Capital Budgeting Techniques

STUDENTS LEARNING OUTCOMES OF THIS CHAPTER

AFTER STUDYING THIS CHAPTER THE STUDENTS WILL ABLE TO:

 Understand the role of capital budgeting techniques in the capital

budgeting process.
 Calculate, interpret, and evaluate the payback period.
 Calculate, interpret, and evaluate the net present value (NPV).
 Calculate, interpret, and evaluate the internal rate of return (IRR).
 Use net present value profiles to compare NPV and IRR techniques.
 Discuss NPV and IRR in terms of conflicting rankings and the theoretical
and practical strengths of each approach.

CHAPTER OVERVIEW
This chapter continues the discussion of capital budgeting begun in the preceding chapter, which
established the basic principles of determining relevant cash flows. Both the sophisticated (net present
value and the internal rate of return) and unsophisticated (average rate of return and payback period)
capital budgeting techniques are presented. Discussion centers on the calculation and evaluation of the
NPV and IRR in investment decisions, with and without a capital rationing constraint.

Capital budgeting is the process of evaluating and selecting long-term investments that are consistent
with the firm’s goal of maximizing owners’ wealth. Long-term investments represent sizable outlays of
funds that commit a firm to some course of action. Consequently, the firm needs procedures to analyze
and select its long-term investments.
Capital Budgeting Techniques/Tools

Techniques

Discounting
Non-discounting/Conventional Techniques
Techniques

PI
NPV
PBP IRR
ARR

Payback Period

The payback period is the amount of time required for the firm to recover its initial investment in a
project, as calculated from cash inflows. In the case of an annuity (such as the Bennett Company’s
project A), the payback period can be found by dividing the initial investment by the annual cash inflow.
For a mixed stream of cash inflows (such as project B), the yearly cash inflows must be accumulated until
the initial investment is recovered. Although popular, the payback period is generally viewed as an
unsophisticated capital budgeting technique, because it does not explicitly consider the time value of
money.

Formula
InitailIn Investment
 In case of annuity, PBP=
CF

 In case of mixed stream, PBP

Unrevored cos t at the start of re cov ery period
Year beforet full re cov ery of initial investment 
CF during re cov ery period

Decision Criteria:
When the payback period is used to make accept–reject decisions, the following decision criteria apply:
 
If the payback period is less than the maximum acceptable payback period, accept the project.

If the payback period is greater than the maximum acceptable payback period, reject the
project.
Example-1

Consider a project with the following information (Annuity Cash flows)

Initial Investment= Tk. 10,000

Year CFs Solution,

1 3000 10,000
2 3000
 3.3Years
So, PBP= 3000
3 3000
4 3000
Example-2

Consider a project with the following information (Mixed-stream Cash flows)

Initial Investment= Tk. 10,000
Year CFs
1 5000
2 7000
3 1000

Solution,
PBP= Year beforet full re cov ery of initial investment  Unrevored cos t at the start of re cov ery period
CF during re cov ery period
10,000  5,000
=1  7,000
 1.71 Years
Personal Finance Example:
Seema Mehdi is considering investing $20,000 to obtain a 5% interest in a rental property. Her good
friend and real estate agent, Akbar Ahmed, put the deal together and he conservatively estimates that
Seema should receive between $4,000 and $6,000 per year in cash from her 5% interest in the property.
The deal is structured in a way that forces all investors to maintain their investment in the property for
at least 10 years. Seema expects to remain in the 25% income-tax bracket for quite a while. To be
acceptable, Seema requires the investment to pay itself back in terms of after-tax cash flows in less than
7 years.
Seema’s calculation of the payback period on this deal begins with calculation of the range of annual
after-tax cash flow:
After-tax cash flow = (1 - tax rate)  Pre-tax cash flow

= (1 - 0.25)  $4,000 = $3,000

= (1 - 0.25)  $6,000 = $4,500
The after-tax cash flow ranges from $3,000 to $4,500. Dividing the $20,000 initial investment by each of
the estimated after-tax cash flows, we get the payback period:

Payback period = Initial investment After-tax cash flow

= $20,000  $3,000 = 6.67 years

= $20,000  $4,500 = 4.44 years

Because Seema’s proposed rental property investment will pay itself back between 4.44 and 6.67 years,
which is a range below her maximum payback of 7 years, the investment is acceptable.

