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This chapter helps to understand the nature and concept of investment decision.
It describes various evaluation criteria in investment decision i.e. Payback
Period, Net Present Value, Profitability Index, Investment Rate of Return,
Modified Internal Rate of Return. It provides suggestion for selection of project.
CONCEPT
In 2010, after being around for 34 years, Giants Stadium was torn down. It used to be the
home stadium for the New York Giants and New York Jets football teams. The stadium was
famous for hosting various events, like Pelé's final game, a Mass led by Pope John Paul II in
1995, and Bruce Springsteen and the E Street Band's sold-out concerts in 2003. It also held
the record for the most NFL games played in one place. Besides the Giants and Jets, other
football teams like the New Jersey Generals, New York/New Jersey Knights, New York/New
Jersey Hitmen, and New York Sentinels also used the stadium.
When the stadium was demolished, there was still a debt of $110 million remaining on it.
This debt was incurred due to the initial construction costs and ongoing renovations, which
were passed on to the public by politicians. Even though the stadium no longer exists and has
become a parking lot, the debt remains unpaid.
This story shows why capital budgeting is essential. When Giants Stadium was taken down,
each resident of New Jersey was burdened with about $13 of the debt associated with the
stadium. This means that the stadium was not a good investment for the citizens of New
Jersey, as it left them with a significant financial obligation when it was gone.
Capital budgeting is a financial process used by businesses and organizations to evaluate
and decide on long-term investment projects. It involves analyzing and determining the
viability of potential capital expenditures, such as purchasing new equipment, acquiring real
estate, expanding facilities, or launching new product lines.
The primary goal of capital budgeting is to allocate financial resources wisely to projects that
are expected to generate the highest returns and contribute to the organization's growth and
profitability. Companies classify projects into different categories and evaluate them
differently based on their purpose. Here are the main categories:
1. Replacement for Continued Operations: When equipment used to produce
profitable products gets worn out or damaged, it needs to be replaced. For these cases,
the company asks whether they should keep the operation running and if they should
use the same production methods. If the answers are yes, the project is usually
approved quickly.
2. Replacement for Cost Reduction: Sometimes, the company may replace still
functioning but outdated equipment to lower costs. These decisions are optional and
require a more detailed analysis.
3. Expansion of Existing Products or Markets: This involves spending money to
increase the production of existing products or to expand sales outlets or distribution
facilities in current markets. These decisions are more complex as they require
forecasting future demand, so a more thorough analysis is needed. Higher-level
management typically makes the final decision.
4. Expansion into New Products or Markets: These investments relate to new
products or entering new geographic areas. Such decisions are strategic and can
significantly change the company's business. Detailed analysis is a must, and the top-
level management usually makes the final call.
5. Safety and Environmental Projects: This category includes expenses necessary to
comply with government regulations, labor agreements, or insurance requirements.
Small projects here are treated similarly to Category 1 projects.
6. Other Projects: This catch-all category includes things like building offices, parking
lots, or acquiring executive aircraft. The handling of these projects varies between
companies.
7. Mergers: In a merger, one company buys another. While different from buying
individual assets or investing in new equipment, similar principles of capital
budgeting apply to analyze mergers.
1. Find Investment Opportunities: Companies first look for investment chances that
match their goals, like upgrading things, expanding, creating new products, or buying
other businesses.
As the athletic director of a mid-major university in Ohio, you are in charge of
renovating the football stadium, which currently has seating for 25,500 spectators.
Some influential supporters have approached you with a request to install an
artificial turf field instead of keeping the existing natural grass field.
After researching synthetic athletic fields, you are considering two options: either
installing FieldTurf, a modern and innovative synthetic playing surface, or sticking
with the current natural grass field. You prefer the idea of installing FieldTurf if it
makes financial sense for the department, especially since there have been issues
with the current natural grass field that was installed just last year.
The cost to replace the natural grass field with FieldTurf is estimated to be
$770,000. This cost includes expenses for preparation, materials, and installation
as quoted to the university.
2. Project Proposals and Initial Screening: When they find potential projects, they
create plans that describe what the project is about, how much it will cost, and the
money it's expected to make. They then check if the projects meet basic requirements
and fit the company's long-term plans.
3. Estimate Cash Flows: For the remaining projects, they figure out how much money
will come in and go out over the project's lifetime. They consider both the initial
investment and the money the project will make in the future.
Let’s consider above example
Suppose Team X, a for-profit business, is currently estimated to earn $34.5 million
in net earnings without considering any new projects.
