenditure proposals to determine whether they meet the
firms minimum acceptable criterion. Ranking approach involves ranking projects on the
basis of some pre-determined measure. The project with the highest return is ranked first
and project with the lowest return ranked last.
(5) Unlimited Funds Vs Capital Rationing: If the firm has unlimited funds for
investment, all independent projects that provide returns greater than some predetermined
level can all be accepted. Typically firms operate under capital rationing since they have
limited resources available for capital expenditure and numerous projects compete for
these resources. Therefore the firmmust ration its funds by allocating them to projects that
will maximize share value.

(6) Expansion Vs Diversification Projects: The most common form of capital

expenditure is to expand the level of projects usually through aacquisition of fixed assets.
Growing firms often need to acquire fixed assets rapidly i.e Purchase of property and plant
facilities. As the firm grows and reaches maturity, most capital expenditure will be made
to replace obsolete or worn out assets. Managers often cite diversification as a reason for
mergers i.e Merging firms A, B, C etc. They contend that diversification helps stabilize a
firm’s earnings and thus benefits its owners. Stabilization of earnings is certainly
beneficial to employees, suppliers, and customers, but its value to stockholders is less
certain. Indeed, research suggests that in most cases diversification does not increase the
firm’s value.

(7) Acquisition Projects: This involves the purchase of a completely new asset where
none existed before e.g. the purchase of a motor vehicle, building a new building for the
first time etc.

(8) Replacement Projects: This involves replacing an old and inefficient asset with
newnand more efficient asst.

(9) Divisible and Indivisible projects: Divisible projects are those projects which start
to generate revenues even before they are complete e.g. a storey building. An indivisible
project is one which can not start to generate revenue unless it’s complete. E.g. A project
of offering computer services in which case the computer must be installed.

CAPITAL UDGETING TECHNIQUES

Methods of Evaluating Capital Investment Proposals

There are number of appraisal methods which may be recommended for evaluating
the capital investment proposals. We shall discuss the most widely accepted methods.
These methods can be grouped into the following categories :
a). The Non-Discounting Techniques
b). The Discounting Techniques

The Non-Discounting Techniques

(l) Pay-back period method

Pay-back Period Method : Pay-back period is also termed as "Pay-out period" or Pay-
off period. Pay out Period Method is one of the most popular and widely recognized
traditional method of evaluating investment proposals. It is defined as the number of years
required to recover the initial investment in full with the help of the stream of annual cash
flows generated by the project.
 Calculation of Pay-back Period : Pay-back period can be calculated into the following
two different situations :
(a) In the case of constant annual cash inflows.

(b) In the case of uneven or unequal cash inflows.

(a) In the case of constant annual cash inflows : If the project generates constant cash
flow the Pay-back period can be computed by dividing cash outlays (original
investment) by annual cash inflows. The following formula can be used to
ascertain pay-back period
.

Pay-back Period = Cash Outlays (Initial Investment)

Annual Cash Inflows
Illustration: 1
A project requires initial investment of Shs. 40,000 and it will generate an
annual cash inflows of Shs. 10,000 for 6 years. You are required to find out
pay-back period.
Solution:
Calculation of Pay-back period
Cash Outlays (Initial Investment) Pay-back Period
Annual Cash Inflows
Pay back period = Shs. 40,000 = 4
Years
Shs 10,000

(b) In the case of Uneven or Unequal Cash Inflows : In the case of uneven or unequal
cash inflows, the Pay-back period is determined with the help of cumulative cash inflow.
It can be calculated by adding up the cash inflows until the total is equal to the initial
investment.
Illustration: 2
From the following information you are required to calculate pay-back period :
A project requires initial investment of Shs. 40,000,000 and generate cash inflows of
Shs. 16.000,000 Shs. 14,000,000 Shs. 8,000,000 and Shs. 6,000,000 in the first, second,
third, and fourth year respectively.
Solution:
Calculation Pay-back Period with the help of "Cumulative Cash Inflows"
 Year Annual Cash Cumulative Cash Inflows
Inflows “000”
“000”
1 16,000 16,000
2 14,000 30,000
3 8,000 38,000
4 6,000 44,000
The above table shows that at the end of 4th years the cumulative cash inflows
exceeds the investment of Shs. 40,000,000 Thus the pay-back period is as follows :
40,000,000 - 38,000,000
Pay-back Period 3 Years +
6,000,000
3 Years +
2,000,000x12
6,000,000
3 Years and 4 Months
Accept or Reject Criterion
Investment decisions based on pay-back period used by many firms to accept or reject
an investment proposal. Among the mutually exclusive or alternative projects whose pay-
back periods are lower than the cut off period, the project would be accepted, if not it
would be rejected.
Advantages of Pay-back Period Method
(1) It is an important guide to investment policy
(2) It is simple to understand and easy to calculate
(3) It facilitates to determine the liquidity and solvency of a firm
(4) It helps to measure the profitable internal investment opportunities
(5) It enables the firm to select an investment which yields a quick return on cash
funds
(6) It used as a method of ranking Competitive projects
(7) It ensures reduction of cost of capital expenditure.
Disadvantages of Pay-back Period Method
(1) It does not measure the profitability of a project
(2) It does not value projects of different economic lives
 (3) This method does not consider income beyond the pay-back period
(4) It does not give proper weight to timing of cash flows
(5) It does not indicate how to maximize value and ignores the relative profitability
of the project
(6) It does not consider cost of capital and interest factor which are very important
factors in taking sound investment decisions.