Pros and Cons of payback period technique:

Merits:

I. Payback period considers the cash flows rather than accounting profits.
Accounting profits can be manipulated by window dressing but CFs can’t be
manipulated by the management of the firm.
II. By measuring how quickly the firm recovers its initial investment, the payback
period also gives an implicit consideration to the time value of money.
III. Its gives information about the firm’s liquidity. Shorter the PBP higher the
liquidity and longer the PBP lesser the liquidity of the firm.
IV. It is easy to calculate, large firms use PBP to evaluate small projects and small
firms use PBP to evaluate most projects because of its easiness.
Demerits:
I. Payback period does not consider the cash flows which occur after the recovery
of the initial investment.
II. Payback period ignores the time value of money and it gives equal
weights/emphasis on all cash flows before the cut-off-date/recovery period. We
can illustrate it through following example-
Cash Flows
Initial Investment Year-1 Year-2
Project
A 1000 500 500
B 1000 700 300
The sum of cash flows of both projects is Tk. 10,000 but project B is preferable because larger cash flow
is occurred in the earlier year and it can be reinvested in any project which may earn further return for
the firm but PBP technique does not consider the timing of cash flows.

III. Maximum acceptable payback period is totally depend on the management that
depends on variety of criteria which may not other principles of usage of
money. It varies with one to another.

IV. The major weakness of the payback period is that the appropriate payback
period is merely a subjectively determined number. It cannot be specified in
light of the wealth maximization goal because it is not based on discounting
cash flows to determine whether they add to the firm’s value.
Discounted Payback Period
The discounted payback period is the amount time that it takes to recover the cost of a project by
adding positive discounted cash flow coming from the projects.

Example

Year CFs CF Cumulative DCFs

Discounted CFs =
(1  k ) n
0 -10,000
1 5000 4545 4545
2 5000 4132 8677
3 4000 3005 11083
10,000  8677
2
So, DPBP = 3005
 2.44 Years

How discounted payback period is better than ordinary payback period?

In calculation of ordinary PBP, we do not consider any cost of capital. But method of “discounted
payback period” only considers discounted cash flow at the rate of cost of capital. This means it give
direct emphasis on the time value of money.

Average/Accounting Rate Return (ARR)

The average rate of return or accounting rate return (ARR) is the rate of return that is calculated by
taking the total cash inflows over the life-time of the investment and dividing it by the number of years
of the investment.

ARR is based on the accounting information rather than cash flows. The average rate return does not
guarantee that the cash inflows are the same in a given year; it simply guarantees that the return
averages out to the average rate of return.

Average annual profit after tax

ARR 
Averageinvestment over lifetime of the project

Total profit
Average Profit After tax=
Number of Years

Investment  SalvageValue
Average Investment 
2
Decision Criteria

 If the ARR is higher than the minimum desired or projected ARR, then the project will be
accepted.

 If the ARR is less than the minimum desired or projected ARR, then the project will be rejected.
 Expected rate of return should always greater than required rate of return to accept any project. The
required rate return sometimes called the cost of capital/hurdle rate/opportunity cost rate/cost of fund
etc.

Example Year EAT

1 10,000
II=50,000
2 12,000
n= 4 Years 3 14,000
4 16,000
Salvage Value=5,000
Total 52,000
Solution
Average Investment= 50,000  5,000  27,500
2
Average annual profit after tax
ARR 
Averageinvestment over lifetime of the project
52,000
Average Annual EAT  13,000
13,000 4
ARR=  48.15%
27,000

Merits and Demerits of ARR

Merits

I. The most favorable attribute of the ARR is its easy calculation and simple to
understand.

II. Provides the same result nearly as IRR. ARR may have acceptance to IRR under
some criteria-

a. Nature of return must be perpetuity.

b. Depreciation must be sufficient to replace the asset.

c. No change in net working capital, in both the cases of old machine and
new machine.

III. Finally, the total benefits associated with the project are taken into account
while calculating ARR.

Demerits:

I. It considers the profit after tax of an organization which may be manipulated by

window-dressing by the management of that organization.

II. It does not consider the time value of money.

 III. The ARR criterion of measuring the worth of investment does not differentiate
between the sizes of the investment required for each project. Competing
investment proposals may have the ARR but may require different average
investment.