The Chief Financial Officer (CFO) of Team X evaluates the potential benefits of
installing FieldTurf in their stadium. By doing so, they expect to be able to host
three college games and three state championship football games in addition to the
current ten home NFL pre-season and regular season games. This additional
revenue is estimated to result in a total net earnings of $40.5 million.
4. Use Capital Budgeting Techniques: They analyze the adjusted cash flows using
techniques like NPV and IRR. These help them understand if the projects will make
money, the risks involved, and if they make financial sense.
Net Present Value (NPV): This compares how much money they expect to
get with how much they spend. If it's positive, it's probably a good investment.
Internal Rate of Return (IRR): This tells them the expected rate of return for
the project. It's the rate where the investment breaks even.
Payback Period: This shows how long it will take to get back the initial
investment.
5. Consider Risks and Sensitivity: They think about the risks that come with
investments and do sensitivity analysis to see how changing certain things would
affect the project's success.
6. Choose and Approve Projects: Based on the results and risks, they rank the projects
and decide which ones to do. The top managers review and approve the chosen
projects.
7. Implement and Monitor: After approval, they start the projects and keep a close eye
on their progress to make sure they are on track to meet their goals.
8. Evaluate After Completion: Once the projects are done, they look at what actually
happened compared to what they expected. This helps them learn from what went
well and what didn't, so they can make better decisions in the future.
RELATION OF PROJECTS
Independent project: It refers to those projects where two projects are not related with each
other. So, in this case one can select both projects or selects one project or rejects both
projects.
Mutually exclusive project: it refers to those projects where two projects compete with each
other and that is why when one project is selected then another project has to be rejected.
Dependent project: it refers to those projects where acceptance of one project depends upon
the acceptance or rejection of another project.
Example 2:
Tottenham hotspur is expecting following CFAT after replacing white hart lane by new
stadium.
( in £ million)
Year 0 1 2 3 4 5
CFAT (1200) 400 200 500 700 500
Here investment is 1200. During year 4, it is successful in accumulating 1800 which means
that it recovered in year 4 so 4 is maximum year and 3 is minimum year.
CFAT during maximum year = 700
Unrecovered amount in minimum year = 1200 – 1100 = 100
Now,
unrecovered amount ∈minimum year
PBP = minimum year +
CFAT during maximum year
100
=3+ 700
= 3.14 years
Decision: if you are comparing 2 projects (mutually exclusive) then choose that projects
which has less PBP.
If there is single project then accept it if PBP is less than maturity period.
Example 3:
Let’s take example 2 and discounting factor is 10%.
Year CFAT PVIF10%, n PV Cumulative
periods PV
1 400 0.9091 363.64 36.64
Minimum
2 200 0.8264 165.28 528.92 year
3 500 0.7513 375.65 904.57
4 700 0.6830 478.1 1382.67
Maximum
5 500 0.6209 310.45 year
Decision: if you are comparing 2 projects (mutually exclusive) then choose that projects
which has less DPBP.
If there is single project then accept it if PBP is less than maturity period.
Net Present Value (NPV)
Net present value is the residual amount which is calculated after deducting initial investment
from total present value of cash flow of project in each year. The net present value (NPV)
tells us how much a project contributes to shareholder wealth—the larger the NPV, the more
value the project adds; and added value means a higher stock price. In single project positive
NPV is selected but project with higher NPV has to be selected for mutually exclusive
projects.
NPV = Total Present value of CFAT - Investment
In even cash flow we can see that it follows pattern of even annuity
Total present value of CFAT
= CFAT * PVIFAi%, n prds
= 4000 * PVIFA10%, 4 prds
= 4000 * 3.1699
= 12679.6
Now, NPV = Total Present value of CFAT – Investment
= 12679.6-10000
= 2679.6
= 1.268
Following method can be applied to both uneven and even cash flow. However there is
shortcut method for even cash flow which will be discussed later.
Step 1: calculate factor
investment
Factor =
average CFAT
Step 2: by referring at PVIFA table at n period find two percentages (rates) between which
that value lies.
Step 3: trial and error
Try finding PV at various rates (there should be at least two rate where value of one rate
should be lower than investment and value of another rate should be higher than investment.)