(2) Rate of Return Method or Accounting Rate of Return Method.

Average Rate of Return Method (ARR) or Accounting Rate of Return Method :
Average Rate of Return Method is also termed as Accounting Rate of Return Method.
This method focuses on the average net income generated in a project in relation to the
project's average investment outlay. This method involves accounting profits not cash
flows and is similar to the pelformance measure of return on capital employed. The
average rate of returr. can be determined by the following equation :
Average Income
Average Rate of Return (ARR) = x IOO
Average Investments

Where,
Average investment would be equal to the Original investment plus salvage value
divided by Two
Original Investment
Average Investment
2
(or)
Original Investment + Scrap Value of the Project

2
Advantages
( l )It considers all the years involved in the life of a project rather than only pay-back
years.
(2)It applies accounting profit as a criterion of measurement and not cash flow.
Disadvantages
 (1) It applies profit as a measure of yardstick not cash flow.
(2) The time value of money is ignored in this method.
(3) Yearly profit determination may be a difficult task.
Illustration: 6
From the following information you are required to find out Average Rate of Return
:
An investment with expenditure of Shs.1,000,000 is expected to produce the
following profits (after deducting depreciation)
1st Year Shs80,000
2nd Year Shs.160,000
3rd Year Shs.180,000
4th YearShs.60,000
Calculation of Accounting Rate of Return
Average Annual Profits — Depreciation and Taxes
X100
Average Rate of Return
Average Investments

Average Annual Profits = 80,000+160,000+180,000+60,000

4

= 480,000 = 120,000
4

Investmt at Begin+ Investmnt at End

Average Investments (Nil Scrap) = 2

= 1,000,000 + 0 =500,000
2

ARR = 120,000 X100 = 24%

500,000
The percentage is compared with those of other projects in order that the investment
yielding the highest rate of return can be selected.

THE DISCOUNTING TECHNIQUES

The discounting techniques are:
1. Discounted pay back Period
2. Net Present Value Method
3. Profitability Index Method
4. Internal Rate of Return Method
5. Modified Internal Rate of Return Method

1. Discounted Pay-back Method : This method is designed to overcome the limitation of

the payback period method. When savings are not levelled, it is better to calculate the
 pay-back period by taking into consideration the present value of cash inflows.
Discounted pay-back method helps to measure the present value of all cash inflows
and outflows at an appropriate discount rate. The time period at which the cumulated
present value of cash inflows equals the present value of cash outflows is known as
discounted pay-back period.

The company is considering investment of Shs.100,000 in a project. The following

are the income forecasts, after depreciation and tax, 1st year Shs. 10,000, 2nd year Shs.
40,000, 3rd year Shs. 60,000, 4th year Shs.. 20,000 and 5th year Shs.. Nil.
From the above information you are required to calculate : Discounted Pay-back
Period at 10% interest factor.

Calculation of Discounted Pay-back Period 10% Interest Rate:

Year Cash Discounting Present Value Cumulative
Inflows Present of Value of
1 Value Factor at Cash Inflows Cash
2 10% (2 x3) Inflows
3 4
1 10,000 0.9091 9,091 9.091
2 40,000 0.8264 33,060 42,151
3 60,000 0.7513 45 ,078 87,229
4 20,000 0.6830 13,660
5 0.6209

Pay-back Period 3 Years + 12,771

X12

13,6
60

3 . 0.935 Years
=3 Year and 11.22 Months
 NET PRESENT VALUE METHOD (NPV) :

