Capital budgeting

It is the procedure a business embraces to assess potential significant projects or

investment. In a perfect world, organizations would seek after any projects and openings that

maximize the shareholders’ value. Having said that, on the grounds that the measure of capital

any business has accessible for new ventures is constrained, the executives utilizes capital

budgeting procedures to figure out which project will yield the best return over a relevant period.

Capital budgeting findings assume a deliberately significant job in the administration of a

business on the grounds that these choices directly affect the profitability of the organization. It

is likewise a fundamental factor attributable to the fact that capital investments are long haul,

require huge assets and if not appropriately arranged, could have appalling cash flow

implications. All investments made by the firm should create worth, and one method for

accomplishing this, is to adopt an approach towards capital budgeting decisions[ CITATION

Suz11 \l 1033 ]. Different tools used for making capital budgeting decisions are i) Payback

period method, ii) Net present value method, iii) Internal rate of return and iv) Modified internal

rate of return.

Conventional Cash Flow

Conventional cash flow is a series of incoming and outgoing cash flows over a period of

time with only one change in the direction of cash flow in entire time period. Generally in

conventional cash flow intimal investment on the project is the outgoing cash flow of the project

which in return generates the number of cash inflows. It have only one internal rate of return

(IRR) which in general should exceed the minimum rate of return needed for the project to bring

profitability to the investors.

Non-Conventional Cash Flow

 If the sign of cash flow changes more than once over the required period of analysis such

cash flows are termed as non-conventional cash flow. Non-conventional cash flows will provide

the analyst with multiple internal rate of return. If there are “n” numbers of sign changes in cash

flow there will be “n” number of internal rate of return for the project. As there are many internal

rate of return to choose from it is a difficult and confusing task for managers to use IRR, NPV

method for non-conventional cash flow instead they use modified internal rate of return (MIRR)

to make the capital budgeting decisions.

With the internal rate of calculation there will be multiple solutions for the project. But

with the modified internal rate of return there exist only one solution. The MIRR permits

business managers to change the accepted rate of reinvested growth from stage to stage in a

project. The most well-known technique is to include the average assessed cost of capital;

however it also gives managers a space to include any particular foreseen reinvestment rate.

Presumption that positive incomes are reinvested at the IRR is viewed as unrealistic practically

speaking. With the MIRR the reinvestment pace of positive incomes is substantially more

legitimate in practice[ CITATION Hay19 \l 1033 ].

Considering the following project, with the rate of return 10%

Years 0 1 2 3
Project A -2500 1500 1500 1500
Project B -14000 7000 7000 7000

Calculating NPV

Project A

NPV = cash flow / (1+r) ^n where r is interest rate and n is number of years

= 1500 / (1.1) ^1 + 1500 / (1.1) ^2 + 1500 / (1.1) ^3 - 2500

= Rs 1230.26
Project B,

NPV = 7000 / (1.1) ^1 + 7000 / (1.1) ^2 + 7000 / (1.1) ^3 - 14000

= Rs. 3407.95

As per NPV if the final calculate NPV is positive value we accept the project and if the

value is negative we reject the project. In above example both the projects yield positive value so

both the project is profitable. But we will choose project B over A is it has higher positive value.

Calculating IRR

For Project A,

1500 / (1+ IRR) ^1 + 1500 / (1+IRR) ^2 + 1500 / (1+IRR) ^3 – 2500 = 0

 IRR A = 36%

Similarly for Project B,

7000 / (1+ IRR) ^1 + 7000 / (1+IRR) ^2 + 7000 / (1+IRR) ^3 – 14000 = 0

 IRR B = 21%

As per the decision rule of IRR, if IRR exceeds cost of capital project is deemed

profitable. Here in this case both projects exceed cost of capital and both are seemed profitable.

Here we will choose project A as internal rate of return is higher than project B.

Years 0 1 2 3 NPV IRR

Project A -2500 1500 1500 1500 1230.26 36%
Project B -14000 7000 7000 7000 3407.95 21%

In above example NPV methods direct us to choose the project B while IRR methods tell us that

project A is more profitable.

Calculating Modified Internal Rate of Return

For Project A,

{1500 / (1.1) ^1 + 1500 / (1.1) ^2 + 1500 / (1.1) ^3} / (1+MIRR) ^ 3 = 2500

Calculating we get MIRR for project A = 14.27%

For Project B,

{7000 / (1.1) ^1 + 7000 / (1.1) ^2 + 7000 / (1.1) ^3} / (1+MIRR) ^ 3 = 14000

Calculating we get MIRR for project B = 7.53%

As the modified internal rate of return of project A is greater we need to select project A

to gain higher profits.

References
Hayes, A. (2019, June 25). Investopedia. Retrieved from investopedia.com:

https://www.investopedia.com/terms/m/mirr.asp

Suzette, V., & Howard, C. (2011). Perspectives on capital budgeting in the South African motor

manufacturing industry. Meditari Accountancy Research, 19(1/2), 75-93.