Step 4: interpolation
TPV LR −Investment
IRR (Rate) = LR+ (HR−LR)
TPV LR−TPV HR
Where,
LR = lower rate
TPVLR = total present value at lower rate
TPVHR = total present value at higher rate
HR = higher rate
Where,
FLR = factor at lower rate
FHR = factor at higher rate
Factor = factor calculated in step 1
Example 8:
Let’s consider uneven CF of example 2
Year 0 1 2 3 4 5
CFAT (1200) 400 200 500 700 500
Step 1:
investment
Factor =
average CFAT
1200
= 400+200 +500+700+500
( )
5
= 2.6
Step 2: by referring at PVIFA table at 5 period 2.6 lies between 26% and 27%
Step 3: trial and error
Try at 26%
Year CFAT PVIF26%, n PV
periods
1 400 0.7937 317.48
2 200 0.6299 125.98
3 500 0.4999 249.95
4 700 0.3968 277.76
5 500 0.3149 157.45
Total present value 1128.62
We need TPV as 1200 so we need to increase value that is why we have to decrease rate and
try in it.
Try at 25%
Year CFAT PVIF25%, n PV
periods
1 400 0.8 320
2 200 0.64 128
3 500 0.512 256
4 700 0.4096 286.72
5 500 0.3277 163.85
Total present value 1154.57
Step 4: interpolation
TPV LR −Investment
IRR (Rate) = LR+ (HR−LR)
TPV LR−TPV HR
1300.11−1200
=20 + (25−20)
1300.11−1154.57
= 23.44%
Note: we can follow previous method for even cash flow also. But we will be doing shortcut
for even cash flow. This shortcut method won’t be applicable to uneven cash flow.
Step 1:
investment
Factor =
average CFAT
10000
=
4000
= 2.5
Step 2: by referring at PVIFA table at 4 period 2.5 lies between 21% and 22% where
FLR = F21% = 2.5404
FHR = F22% = 2.4936
Step 3:
Interpolation
F LR −factor
IRR (Rate) = LR+ ( HR−LR)
F LR −F HR
2.5404−2.5
= 21 + (22−21)
2.5404−2.4936
= 21.86%
Decision: if you are comparing two projects (mutually exclusive) then choose projects
having higher IRR.
If you have only one project then accept project which gas higher IRR than cost of capital
and vice-versa.
NPV equals 0 when IRR 25%, but it also equals 0 when IRR 400%.10 Therefore, Project M
has an IRR of 25% and another of 400%, and we don’t know which one to use. This
relationship is depicted graphically in Figure. The graph is constructed by plotting the
project’s NPV at different discount rates.
Formula:
MIRR = ¿
Where,
TVI = terminal value (future value) of cash inflow
PV0 = present value of cash outflow
n = number of periods
Example 10:
West ham FC constructed new stadium and following are cash flow.
CFAT (240) (160) 40 120 160 200 240
Year 0 1 2 3 4 5 6
Cost of capital is 15%. Calculate MIRR.
Step 1: calculation of PV of cash outflow
240 160
PV0 = 0
+ 1
(1+0.15) (1+0.15)
= 240+139.13
= 379.13
Step 2: calculation of terminal value of cash inflow
Year CFAT FVIF15%, n TV
periods
1 40 1.7490 69.96
2 120 1.5209 182.508
3 160 1.3225 211.6
4 200 1.15 230
5 240 1 240
Total terminal value 934.068
Now,
MIRR = ¿
=¿
= 0.1622
=16.22%
Decision: if you are comparing two projects (mutually exclusive) then choose projects
having higher MIRR assuming that these MIRR is greater than cost of capital.
If you have only one project then accept project which gas higher MIRR than cost of
capital and vice-versa.
NPR-IRR CONFLICT
The situation presented here involves two investment projects, one referred to as "S" and the
other as "L." The IRR (Internal Rate of Return) calculation suggests that project "S" should
be chosen, while the NPV (Net Present Value) calculation favors project "L." With a cost of
capital of only 10%, a 49% rate of return on a $100,000 investment is more profitable than a
59% return on a $1 investment. When Ed gave this example in his firm’s executive meeting
on the capital budget, the CFO argued that this example was extreme and unrealistic, and that
no one would choose S in spite of its higher IRR. Ed agreed, but he asked the CFO where the
line should be drawn between realistic and unrealistic examples. When Ed received no
answer, he went on to say that (1) it’s hard to draw this line and (2) the NPV is always better
because it tells us how much value each project will add to the firm, and value is what the
firm should maximize.
In summary, the example illustrates a scenario where different investment appraisal methods
(IRR and NPV) may provide conflicting recommendations. However it is better to choose on
the basis of NPV because it:
Considers multiple cash flow changes
Assumes that any cash flows generated from the investment are reinvested at the company's
cost of capital which is a more realistic assumption
Considers the absolute value of cash flows and is directly related to the scale of the
investment.