IV. It ignores the project’s life. We can easily understand it through the following
example-

Projects Initial CFs

Investment 1 2 3 4
A -1,00,000 20,000 20,000
B -1,00,000 20,0,,00 20,000 20,000 20,000

20000
ARR A   40%
50000

ARRB  40%

Both are same in ARR but do not have the same effectiveness.

Problem

II=Tk. 20,000 Years Net Profits

n= 4 Years 1 7,000
2 8,000
Salvage Value=2,000 3 10,000

Depreciation Under SLM 4 10,000

Requirement: Calculate the Cash Flows

Solution

Depreciable Cost
Yearly depreciation=
No. of ExpextedYears
20,000  2,000

4
 Tk . 4,500

Year Net Profit Depreciation CFs (Profit+Dep.)

 1 7,000 4500 11500
2 8,000 4500 12500
3 10,000 4500 14500
4 10,000 4500 14500
Net Present Value (NPV)
Net present value (NPV) is a sophisticated capital budgeting technique, found by subtracting a project’s
initial investment from the present value of its inflows discounted at a rate or discounted at the firm’s
cost of capital.

NPV is a way of comparing the value of money now with the value of money in future. Because net
present value (NPV) gives explicit consideration to the time value of money.

The method used by most large companies to evaluate investment projects is net present value (NPV).
The intuition behind the NPV method is simple. When firms make investments, they are spending
money that they obtained, in one form or another, from investors. Investors expect a return on the
money that they give to firms, so a firm should undertake an investment only if the present value of the
cash flow that the investment generates is greater than the cost of making the investment in the first
place. Because the NPV method takes into account the time value of investors’ money, it is a more
sophisticated capital budgeting technique than the payback rule.

When NPV is used, both inflows and outflows are measured in terms of present dollars. For a project
that has cash outflows beyond the initial investment, the net present value of a project would be found
by subtracting the present value of outflow
ws from the present value of inflows.
Formula of NPV

In Case of Annuity:

   ICO
n
NPV   i 1
CF 1(1i ) n
i

NPV  CF ( PVIFi ,n )  ICO

In Case of Mixed Stream of CFs

n
CF
NPV    ICO
i 1 (1  i ) n
 CF1 CF2 CFn 
   .............    ICO
 (1  i ) (1  i ) (1  i ) n 
1 2

 
Or , CF1 (1  i ) 1  CF2 (1  i )  2  ...............  CFn (1  i )  n  ICO
In Case of Perpetuity

CF
NPV   ICO
Kg g= growth rate
K= Cost of capital
CF
Or , NPV   ICO K-g=i-g
i

* When growth rate has no exis tan ce

Decision Criteria

When NPV is used to make accept–reject decisions, the decision criteria are as follows:

 If the NPV is greater than $0, accept the project.

 If the NPV is less than $0, reject the project.

We can illustrate the net present value (NPV) approach by using the Bennett Company data presented in
Table 10.1. If the firm has a 10% cost of capital, the net present values for projects A (an annuity) and B
(a mixed stream) can be calculated as shown on the time lines in Figure 10.2.
Calculation as shown on the time lines in Figure 10.2. These calculations result in net present values for
projects A and B of $11,071 and $10,924, respectively. Both projects are acceptable, because the net
present value of each is greater than $0. If the projects were being ranked, however, project A would be
considered superior to B, because it has a higher net present value than that of B ($11,071 versus
$10,924).
What is the rationale of the positive NPV?

If the NPV is greater than $0, the firm will earn a return greater than its cost of capital. Such action
should increase the market value of the firm, and therefore the wealth of its owners by an amount equal
to the NPV.

When NPV is negative, then it expresses-

The project’s return will be unable to earn the cost of capital. If the financial manager accepts the
project, the firm will lose the market value by the amount equal to the negative NPV.

What do you mean by NPV=Tk. 0? What should the financial manager do in case of
NPV=Tk. 0?
NPV =Tk. 0 means that only the project’s cash flows are just sufficient to repay the initial investment. It
means the firm will get no profit or bear no losses.

The financial managers can marginally accepts the projects if there no alternative to them. Because
every fund of an organization has an idle cost if the fund remain idle. However the market value of the
firm will remain unchanged through accepting the projects with NPV=Tk.0.
But in case of mutually exclusive projects, the firm can go for the next projects that provide higher NPV.

