Capital Budgeting Techniques

Solved Problems
1. Given below are the cash flows of a project:

Year Cash Flow

0 (100,000)
1 20,000
2 30,000
3 40,000
4 50,000
5 30,000
The minimum hurdle rate of the project is 12%. Calculate the (a) Net Present Value, (b)
Internal Rate of Return for the project.

Solution:
(a) NPV @ 12%:
Year Cash Flow PVIF @ 12% Present Value
0 (100,000) 1.0000 (100,000)
1 20,000 0.8929 17,857
2 30,000 0.7972 23,916
3 40,000 0.7118 28,471
4 50,000 0.6355 31,776
5 30,000 0.5674 17,023
NPV @ 12% 19,043

(b) IRR:
In order to find the IRR, we need to find the discount rate at which the NPV at that rate is
zero. As the NPV @ 12% is positive, we need to increase the discounting rate, say to 19%.
NPV @ 19%:
Year Cash Flows PVIF @ 19% Present Value
0 (100,000) 1.0000 (100,000)
1 20,000 0.8403 16,807
2 30,000 0.7062 21,185
3 40,000 0.5934 23,737
4 50,000 0.4987 24,933
5 30,000 0.4190 12,571
NPV @ 19% (767)

Dr Pankaj Varshney Page 1 of 7

At 19%, the NPV is negative, so we need to lower the discount rate slightly, say to 18%. NPV
at 18% is as follows:

Year Cash Flows PVIF @ 18% Present Value

0 (100,000) 1.0000 (100,000)
1 20,000 0.8475 16,949
2 30,000 0.7182 21,546
3 40,000 0.6086 24,345
4 50,000 0.5158 25,789
5 30,000 0.4371 13,113
NPV @ 18% 1,743

At 18%, the NPV is positive, which means that the IRR falls between 18% and 19%. By
interpolation, we can find the IRR as follows:
18% +x
18% + (1743/(1743+767)
18% + (1743/2510)
18%+0.69% = 18.69%

The IRR is 18.69% which is greater than the hurdle rate (discount rate), hence we may
accept the project.

2. Premium Manufacturing Company is evaluating two forklift systems to use in its plant
that produces the towers for a windmill power farm. The costs and the cash flows
from these systems are as follows:
(Rs.)
Year 0 Year 1 Year 2 Year 3
Otis Forklifts −3,123,450 979,225 1,358,886 2,111,497
Craigmore Forklifts −4,137,410 875,236 1,765,225 2,865,110

If the company uses a 12 percent discount rate for all projects, determine which
forklift system should be purchased using the net present value (NPV) approach.
Compute the IRR for each of the two systems. Is the choice different from the one
determined by NPV?

Dr Pankaj Varshney Page 2 of 7

Solution:
NPV for Otis Forklifts:
n
CFt
NPV= -I
t=0 (1+r) t
979,225 1,358,886 2,111,497
= -3,123,450 + 1
+ 2
+
(1+0.12) (1.12) (1.12)3
= -3,123,450 + 874,308 + 1,083,296 + 1,502,922
= Rs.337,075/-
NPV for Craigmore Forklifts:
n
CFt
NPV= t
−I
t=0 (1+r)

875,236 1,765,225 2,865,110

= -4,137,410 + 1
+ 2
+
(1+0.12) (1.12) (1.12)3
= -4,137,410 + 781,461 + 1,407,229 + 2,039,227
= Rs.90,606/-
Based on NPV, the Company should purchase the Otis forklift since it has a larger NPV.

IRR for two forklift systems:

Otis Forklifts:
As NPV (Otis) @ 12% Rs. 337,075 > 0, we need to use a higher discount rate to get NPV
= 0.
At r = 15%, the NPV (Otis) is as follows:
979,225 1,358,886 2,111,497
NPV= -3,123,450 + 1
+ 2
+
(1+0.15) (1.15) (1.15)3
= -3,123,450 + 851,500 + 1,027,513 + 1,388,344
= Rs.143,907/-

Try a higher rate. At r = 17%,

NPV= -3,123,450 + 836,944 + 992,685 + 1,318,357
= Rs.24,536/-

Try a still higher rate. At r = 18%,

NPV= - 3,123,450 + 833,383 + 984,254 + 1,301,598
=Rs. -4,215/-
Thus the IRR for Otis is between 17% and 18%. By interpolation, we can find the IRR as
follows:
17% +x
17% + (24536/(24536+4215)
17% + (24536/28751)
17%+0.85% = 17.85%

Dr Pankaj Varshney Page 3 of 7

Thus, IRR (Otis) is 17.85%.

Craigmore Forklifts:
Similarly, we can find the IRR for Craigmore forklifts which is 13.06 %.

Based on the IRR, we would still pick Otis over Craigmore forklift systems.