CONCLUSIONS
We have discussed five capital budgeting decision criteria—NPV, IRR, MIRR, payback, and
discounted payback. In making the accept/reject decision, large, sophisticated firms such as
Boeing and Airbus generally calculate and consider all five measures because each provides a
somewhat different piece of information about the decision. Each measure provides unique
information that helps them assess the projects better.
1. Net Present Value (NPV): NPV is the most important criterion as it directly
measures the value a project adds to the company's wealth. It helps determine if the
project will be financially beneficial in terms of increasing shareholder value.
2. Internal Rate of Return (IRR) and Modified Internal Rate of Return (MIRR):
IRR and MIRR show the project's profitability as a percentage rate of return, which is
helpful for decision-makers. They also indicate the project's "safety margin" or how
much room for error exists in the projected returns. MIRR is preferred over IRR for
more accurate reinvestment rate assumptions.
3. Payback Period and Discounted Payback Period: Payback measures the time it
takes to recoup the initial investment, while discounted payback considers the time
value of money. These measures offer insights into a project's liquidity and risk.
Longer payback periods suggest less liquidity and potentially higher risk.
In conclusion, each measure provides different kinds of information, and all of them should
be considered during capital budgeting decisions. NPV holds the greatest significance, but
ignoring the information provided by other criteria would be unwise. Calculating all the
measures allows for a more comprehensive evaluation of the projects.
Workout illustrations
Project X has an NPV of 3 million. Project Y is has NPV of 2.5 million. They are mutually
exclusive. Which project should be chosen? Explain.
Here, Being mutually exclusive I should choose only one project and I would like to choose
Project X because it has higher NPV than NPV of project Y.
NPV
Project K costs 52125, its expected cash inflows are 12000 per year for 8 years, and its
WACC is 12%. What is the project’s NPV?
Here,
Cost = 52125
Now total present value:
= 12000 * PVIFA12%,8 PRDS
= 12000 * 4.9676
= 59611.2
Now,
Net present value = 59611.2 – 52125
= 7486.2
IRR
Project X costs $78,500, its expected cash inflows are $18,000 per year for 6 years. What is
the project’s IRR?
Here,
cost
Factor =
average CFAT
78500
=
18000
= 4.36
Now, looking at PVIFA table at 6 periods, 4.36 lies between 9% and 10%
Where, 9% = 4.4859
10% = 4.3553
Now,
LR = 9%
HR = 10%
Factor LR = 4.4859
Factor HR = 4.3553
Factor = 4.36
Interpolation:
factor LR −factor
= LR+ (HR−LR)
factor LR −factor HR
4.4859−4.36
= 9+ (10−9)
4.4859−4.3553
= 9.96
Therefore, IRR = 9.96%
MIRR
Project Alpha requires an investment of 125000, and it is projected to generate annual cash
inflows of 29500 for a period of 5 years. Determine the modified internal rate of return
(MIRR) for Project Alpha if reinvestment rate is 10%.
Here,
Cash outflow in year 0 = 125000
Cash inflow from year 1 to 5 = 29500 (each year)
Reinvestment rate = 10%
Now,
Terminal value of cash inflow:
100000−79577.6
=3+
21856
= 3.93 years
PBP of uneven cash flow
Leicester Tigers, rugby union, is considering a new outdoor equipment rental business. The
initial investment is £150,000. The expected cash flows over the next five years are as
follows: Year 1: £30,000, Year 2: £40,000, Year 3: £50,000, Year 4: £45,000, Year 5:
£65,000. Calculate payback period.
Here,
Investment = 150000
Year CFAT Cumulative CFAT
1 30000 30000
2 40000 70000
3 50000 120000
4 45000 165000
5 65000
Now,
Minimum year = 3
Maximum year = 4
unrecovered amount ∈minimum year
PBP = minimum year +
CFAT during maximum year
150000−120000
=3+
45000
= 3.67 years
Therefore it takes Leicester Tigers 3.67 years to recover its investment.
NPV
Your division is considering two facility investment projects, each of which requires an
upfront expenditure of $15 million. You estimate that the investments will produce the
following net cash flows:
Year 0 1 2 3
Project A (15) 5 10 20
Project B (15) 20 10 5
What are the project’s net present values, assuming the cost of capital is 10%? 5%? 15%?