In case of independent project the financial manager can accept the project if the firm has unlimited
funds. Because when the project is independence, different projects have different goals. That is the
cash flows of the independent projects are totally different from one another. If a financial manager
accepts an independent project, it does not mean that it is impossible to accept another project in case
of unlimited fund.

Internal Rate of Return (IRR)

Internal rate of return (IRR) is the discount rate that equates the NPV of an investment opportunity with
$0 (because the present value of cash inflows equals the initial investment); it is the rate of return that
the firm will earn if it invests in the project and receives the given cash inflows.
Or, internal rate of return (IRR) can be defined as the rate that equates the present value of all cash in

flows from a project with the project’s initial cash outlay. It is the rate of return that the firm will earn if
it invests in the project and receives the given cash inflows. Mathematically, the IRR is the value of r in
Equation 10.1 that causes NPV to equal $0.

Formula of IRR
IRR  NPV  0
n
CFn
NPV    ICO
i 1 (1  i ) n
n
CFn
or , 0   (1  IRR)
i 1
n
 ICO
n
CFn
or ,   ICO
i 1 (1  IRR) n
CF1 CF2 CFn
or ,   ...................   ICO
(1  IRR)1 (1  IRR) 2 (1  IRR) n
Decision Criteria
When IRR is used to make accept–reject decisions, the decision criteria are as follows:

• If the IRR is greater than the cost of capital, accept the project.
• If the IRR is less than the cost of capital, reject the project.

The criteria guarantee that the firm will earn at least its required rate of return. Such an outcome should
increase the market value of the firm and therefore the wealth of the owners.

Calculating the IRR

Most financial calculators have a preprogrammed IRR function that can be used to simplify the IRR
calculation. With these calculators, you merely punch in all cash flows just as if to calculate NPV and
then depress IRR to find the internal rate of return. Computer software, including spreadsheets, is also
available for simplifying these calculations.

We can demonstrate the internal rate of return (IRR) approach by using the Bennett Company data
presented in Table 10.1. Figure 10.3 uses time lines to depict the framework for finding the IRRs for
Bennett’s projects A and B. We can see in the figure that the IRR is the unknown discount rate that
causes the NPV to equal $0.
Comparing the IRRs of projects A and B given in Figure 10.3 to Bennett Company’s 10% cost of capital,
we can see that both projects are acceptable because

IRRA = 19.9%>10.0% cost of capital

IRRB = 21.7%> 10.0% cost of capital

Comparing the two projects’ IRRs, we would prefer project B over project A because IRRB = 21.7% >
IRRA = 19.9%. If these projects are mutually exclusive, meaning that we can choose one project or the
other but not both, the IRR decision technique would recommend project B.

Calculating IRR Manually

To calculate IRR manually is not very easy task. Generally we use “Trial-and-Error” method to calculate
IRR when we do not use a programmed calculator or Computer software. This method can easily be
understood through the following examples.

Example (in case of mixed stream cash flows):

Consider a project with initial investment of Tk. 10,000 and cash inflow from the project per year is Tk.
2500 and has life of 10 years. And the firm has the cost of capital of 12%. Calculate the IRR.

Solution:
Fake Payback Period = 10,000
2,500

=4
Or,
PVIFAk %,10 years  10,000  2,500
4

Now,
PVIFA20%,10 yrs. = 401925
PVlFA24%,10 yrs. = 3.6819
Here, PVCFat 20%  2500  4.1925 or ,

2500 1 1.20  10
 10481
.20

And PVCFat 24%  2500  3.6819 or ,


2500 1 1.24  10
  9205
.24

So,
IRR  LR  ( PV atNPVat
LR  PV at HR )  ( HR  LR )
LR

 20  10481
104819205  ( 24  20)
10000

 20  1276
481
4
 21.5

Answer: IRR of the project is 21.5 % which is greater than the cost of capital (12%), so the project can be
accepted.

Example (in case of mixed stream cash flows):

Year Project - A Project- B

0 (1200) (1200)
1 1000 100
2 500 600
3 100 1080
Cost of capital= 10%

Solution

Project – A

Average annuity =
Fake PBP (PVIFA) = 1200
533  2.25

PV @ 15% =
= 1313 Tk.
PV @ 16% =
= 1298 Tk.
So, IRR = 15 +
= 22.53
= 23%

Project – B
Fake annuity =
Fake PBP (PVIFA) =
PV @ 20% = 1125
PV @ 24% = 1037

So,
IRR =

As the cost of capital of the firm is 10% both of the project A and B are acceptable because IIR of both
projects are higher than its cost of capital. If A and B are mutually exclusive projects then Project A
should be accepted as its IRR is greater than project B (23%>17%).