3. Consider the following two mutually exclusive projects:

Cash Flows
Project Year 0 Year 1 Year 2 Year 3
A -100 +60 +60 0
B -100 0 0 +140
a. Calculate the NPV of each project at 0%, 10%, & 20% and plot the NPV profile. What
is the IRR of each of the projects (estimate from the NPV Profile)? In what
circumstances should the company accept Project A?
b. Calculate the NPV of the differential cash flows (Project B - Project A). How would
you interpret the results?
Solution:
NPV:
Project A:
Yea Cash PVIF @ Present Present Present
r Flow 0% Value PVIF @10% Value PVIF @ 20% Value

0 (100) 1.0000 (100.00) 1.0000 (100.00) 1.0000 (100.00)

1 60 1.0000 60.00 0.9091 54.55 0.8333 50.00

2 60 1.0000 60.00 0.8264 49.59 0.6944 41.67

3 - 1.0000 - 0.7513 - 0.5787 -

NPV @ 0% 20.00 NPV @ 10% 4.13 NPV @ 20% (8.33)
Project B:

Yea Cash PVIF @ Present Present Present

r Flow 0% Value PVIF @10% Value PVIF @ 20% Value

(100.00 (100.00
0 (100) 1.0000 (100.00) 1.0000 ) 1.0000 )

1 - 1.0000 - 0.9091 - 0.8333 -

2 - 1.0000 - 0.8264 - 0.6944 -

3 140 1.0000 140.00 0.7513 105.18 0.5787 81.02

NPV @ 0% 40.00 NPV @ 10% 5.18 NPV @ 20% (18.98)
Dr Pankaj Varshney Page 4 of 7
 b. From the graph, we can estimate the IRR of each project from the point
where its line crosses the horizontal axis:
IRRA = 13.1% and IRRB = 11.9%

50.00
40.00
30.00
20.00 Project A
NPV

10.00 Project B
0.00 Increment

-10.00
-20.00
-30.00
0% 10% 20%
Discount Rate

The company should accept Project A if its NPV is positive and higher than that of Project
B; that is, the company should accept Project A if the discount rate is greater than 10.7%
(the intersection of NPVA and NPVB on the graph below) and less than 13.1%.

The cash flows for Project B – Project A & NPV are as follows:
Project B - Project A:

Cash PVIF @ Present PVIF Present PVIF @ Present

Year Flow 0% Value @10% Value 20% Value

0 - 1.0000 - 1.0000 - 1.0000 -

1 (60) 1.0000 (60.00) 0.9091 (54.55) 0.8333 (50.00)

2 (60) 1.0000 (60.00) 0.8264 (49.59) 0.6944 (41.67)

3 140 1.0000 140.00 0.7513 105.18 0.5787 81.02

NPV @ NPV @ NPV @
0% 20.00 10% 1.05 20% (10.65)

IRRB-A = 10.7%
The company should accept Project A if the discount rate is greater than 10.7% and less
than 13.1%. As shown in the graph, for these discount rates, the IRR for the incremental
investment is less than the opportunity cost of capital.

Dr Pankaj Varshney Page 5 of 7

4. Mr. Gopi, the President of Gaint Enterprises, has to make a choice between two
possible investments:
Cash Flows (Rs Thousands)
Project Year 0 Year 1 Year 2 IRR (%)
A -400 +250 +300 23
B -200 +140 +179 36
The discount rate is 9%. Mr. Gopi is tempted to choose Project B due to its higher
IRR.
Explain to Mr. Gopi why this is not correct. Show him how to adapt the IRR to
choose the best project. Also show that this project also has higher NPV.
Solution:
Because Project A requires a larger capital outlay, it is possible that Project A has both a
lower IRR and a higher NPV than Project B. (In fact, NPVA is greater than NPVB for all
discount rates less than 10 percent.) Because the goal is to maximize shareholder
wealth, NPV is the correct criterion.
To use the IRR criterion for mutually exclusive projects, calculate the IRR for the
incremental cash flows:
C0 C1 C2 IRR
A-B -200 +110 +121 10%

Because the IRR for the incremental cash flows exceeds the cost of capital, the
additional investment in A is worthwhile.
250 300
NPVA = - 400+ + =Rs.81.86
1.09 (1.09)2
140 179
NPVB = -200+ + =Rs. 79.10
1.09 (1.09)2

5. Pipli Pharma has Rs. 1 million allocated for Capital expenditures. Which of the
following projects should the company accept to stay within the budget? How
much does the limit of budget cost the company in terms of its market value?
The opportunity cost of capital for each project is 11%.
(In Rs’000s)
Project Investment NPV IRR (%)
1 300 66 17.2
2 200 -4 10.7
3 250 43 16.6
4 100 14 12.1
5 100 7 11.8
6 350 63 18.0
7 400 48 13.5

Dr Pankaj Varshney Page 6 of 7

Solution:
Using the Profitability Index (Net Present Value/Investment), we find:
Project Profitability Index
1 0.22
2 -0.02
3 0.17
4 0.14
5 0.07
6 0.18
7 0.12

Thus, given the budget of Rs. 1 million, the best the company can do is to accept
Projects 1, 3, 4, and 6.
If the company accepted all positive NPV projects, the market value (compared to
the market value under the budget limitation) would increase by the NPV of
Project 5 plus the NPV of Project 7: Rs. 7,000 + Rs. 48,000 = Rs. 55,000
Thus, the budget limit costs the company Rs. 55,000 in terms of its market value.

6. Find the PI and MIRR of the projects in Q-1.

Profitability Index:
PV of Cash Inflows 119,043
PV of Cash Outflows 100,000
Net Present Value 19,043
Profitability Index 0.1904

Modified Internal Rate of Return:

Year Cash Flow FVIF @ 12% FV of CF
0 (100,000)
1 20,000 1.5735 31,470
2 30,000 1.4049 42,148
3 40,000 1.2544 50,176
4 50,000 1.1200 56,000
5 30,000 1.0000 30,000
FV of Cash Inflows 209,794

209794/(1+r*)^5 =
100000
1+ r* =
(209794/100000)^(1/5)
r* = 1.15973 - 1
r* = 0.15973 = 15.97%

*****
Dr Pankaj Varshney Page 7 of 7