What does this analysis tell you about the projects?
Here,
For project A:
Year CFAT PVIF10%,n PV PVIF5%, n PRDS PV PVIF15%,n PV
PRDS PRDS
1 5 0.9091 4.5455 0.9524 4.762 0.8696 4.348
2 10 0.8264 8.264 0.9070 9.070 0.7561 7.561
3 20 0.7513 15.026 0.8638 17.276 0.6575 13.15
TPV 27.8355 31.108 25.059
Now,
NPV at 10% = 27.8355 – 15 = 12.8355
NPV at 5% = 31.108 – 15 = 16.108
NPV at 15% = 25.059 – 15 = 10.059
For project B:
Year CFAT PVIF10%,n PV PVIF5%, n PRDS PV PVIF15%,n PV
PRDS PRDS
1 20 0.9091 18.182 0.9524 19.04 0.8696 17.392
8
2 10 0.8264 8.264 0.9070 9.070 0.7561 7.561
3 5 0.7513 3.7565 0.8638 4.319 0.6575 3.2875
TPV 30.2025 32.43 28.2405
7
Now,
NPV at 10% = 30.2025 – 15 = 15.2025
NPV at 5% = 32.437 – 15 = 17.437
NPV at 15% = 28.204 – 15 = 13.204
From above projects we can conclude following conclusions:
When discounting rate is increased then net present value of projects decreases. There is
negative relation between discounting rate and net present value. Likewise, higher CFAT in
earlier year than later year brings higher net present value.
NPV and IRR
Charlee, a sport kit and clothing manufacturing company, is considering two projects i.e.
production of new kit or addition of new sales department with the following cash flows (in
millions)
Year 0 1 2 3
New kit (25) 5 10 17
New department (20) 10 9 6
a. What are the projects’ NPVs assuming the WACC is 10%? 5%? 15%?
b. What are each projects’ IRR? If the WACC was 10% and were mutually exclusive,
which project would you choose based on IRR?
Here,
For new kit:
Year CFAT PVIF10%,n PV PVIF5%, n PRDS PV PVIF15%,n PV
PRDS PRDS
1 5 0.9091 4.5455 0.9524 4.762 0.8696 4.348
2 10 0.8264 8.264 0.9070 9.070 0.7561 7.561
3 17 0.7513 12.7721 0.8638 14.6846 0.6575 11.1775
TPV 25.5816 28.5166 23.0865
Now,
NPV at 10% = 25.5816 – 25 = 0.5816
NPV at 5% = 28.5166 – 25 = 3.5166
NPV at 15% = 23.0865 – 25 = (1.9135)
For new department:
Year CFAT PVIF10%,n PV PVIF5%, n PRDS PV PVIF15%,n PV
PRDS PRDS
1 10 0.9091 9.091 0.9524 9.524 0.8696 8.696
2 9 0.8264 7.4376 0.9070 8.163 0.7561 6.8049
3 6 0.7513 4.5078 0.8638 5.1828 0.6575 3.945
TPV 21.0364 22.8698 19.4459
Now,
NPV at 10% = 21.0364 – 20 = 1.0364
NPV at 5% = 22.8698 – 20 = 2.8698
NPV at 15% = 19.4459 – 20 = (0.5541)
Here, TPV is 24.0387 which is less than 25 and we have to increase value so we have to
decrease rate.
At 12%
Year CFAT PVIF12%,n PV
PRDS
1 5 0.8929 4.4645
2 10 0.7972 7.972
3 17 0.7118 12.1006
TPV 24.5371
Now, interpolation:
TPV LR −Investment
= LR+ (HR−LR)
TPV LR−TPV HR
25.5816−25
= 10+ (12−10)
25.5816−24.5371
= 11.11 %
For new department:
20
Factor = (10+9+6)
3
= 2.4
Looking at PVIFA table at 3 periods, 2.4 lies between 12% and 13%
12% = 2.4018
13% = 2.3612
Now, trial and error
At 12%
Year CFAT PVIF12%,n PV
PRDS
1 10 0.8929 8.929
2 9 0.7972 7.1748
3 6 0.7118 4.2708
TPV 20.3746
Here, TPV is 20.3746 which is more than 20 and we have to decrease value so we have to
increase rate.