Pros and Cons of IRR:

Pros:
I. The IRR method considers the time value of money.
II. It is comparatively easier to calculate and understand.
III. The IRR method of capital budgeting technique considers all of cash flows associated with the
projects.
IV. It is comparable with interest rate which help the financial manager to take decision wether the
projects will be accepted or not.
V. The IRR technique also considers the salvage value of the assets.

Cons:
I. The IRR technique does not tell how much value of the firm will increase by accepting the
project.
II. Whether multiple IRR is exists the technique may fail to give the proper result.
III. For mutually exclusive project IRR technique has comparatively more time more and monetary
cost expensive. Sometimes have to use computer program to calculate proper result.

Net Present Value Profiles

NPV Profiles are graphs that depict project NPVs for various discount rates and provide an
excellent means of making comparisons between projects.
To prepare NPV Profiles for Bennett Company’s projects A and B, the first step is to develop a
number of discount rate-NPV coordinates and then graph them as shown in the following table
and figure.

Table: Discount Rate–NPV Coordinates for Projects A and B

 Figure: NPV Profiles

Profitability Index (PI):

Profitability index is a measure of the profitability of an investment computed by dividing the net
present value by the initial cost of investment.

CFA 1(1i )  n 
 

PI  Pr esent Value of Cash inf lows

Pr esent value of cash outflows
 ICO
i

Or, PI = [ CF1

CF2
 ................... 
CFn
]  ICO
(1  IRR)1 (1  IRR) 2 (1  IRR) n

Decision Criteria:
 PI >1; Accept the project
 PI <1; Reject the project

Pros and Cons of PI:

Pros
I. Profitability technique considers the time value o money.
II. Profitability Index also considers all cash flows.
III. PI also considers the time and amount of cash flows.
Cons
I. If you accept the project, this technique only tell you only about incase or decrease of value o
the firm but not tell you how much value will be added.
II. To calculate the PI it is needed to determine discount rate which is not easy.
III. It is complex method.

If the Cash flow is conventional and the project is independent, then the NPV, IRR and PI will give the
same accept-reject decision.

Let us prove the above statement through the following example:

ICO= Tk. 10,000 CF= Tk.3,000

Cost of Capital= 10% N= 5 Years
 Calculate NPV, IRR and PI

Solution:
We know,

NPV 

CF 1  (1  i )  n
 ICO

i



3,000 1  (1  i ) 5 
10,000
.10
 Tk .1372

Again,

IRR  LR  NPVat LR
( PV at LR  PV at HR )  ( HR  LR )
Now,
Discount Factor  ICO
CF  10
3, 000  3.3
, 000

PVCFat15%  3000  3.352  10,056

PVCFat16%  3000  3.274  9,822

So,
IRR 15  1005610000
(100569822)  (16  15)
 15%

Now, we know, 
CF A 1 (1 i )  n 
PVA  i
30001 (1 .10 )  5 
PI  Pr esent Value of Cash inf lows
Pr esent value of cash outf lows  i

 11372  Tk .11,372
10000

 1.13
Comment: All the techniques suggest us to accept the project as NPV>0; IRR>COC; and PI>1. That is all
of three techniques give us same accept-reject decisions with conventional cash flow pattern and with
independent project.

Ranking Conflicts:

Ranking different investment opportunities is an important consideration when projects are mutually
exclusive or when capital rationing is necessary. When projects are mutually exclusive, ranking enables
the firm to determine which project is best from a financial standpoint. When capital rationing is
necessary, ranking projects will provide a logical starting point for determining which group of projects
to accept. As we’ll see, conflicting rankings using NPV and IRR result from differences in the
reinvestment rate assumption, the timing of each project’s cash flows, and the magnitude of the initial
investment.
If projects are ranked differently using these methods, the conflict in ranking will be due to one or a
combination of the following three project differences.
I. Scale of investment differences
II. Differences in CF pattern or timing of CFs
III. Differences in project’s life