This is one of the Discounted Cash Flow technique which explicitly recognizes the time
value of money. In this method all cash inflows and outflows are converted into present
value (i.e., value at the present time) applying an appropriate rate of interest (usually cost
of capital).
 In other words, Net Present Value Method discount inflows and outflows to their
present value at the appropriate cost of capital and set the present value of cash inflow
against the present value of outflow to calculate Net Present Value. Thus, the Net Present
Value is obtained by subtracting the present value of cash outflows from the present value
of cash inflows.
Equation for Calculating Net Present Value:
(1) In the case of conventional cash flows, i.e., all cash outflows are entirely initial
and all cash inflows are in future years, NPV may be represented as follows :

NPV -1
(2) In the case of non-conventional cash inflows, i.e., where there are a series of cash
inflows as well as cash outflows the equation for calculating NPV is as :

NPV = 10 +

Where :
NPV Net Present Value
Future Cash Inflows at different times
Cost of Capital or Cut-off rate or Discounting Rate
1 Cash outflows at different times
Rules of Acceptance : If the rate of return from a project is greater than the return
from an equivalent risk investment in securities traded in the financial market, the Net
Present Value will be positive. Alternatively, if the rate of return is lower, the Net Present
Value will be negative.
In other words, if a project has a positive Net Present Value it is considered to be
viable because the present value of the inflows exceeds the present value of the outflows.
If the projects are to be ranked or the decision is to select one or another, the project with
the greatest Net Present Value should be chosen
Symbolically the accept or reject criterion can be expressed as follows :
Where
 NPV > Zero Accept the proposal
NPV < Zero Reject the Proposal
Advantages of Net Present Value Method
(l)It recognizes the time value of money and is thus scientific in its approach.
(2) All the cash flows spreadover the entire life of the project are used for calculations.
(3) It is consistent with the objectives of maximizing the welfare of the owners as it
depicts the positive or otherwise present value of the proposals.
Disadvantages
(l) This method is comparatively difficult to understand or use.
(2) When the projects in consideration involve different amounts of investment, the
Net Present Value Method may not give satisfactory results.

ILLUSTRATION
A Company had the following two projects to invest in. The cost of capital is 10%

Year Project A Project B

Ksh.’000’ Ksh.’000’
0 ( 10,000) (10,000)
1 5,000 1,000
2 4,000 3,000
3 3,000 4,000
4 1,000 6,000

Required:
Calculate the NPV of the two projects.
Which project would you recommend if:
i. The projects are independent
ii. The projects are mutually exclusive

Project A
 Year CF PVIF10% CFxPVIF10%
Shs.’000’ Kshs.’000’ Kshs.’000’
0 (10,000) 1.000 (10,000)
1 5,000 0.9091 4,545.5
2 4,000 0.8264 3,305.6
3 3,000 0.7513 2,253.9
4 1,000 0.6830 683

NVP = Kshs.10,788,000- Kshs.10,000,000 = Kshs.788,000

Project B

Year CF PVIF10% CFxPVIF10%

Shs.’000’ Kshs.’000’ Kshs.’000’
0 (10,000) 1.000 (10,000)
1 1,000 0.9091 909.1
2 3,000 0.8264 2,479.2
3 4,000 0.7513 3,005.2
4 6,000 0.6830 4,098

NVP = Kshs.10,491,500 – Kshs.10,000,000 = Kshs.491,500

Decision:
If the projects are independent, both are acceptable
If they are mutually exclusive, project A is accepted because it yields higher NPV.

PROFITABILITY INDEX METHOD

Profitability Index is also known as Benefit Cost Ratio. It gives the present value of future
benefits, computed at the required rate of return on the initial investment. Profitability
Index may either be Gross Profitability Index or Net Profitability Index. Net Profitability
 Index is the Gross Profitability Index minus one. The Profitability Index can be calculated
by the following equation :

Profitability Index = Present value of cash inflows

Initial Cash Outlays

Rule of Acceptance : As per the Benefit Cost Ratio or Profitability Index a project
with Profitability Index greater than one should be accepted as it will have Positive Net
Present Value. Likewise if Profitability Index is less than one the project is not beneficial
and should not be accepted.
Advantages of Profitability Index:
(1) It duly recognizes the time value of money.
(2) For calculations when compared with internal rate of return method it requires
less time.
(3) It helps in ranking the project for investment decisions.
(4) As this method is capable of calculating incremental benefit cost ratio, it can be
used to choose between mutually exclusive projects.

EXAMPLE
Consider the previous example. Calculate the profitability index of projects A and B.
Pi A = 10,788,000 = 1.0788
10,000,000

Pi B = 10,491,500 = 1.04915
10,000,000

Project A has a higher profitability index.

In a case of mutually exclusive projects, it gains preference over project B.