At 13%
Year CFAT PVIF13%,n PV
PRDS
1 10 0.8850 8.850
2 9 0.7831 7.0479
3 6 0.6931 4.1586
TPV 20.0565
Now, interpolation:
TPV LR −Investment
= LR+ (HR−LR)
TPV LR−TPV HR
20.0565−20
= 13+ (14−13)
20.0565−19.7475
= 13.1828%
Here, WACC = 10%
IRR of new kit = 11.11%
IRR of new department = 13.1828%
Both of them have IRR greater than WACC but being mutually exclusive, I have to select
only one so I would like to select new department.
For project Y:
NPV = 3500 * PVIFA12%, 4 prds - 10000
= 3500 * 3.0373 – 10000
= 630.55
Calculation of IRR:
For project X:
As we know that TPV of X at 12% is 10966.35. Here we have to decrease value of TPV so
we have to increase rate in order to decrease value. So we need to try at higher rate in trial
and error.
Let’s try at 15%
Year CFAT PVIF15%,n prds PV
1 6500 PVIF15%,1 prds = 0.8696 5652.4
2 3000 PVIF15%,2 prds = 0.7561 2268.3
3 3000 PVIF15%,3 prds = 0.6575 1972.5
4 1000 PVIF15%,4 prds = 0.5718 571.8
TPV 10465
Now, interpolation:
TPV LR −Investment
= LR+ (HR−LR)
TPV LR−TPV HR
10465−10000
= 15+ (20−15)
10465−9718.05
= 18.11%
As we know that TPV of Y at 12% is 10630.55. Here we have to decrease value of TPV so
we have to increase rate in order to decrease value. So we need to try at higher rate in trial
and error.
Try at 15%
= 3500 * PVIFA15%, 4 prds
= 3500 * 2.8550
= 9992.5
Now, interpolation:
TPV LR −Investment
= LR+ (HR−LR)
TPV LR−TPV HR
10630.55−10000
= 12+ (15−12)
10630.55−9992.5
= 14.97%
For MIRR:
For project X:
Step 1: calculation of PV of cash outflow
PV0 = 10000
Step 2: calculation of terminal value of cash inflow
Year CFAT FVIF12%, n periods TV
1 6500 FVIF12%, 3 periods = 1.4049 9131.85
2 3000 FVIF12%, 2 periods = 1.2544 3763.2
3 3000 FVIF12%, 1 periods = 1.1200 3360
4 1000 FVIF12%, 0 periods = 1 1000
Total terminal value 17255.05
Now,
MIRR = ¿
=¿
= 0.1461
= 14.61%
For project Y:
PV of cash outflow = 10000
Total terminal value of cash inflow = 3500 * FVIFA12%, 4 prds
= 3500 * 4.7793
= 16727.55
Now,
MIRR = ¿
= ¿
= 0.1373
= 13.73%
If projects are independent:
IRR of X = 18.11%
IRR of Y = 14.97%
WACC = 12%
Here, we can select both projects because both of them have IRR higher than WACC.
NPV of X = 966.35
NPV of Y = 630.55
Here, we can select both projects because both of them have positive NPV.
MIRR of X = 14.61%
MIRR of Y = 13.73%
WACC = 12%
Here, we can select both projects because both of them have MIRR higher than WACC.
MIRR
Project X costs 1000, and its cash flows are the same in Years 1 through 10. Its IRR is 12%,
and its WACC is 10%. What is the project’s MIRR? (Hint: 1st find yearly cash flow by help
of IRR then find MIRR)
Here,
Investment = 1000
IRR = 12%
WACC = 10%
It has same cash flow in each year for 10 years
Now,
Cash flow * PVIFA12%, 10prds = 1000
Cash flow * 5.6502 = 1000
Therefore, cash flow = 176.98
For MIRR:
PV of cash outflow = 1000
Total terminal value of cash inflow = 176.98 * FVIFA10%, 10 prds
= 176.98 * 15.9374
= 2820.60
Now,
MIRR = ¿
= ¿
= 0.1093
= 10.93%
Questions
Theoretical question
1. Define capital budgeting.
2. In capital budgeting cash flow after tax is used instead of net profit. Why?
3. Give concept of NPV, MIRR and IRR.
4. Explain the advantages of discounting technique over non-discounting techniques.
5. Classify projects into different categories and evaluate them differently based on their
purpose.
6. List out process of capital budgeting.
7. What do you mean by independent and mutually exclusive project?
a. What are the projects’ NPVs assuming the WACC is 5%? 10%? 15%?
b. What are the projects’ IRR at each of these WACC?
c. Find cross over rate.