Superiority among NPV, IRR and PI

I. Scale of investment differences:

Year Project-A Project-B

0 (100) (1,00,000)
1 - -
2 400 1,56,250
Cost of capital =10%

Project-A

ICO  CF
(1 IRR) n
NPV  CF (1  i )  n  ICO
 400(1  .10)  2  100
or ,100  400
(1 IRR) 2  Tk . 231

or ,1  IRR  4 CF (1 i )  n
PI  ICO
or , IRR  1  400 (1.10 )  2
100

 100%  3.31

Project-B

NPV  CF (1  i )  n  ICO
ICO  CF
(1 IRR) n
156250(1  .10)  2  100000
or ,100000  156250
(1 IRR) 2  Tk . 29132
or , (1  IRR) 2  156250
100000
CF (1 i )  n
or ,1  IRR  1.5625 PI  ICO

or , IRR  1.25  1  156250(1.10 )  2

100000
 .25  25%  1.29
Project IRR NPV at 10% tk. PI
A 100% 231 3.31
B 25% 29132 1.29
Ranking of the projects based on technique used
1st ranking A B A
nd
2 ranking B A B
Comment: Here is a conflict among the techniques, here we should accept the project B based on NPV
result, because only NPV will tell you how much value of the firm will be increased in term of taka and
other two techniques express the percentage and relative income which ignores the scale of
investment.

II. Differences in CF pattern or timing of CFs

Year Project - A Project- B

0 (1200) (1200)
1 1000 100
2 500 600
3 100 1080
Cost of capital= 10%

Project – A

Average annuity =

1200
Fake PBP =  2.25
533
PV @ 15% =
= 1313 Tk.
PV @ 16% =
= 1298 Tk.
So, IRR = 15 +
= 22.53
= 23%

 
NPV = 1000(1.10) 1  500(1.10) 2  100(1.10) 3  1200
= 198 tk.
PI

Project – B
Fake annuity =

Fake PBP =
PV @ 20% = 1125
PV @ 24% = 1037
IRR =

NPV = 
= 198 tk.
PI =
Here, NPV of two projects at different discount rates are shown below:

DR NPV - A NPV – B
Cross rate: cross rate of cost of
0% 400 580
capital rate at which NPVs of
5% 292 372
10% 198 198 two or more projects are
17% 82 0 similar (here 10%).
23% 0 -142

Ranking of the projects based on technique used

Project NPV IRR PI
A 198 23% 1.17
B 198 17% 1.17

We can plot this information in NPV profile of these two projects to understand easily:

NPV Profile

Rankings K 10% K 10%

NPV IRR PI NPV IRR PI
1st place A A A B A B
2nd place B B B A B A
 III. Difference in project lives:

Year Net Cash flow

Project - A Project – B
0 (1000) (1000)
1 - 2000
2 - -
3 3375 -
Cost of Capital = 10%

Project – A

ICO = or, or, IRR = 1.5 – 1 = .5 = 50%

NPV =

= 1536 tk.

PI = =

Project – B

ICO = or,

NPV =

= 818 tk.

PI = =

Project IRR NPV @ 10% PI @ 10%

A 50% Tk. 1536 2.54
B 100% Tk. 818 1.82

Ranking the projects based on your results reveals

Ranking IRR NPV PI

1st place B A A
2nd place A B B

Once again here we see a conflict in project ranking among the alternative methods. By now we can
make the decision of accepting the project – A based on net present value.

To see that the NPV method will lead to the proper rankings even when faced with mutually exclusive
projects, possessing unequal lives, we can compare the projects are of a common termination date. To
do so, we assume that the shorter lived projects cash flows are reinvested up to the termination date of
the longer lived project at firms cost of capital. Then –

Net Cash flows

0 1 2 3 NPV @ 10%
Project A (1000) 0 0 3375 1536
Project B (1000) 2000 0 0 818

If the project B’s cash flow are reinvested and

compounded 2 years @ 10% then
=2420 TK. 818

Because projects A and B each require the same initial cash outlay, we can compare these two projects
on the basis of terminal values. Notice that, on this basis project-A, the project with higher NPV, is
preferred because its terminal values of taka 3375 is higher than the tk. 2420 terminal value of the
project B. so project A is preferred over project B because it has a positive NPV and adds value tk. 718
(1536 – 818) more in present value to the firm.