Internal Rate of Return Method (IRR) : Internal Rate of Return Method is also called as
"Time Adjusted Rate of Return Method." It is defined as the rate which equates the present
value of each cash inflows with the present value of cash outflows of an investment. In
other words, it is the rate at which the net present value of the investment is zero.
Horngren and Foster define Internal Rate of Return as the rate of interest at which the
present value of expected cash inflows from a project equals the present value of expected
cash outflows of the project.
The Internal Rate of Return can be found out by Trial and Error Method. First,
compute the present value of the cash flow from an investment, using an arbitrarily
selected interest rate, for example 10%. Then compare the present value so obtained with
the investment cost.
If the present value is higher than the cost of capital, try a higher interest rate and go
through the procedure again. On the other hand if the calculated present value of the
expected cash inflows is lower than the present value of cash outflows, a lower rate should
be tried. This process will be repeated until and unless the Net Present Value becomes
zero. The interest rate that brings about this equality is defined as the Internal Rate of
Return.
Alternatively, the internal rate can be obtained by Interpolation Method when we
make use of 2 rates. One with positive Net Present Value and other with negative Net
Present Value. The IRR is considered as the highest rate of interest which a business is
able to pay on the funds borrowed to finance the project out of cash inflows generated by
the project. The procedure is as follows:
Step 1
Choose two discount rates
One rate should give a positive NPV and the other a negative NPV.
Step 2
Interpolate as follows:
IRR = Lower rate + Positive NPV X ( Higher rate – Lower rate)
Higher PV- Lower PV

Evaluation
 A popular discounted cash flow method, the internal rate of return criterion has
several virtues .
(l) It takes into account the time value of money.
(2) It considers the cash flows over the entire life of the project.

(3) It is more meaningful and acceptable to users because it satisfies them in terms
of the rate of return on capital.
Limitations
(l) The internal rate of return may not be uniquely defined.
(2) The IRR is difficult to understand and involves complicated computational
problems.
(3) The internal rate of return figure cannot distinguish between lending and
borrowings and hence high internal rate of return need not necessarily be a
desirable feature.
EXAMPLE
A Company had the following two projects to invest in. The cost of capital is 10%

Year Project A Project B

Ksh.’000’ Ksh.’000’
0 ( 10,000) (10,000)
1 5,000 1,000
2 4,000 3,000
3 3,000 4,000
4 1,000 6,000

Required:
Calculate the IRR of the two projects.
Which project would you recommend if:
iii. The projects are independent
iv. The projects are mutually exclusive

PROJECT A
IRR
Year CF PVIF10% CFxPVIF10%
Shs.’000’ Kshs.’000’ Kshs.’000’
0 (10,000) 1.000 (10,000)
1 5,000 0.9091 4,545.5
2 4,000 0.8264 3,305.6
3 3,000 0.7513 2,253.9
4 1,000 0.6830 683

Year CF PVIF20% CFxPVIF20%

Shs.’000’ Kshs.’000’ Kshs.’000’
0 (10,000) 1.000 (10,000)
1 5,000 0.8333 4,166.7
2 4,000 0.6944 2,777.8
3 3,000 0.5787 1,736.1
4 1,000 0.4823 482.3

Rate PV inflows NPV

10% 10,788 788

IRR 10,000 0

20% 9,162.7 -837.3

IRR = 10% + 788 X (20% - 10% )
10,788-9,162.7

= 10 % + 4.8483
=14.85%

Year CF PVIF10% CFxPVIF10%

Shs.’000’ Kshs.’000’ Kshs.’000’
0 (10,000) 1.000 (10,000)
1 1,000 0.8333 909.1
2 3,000 0.6944 2,479.2
3 4,000 0.5787 3,005.2
4 6,000 0.4823 4,098
10,941.5

Year CF PVIF20% CFxPVIF20%

Shs.’000’ Kshs.’000’ Kshs.’000’
0 (10,000) 1.000 (10,000)
1 1,000 0.8333 833.3
2 3,000 0.6944 2,083.2
3 4,000 0.5787 2,308
4 6,000 0.4823 2,893.8
8,118.3

Rate PV inflows NPV

10% 10,941.5 491.5

IRR 10,000 0

20% 8,118.3 1,881.7

IRR = 10% + 491.5 X (20% - 10% )
10,491.5-8,118.7

= 10 % + 2.07139
=12.07139%
Project A is preferred since it has higher IRR

MULTIPLE Internal Rates of Returns (IRRs)