CAPITAL BUDGETING CRITERIA
19. Manchester united is going to invest in two projects ie X and Y. project X refers to
increment of capacity of stadium. Project Y refers to incremental in training and
development facilities. Each project costs 20,000 (‘000) and the firm’s WACC is
12%. The expected cash flows are as follows:
Year 0 1 2 3 4
Project X (20000) 13000 6000 6000 2000
Project Y (20000) 7000 7000 7000 7000
a. Calculate each project’s NPV, IRR, MIRR, payback, and discounted payback.
b. Which project(s) should be accepted if they are independent?
c. Which project(s) should be accepted if they are mutually exclusive?
d. How might a change in the WACC produce a conflict between the NPV and IRR
rankings of the two projects? Would there be a conflict if WACC were 5%?
e. Why does the conflict exist?
CAPITAL BUDGETING CRITERIA
20. A firm with a 14% WACC is evaluating two projects for this year’s capital budget.
After-tax cash flows, including depreciation, are as follows:
Year 0 1 2 3 4 5
Project A (6000) 2000 2000 2000 2000 2000
Project B (18000) 5600 5600 5600 5600 5600
a. Calculate NPV, IRR, MIRR, payback, and discounted payback for each project.
b. Assuming the projects are independent, which one(s) would you recommend?
c. If the projects are mutually exclusive, which would you recommend?
CAPITAL BUDGETING CRITERIA
21. A firm with a 14% WACC is evaluating two projects for this year’s capital budget.
After-tax cash flows, including depreciation, are as follows:
Year 0 1 2 3 4 5
Project A (8000) 2500 2500 2500 2500 2500
Project B (24000) 7200 7200 7200 7200 7200
a. Calculate NPV, IRR, MIRR, payback, and discounted payback for each project.
b. Assuming the projects are independent, which one(s) would you recommend?
c. If the projects are mutually exclusive, which would you recommend?
CAPITAL BUDGETING CRITERIA: ETHICAL CONSIDERATIONS
22. An electric utility is considering a new power plant in northern Arizona. Power from
the plant would be sold in the Phoenix area, where it is badly needed. Because the
firm has received a permit, the plant would be legal; but it would cause some air
pollution. The company could spend an additional $40 million at Year 0 to mitigate
the environmental problem, but it would not be required to do so. The plant without
mitigation would cost $240 million, and the expected cash inflows would be $80
million per year for 5 years. If the firm does invest in mitigation, the annual inflows
would be $84 million. Unemployment in the area where the plant would be built is
high, and the plant would provide about 350 good jobs. The risk-adjusted WACC is
17%.
a. Calculate the NPV and IRR with and without mitigation.
b. How should the environmental effects be dealt with when evaluating this project?
c. Should this project be undertaken? If so, should the firm do the mitigation? Why
or why not?
CAPITAL BUDGETING CRITERIA: MUTUALLY EXCLUSIVE PROJECTS
23. A firm with a WACC of 10% is considering the following mutually exclusive
projects:
Year 0 1 2 3 4 5
Project A (400) 55 55 55 225 225
Project B (600) 300 300 50 50 49
Year 0 1 2 3 4
Project A (1000) 900 250 10 10
Project B (1000) 0 250 400 800
The company’s WACC is 10%. What is the IRR of the better project? (Hint: The
better project may or may not be the one with the higher IRR.)
MIRR
27. A firm is considering two mutually exclusive projects, X and Y, with the following
cash flows:
Year 0 1 2 3 4
Project A (1000) 100 300 400 700
Project B (1000) 1000 100 50 50
The projects are equally risky, and their WACC is 12%. What is the MIRR of the
project that maximizes shareholder value?
MIRR
28. A firm is considering two mutually exclusive projects, X and Y, with the following
cash flows:
Year 0 1 2 3 4
Project A (1000) 100 300 400 700
Project B (2000) 1800 200 50 100
The projects are equally risky, and their WACC is 10%. What is the MIRR of the
project that maximizes shareholder value?
COMPREHENSIVE PROBLEM
CHOOSING MANDATORY PROJECTS ON THE BASIS OF LEAST COST
29. Kim Inc. must install a new air conditioning unit in its main plant. Kim must install
one or the other of the units; otherwise, the highly profitable plant would have to shut
down. Two units are available, HCC and LCC (for high and low capital costs,
respectively). HCC has a high capital cost but relatively low operating costs, while
LCC has a low capital cost but higher operating costs because it uses more electricity.
The costs of the units are shown here. Kim’s WACC is 7%.