Problem: The Taxi Corporation is considering two mutually exclusive projects, which information is as
follows-

Project Cash flows in year

Year (0) Year (1) Year (2)

X (1000) 1180 -
Y (1000) - 1300
Cost of capital 8%

1. Calculate NPV and IRR of each project.

2. Rank the projects according to the methods and recommend which project
should be accepted?

Solution:
 Projects – X

NPV =

= 92.59 Tk.

IRR:

ICO = or, = 1.18 or, IRR = 1.18 – 1 = .18 = 18%

Projects – Y

NPV =

= 115 Tk.

IRR:

ICO = or, = 1.140 or, IRR = 1.140 – 1

= .14 = 14%

Ranking NPV IRR

1st place Y X
2nd place X Y

Here we should compare the terminal cash flow of the project X with that of the project Y. if the project
X’s cash flows is reinvested at the firms cost of capital then we find the terminal value of cost of the cash
flows. That is

= and NPV remain same that is tk. 93. So here we should accept project
Y because it will maximize firms wealth more than project X by taka 22(115 – 93).

Multiple Internal Rate of Return (MIRR):

Multiple Internal Rate of Returns (IRRs) means more than one IRR resulting from a capital budgeting
project with a non-conventional cash flows pattern the maximum number of IRRs for a project is equal
to the number of sign changes in its cash flows.
Example: Year (0) CF-1 CF-2 cost of capital = 8%
-100 310 - 220
(204) PV@8%
NCF=Tk. 106

In this case, the cash flow pattern is nonconventional and gives than one IRR. To get this we have to
convert the multiple IRR into one IRR of these cash flows:-

The present value of CF-2 in year 1 =

Then net cash flow in year 1 = 310 – 204 = 106

ICO =

Comment: Here IRR is less than cost of capital 8%. So, we should reject the project.

Alternative way: Calculating the FV of CF1 in CF2 at 8% we get

Net cash flow of year 2 = Tk. 115

Now, ICO =

Problems/ limitations of PI:

1. If there is unutilized funds or funds are not fully utilized.

2. If there is more than one constraints, e.g., (short of budget & project)
3. -then there may be a wrong decision by using the PI techniques
Example - (1):
Projects ICO NPV PI
A 60000 90000 2.5
B 20000 25000 2.5
C 15000 6000 1.4
D 10000 3000 1.3
E 10000 3500 1.35
Budget ceiling of financial manager is tk. 100000 or 10 million.

In this case, if the financial manager accepts the projects based PI, and then project A, B, and C will be
accepted.

i.e.,
 Projects ICO
A 60000
B 20000
C 15000
Total =95,000
(that means 5000 tk. is remaining in hand)

In this case, the financial manager should accept the next two best project that is project D and E.
because their NPV is higher by (6500 – 6000) = 500 tk.

And, if the firm in debt retirement then the financial manager can-

1) Keeps it idle.
2) Provide the fund as dividend to the shareholders.
3) Use the fund in debt retirement if the financial manager accepts the project according
to PI. It depends upon the firm’s managers.
Example under problem-2:

Projects ICO NPV PI

A 10 21 3.1 Taka in million
B 5 16 4.2
C 5 12 3.4

And their CF pattern as-

Project CF NPV PI
0 1 2
A -10 30 5 21 2.1
B -5 5 20 16 4.2
C -5 5 15 12 3.4
D 0 -40 60 13 1.4
*Cost of capital = 10%
In the first year firm has 10 million to invest. Here, the firm can accept project A or B and C. In the 2nd
year firm has another 10 million in hand, and has another project to invest which requires Tk. 40 million.
In this case firm will accept project A, because its 1st year CF 30 million, can be reinvested in project D.
By doing this the firm will add value more = (21+13) = 34 million, than (16+12) = 28 million of project B
and C.

Payback Period: Choosing between two projects with acceptable payback periods Shell Camping
Gear, Inc., is considering two mutually exclusive projects. Each requires an initial investment of
$100,000. John Shell, president of the company, has set a maximum payback period of 4 years. The
after-tax cash inflows associated with each project are shown in the following table:

Cash Inflows
Year Project-A Project-B
 1 Tk. 10,000 Tk. 40,000
2 20,000 30,000
3 30,000 20,000
4 40,000 10,000
5 20,000 20,000

a. Determine the payback period of each project.

b. Because they are mutually exclusive, Shell must choose one. Which should the company
invest in?
c. Explain why one of the projects is a better choice than the other.