One problem with the IRR is that, under certain conditions, a project may have more
than one IRR. First, note that a project is said to have normal cash flows if it has one
or more cash outflows (costs) followed by a series of cash inflows. Such project is said to
have a conventional cash flow pattern. If, however, a cash outflow occurs sometime after
the inflows have started, meaning that the signs of the cash flows change more than once,
then the project is said to have nonnormal cash flows. Such a project is said to have
unconventional cash flow pattern. Here’s an illustration of these concepts:

Normal: − + + + + + or − − − + + + + + …….(Conventional cash flow pattern)

Nonnormal: − + + + + − or − + + + − + + +….(Unconventional cash flow pattern)

An example of a project with non-normal flows would be a strip coal mine where the
company first spends money to buy the property and prepare the site for mining, has
positive inflows for several years, and then spends more money to return the land to its
original condition. In this case, the project might have two IRRs—that is, multiple IRRs.

To illustrate multiple IRRs, suppose a firm is considering a potential strip mine

(Project M) that has a cost of $1.6 million, will produce a cash flow of $10 million
at the end of Year 1; then, at the end of Year 2, the firm must spend $10 million to
restore the land to its original condition. Therefore, the project’s expected net cash
flows are as follows (in millions):
 Year 0 End of Year 1 End of Year 2
Cash flows −$1.6 +$10 −$10

We can substitute these values into Equation 10-2 and then solve for the IRR:

NPV = −$1.6 million + $ 10 million -10million = 0

(1+ IRR )0 (1+IRR)1 (1+IRR)2

Here the NPV equals 0 when IRR = 25%, but it also equals 0 when IRR = 400%.
Therefore, Project M has one IRR of 25% and another of 400%, and we don’t know
which one to use. This relationship is depicted graphically in Figure 10-4. The graph
is constructed by plotting the project’s NPV at different discount rates.

Observe that no dilemma regarding Project M would arise if the NPV method
were used; we would simply find the NPV at the appropriate cost of capital and use
it to evaluate the project. We would see that if Project M’s cost of capital were 10%
then its NPV would be −$0.774 million and the project should be rejected. If r were
between 25% and 400% then the NPV would be positive, but any such number
NPV
NPV=$1.6 + 10/(1+r) -10/(1+r)2

$.70

$0
25% 100% 200% 300% 400% Cost of Capital
$.30

r NPV
0% −$1.600
10% −$0.774
25% $0.000 = IRR #1 = 25%
110% $0.894
400% $0.000 = IRR #2 = 400%
500% −$0.211

It is logical for managers to want to know the expected rate of return on investments,
and this is what the IRR is supposed to tell us. However, the IRR is based on the
assumption that projects’ cash flows can be reinvested at the IRR itself, and this
assumption is usually wrong: The IRR overstates the expected return for accepted projects
because cash flows cannot generally be reinvested at the IRR itself. Therefore, the IRR for
accepted projects is generally greater than the true expected rate of return. This imparts an
upward bias on corporate projections based on IRRs.
Given this fundamental flaw, is there a percentage evaluator that is better than the regular
IRR? We can modify the IRR to make it a better measure of profitability. This new
measure is the Modified IRR (MIRR). It is similar to the regular IRR, except it is based on
the assumption that cash flows are reinvested at the WACC (or some other explicit rate if
that is a more reasonable assumption).

The MIRR is calculated by equating the present value of cost of the project with its
terminal value as shown and then solve for MIRR
n
Cost = ƩCFIt(1+k)n-1
t=1
(1 + MIRR)n
Where:
CIFt = Cash inflows at time t
k = Cost of capital
n = The projects life

n
ƩCFIt(1+k)n-1
t=1 is the terminal value of the project
(1 + MIRR)n

Example
Calculate the MIRR for the two projects A and B in the previous example.

Project A
Cost 10,000 = 5,000(1+0.1)4-1+4,000(1+0.1)4-2+3,000(1+0.1)4-3+1,000(1+0.1)4-4
(1 + MIRR)4

= 6,655 + 4,840 + 3,300 + 1,000

(1+ MIRR)4
 (1 + MIRR)4 = 15,795
10,000
= 1.5795
(1 + MIRR ) = 4 1.5795
MIRR = 1.121062712 - 1
= 12.11%

Project B

Cost, 10,000 = 1,000(1+0.1)4-1 + 3,000(1+0.1)4-2 + 4,000(1 +0.1)4-1 + 6,000(1 +0.1)4-4

(1+ MIRR)4

= 1,331 + 3,630 + 4,400 + 6,000

(1+ MIRR)4
(1+MIRR)4 = 15,361
10,000
(1+MIRR)4 = 4 1.5361
MIRR = 1.113281193 – 1
= 11.33%