Year 0 1 2 3 4 5
Project (600000) (50000) (50000) (50000) (50000) (50000)
A
Project (100000) (175000) (175000) (175000) (175000) (175000)
B
a. Which unit would you recommend? Explain. (Use NPV; use project with lowest
negative NPV)
b. If Kim’s controller wanted to know the IRRs of the two projects, what would you
tell him?
(Hint: IRR cannot be calculated using all negative cash flow. However, if we
assume total revenue as 200000 for each cash flow then we can find net cash flow
as following and calculate IRR:
YEAR 0 1 2 3 4 5
HCC (600000) 15000 15000 150000 15000 15000
0 0 0 0
LCC (100000) 25000 25000 25000 25000 25000
Now, we can calculate IRR)
c. If the WACC rose to 15% would this affect your recommendation? Explain your
answer and the reason this result occurred.
NPV PROFILES: TIMING DIFFERENCES
30. An oil-drilling company must choose between two mutually exclusive extraction
projects, and each costs 12 million. Under Plan A, all the oil would be extracted in 1
year, producing a cash flow at t=1 of 14.4 million. Under Plan B, cash flows would be
$2.1 million per year for 20 years. The firm’s WACC is 12%.
a. Construct NPV profiles for Plans A and B, identify each project’s IRR, and show
the approximate crossover rate.
b. Is it logical to assume that the firm would take on all available independent,
average risk projects with returns greater than 12%? If all available projects with
returns greater than 12% have been undertaken, does this mean that cash flows
from past investments have an opportunity cost of only 12% because all the
company can do with these cash flows is to replace money that has a cost of 12%?
Does this imply that the WACC is the correct reinvestment rate assumption for a
project’s cash flows? Why or why not?
NPV PROFILES
31. Lacoste, sports equipment manufacturing company, must decide between two
mutually exclusive production projects, each requiring an investment of $8 million.
Under Plan A, all the equipment would be produced in 1 year, generating a cash flow
at t=1 of $9.6 million. Under Plan B, cash flows would be $1.4 million per year for 15
years. The company's required rate of return is 10%.
a. Create NPV profiles for Plans A and B, determine the IRR for each project, and
identify the approximate crossover rate.
b. Can we assume that the company would undertake all available independent, average-
risk projects with returns higher than 10%? If all available projects with returns
greater than 10% have been pursued, does this mean that cash flows from prior
investments have an opportunity cost of only 10% because the company can only
reinvest the money at a cost of 10%? Does this suggest that the required rate of return
is the appropriate reinvestment rate assumption for project cash flows from previous
investments only have an opportunity cost of 10%? Does this suggest that the required
rate of return is an appropriate assumption for reinvestment of a project's cash flows?
Explain your reasoning
NPV PROFILES: SCALE DIFFERENCES
32. A company is considering two mutually exclusive expansion plans. Plan A requires a
$40 million expenditure on a large-scale integrated plant that would provide expected
cash flows of $6.4 million per year for 20 years. Plan B requires a $12 million
expenditure to build a somewhat less efficient, more labor-intensive plant with
expected cash flows of $2.72 million per year for 20 years. The firm’s WACC is 10%.
a. Calculate each project’s NPV and IRR.
b. Graph the NPV profiles for Plan A and Plan B and approximate the crossover rate.
c. Calculate the crossover rate where the two projects’ NPVs are equal.
d. Why is NPV better than IRR for making capital budgeting decisions that add to
shareholder value?
a. Calculate the projects’ NPVs, IRRs, MIRRs, regular paybacks, and discounted
paybacks.
b. If the two projects are independent, which project(s) should be chosen?
c. If the two projects are mutually exclusive and the WACC is 10%, which project(s)
should be chosen?
d. Plot NPV profiles for the two projects. Identify the projects’ IRRs on the graph.
e. If the WACC was 5%, would this change your recommendation if the projects
were mutually exclusive? If the WACC was 15%, would this change your
recommendation? Explain your answers.
f. The crossover rate is 13.5252%. Explain what this rate is and how it affects the
choice between mutually exclusive projects.
g. Is it possible for conflicts to exist between the NPV and the IRR when
independent projects are being evaluated? Explain your answer.
h. Now look at the regular and discounted paybacks. Which project looks better
when judged by the paybacks?
i. Define the MIRR. What’s the difference between the IRR and the MIRR, and
which generally gives a better idea of the rate of return on the investment in a
project? Explain.
j. Why do most academics and financial executives regard the NPV as being the
single best criterion and better than the IRR? Why do companies still calculate
IRRs?