Addis Ababa University

College of Business & Economics

Department of Management

MBA Program
Comparison of Capital Budgeting Techniques
Course Title: - Intermediate Financial Management
Instructor’s Name: - Dr. Venkati Ponnala

Group Members
Sr. No. Member’s Name ID. No.
1 Daniel Girma GSR/2007/06
2 Fekadu Abdissa GSR/2014/06
3 Goshu Girma GSR/2017/06
4 Merga Ademe GSR/2026/06

January 31, 2014

Background
The Dilemma at Day-Pro
Day-Pro Company is a chemical manufacturing company
Planned to manufacture thermosetting resin as a packing
material.
Company’s Research and development teams have come with
two mutually exclusive alternatives: -
1. Synthetic Resin
 Cost more to produce initially
 Have greater economies of scale
2. Epoxy Resin
 Lower startup cost
Tim Palmer, Assistant Treasure, has been assigned the task of
analyzing the costs and benefits of the two and presenting his
finding to the Board.
Cash Flow Forecast
A. Synthetic Resin
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Net Income - 150,000 200,000 300,000 450,000 500,000
Depreciation
(Straight line)
- 200,000 200,000 200,000 200,000 200,000
Net Cash Flow (1,000,000) 350,000 400,000 500,000 650,000 700,000
B. Epoxy Resin
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Net Income - 440,000 240,000 140,000 40,000 40,000
Depreciation
(Straight line)
- 160,000 160,000 160,000 160,000 160,000
Net Cash Flow (800,000) 600,000 400,000 300,000 200,000 200,000
Question 1
I. Calculate the payback period of each project.
 The Payback period is simply defined as the period (i.e.
the number of years) required to recover the original
investment cost.
 Synthetic Resin
 Original investment= $ 1,000,000
 Cash flow for the first 2 years = $ 750,000
 Difference= $ 250,000
 Cash flow for the 3rd year= $ 500,000
 Difference/3rd yr Cash Flow= 0.50
 Payback period= 2+0.50= 2 and half years
Question 1 cont…
 Epoxy Resin
 Original investment= $ 800,000
 Cash flow for the first year= $ 600,000
 Difference= $ 200,000
 Cash flow for the 2nd year= $ 400,000
 Difference/2nd yr CF= 0.50
 Payback period= 1+0.50 = 1 and half years
 Therefore, the project with Synthetic Resin pays back its
original investment between year 2 and 3; whereas, the
project with Epoxy Resin pays between year 1 and 2 of
project operational period.
Question 1 cont…
II. Explain what argument Tim should make to show
that the pay period is not appropriate in this case.
 Even if payback period is extensively used especially
for small investments, it is a very crude measure of
project worth. Its drawbacks are: -
 It ignores the time value of money.
 It does not consider cash flows beyond the payback
period. For example, in our case the project with
Synthetic Resin has large cash flows after payback
period.
 It discriminates heavily against projects with a long
gestation period.
 Therefore, Tim can justify that the payback period is
not an appropriate indicator of project worth.
Question 2
I. Calculate the Discounted Payback Period (DPP)
using 10% as discount rate.
 DPP has the same definition with previous payback
period except the former uses discounted cash flow.
 Discounted cash flow of both project is as follow

Synthetic Resign Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Net Cash Flow (1,000,000) 350,000 400,000 500,000 650,000 700,000
Discount Factor 1.00 0.9091 0.8264 0.751 0.683 0.621
Discounted Cash
Flow
(1,000,000) 318,182 330,579 375,657 443,959 434,645
Question 2 cont…
Epoxy Resign Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Net Cash Flow (800,000) 600,000 400,000 300,000 200,000 200,000
Discount Factor 1.00 0.9091 0.8264 0.751 0.683 0.621
Discounted Cash
Flow
(800,000) 545,455 330,579 225,394 136,603 124,184

 Synthetic Resin
 Original investment= $ 1,000,000
 Cash flow for the first 2 years = $ 648,761
 Difference= $ 351,239
 Cash flow for the 3rd year= $ 375,657
 Difference/3rd yr Cash Flow= 0.935
 Payback period= 2+0.935= 2.935 years
Question 2 cont...
 Epoxy Resin
 Original investment= $ 800,000
 Cash flow for the first year= $ 545,455
 Difference= $ 254,545
 Cash flow for the 2nd year= $ 330,579
 Difference/2nd yr CF= 0.77
 Payback period= 1+0.77= 1 .77 years
 Similar with previous payback period, the project with
Synthetic Resin pays back its original investment
between year 2 and 3; whereas, the project with Epoxy
Resin pays between year 1 and 2 of project operational
period.
Question 2 cont...
II. Should Tim ask the board to use Discounted
Payback Period (DPP) as the deciding factor?
Explain
 No! DPP should not be taken as a deciding factor.
 Except that DPP uses discounted cash flow, all
drawbacks of payback period persisted for DPP. As a
result, there is no need of using it as a deciding factor
of project selection.
Question 3
I. If the management prefers to have a 40%
accounting rate of return (ARR), which project
would be accepted?
 ARR is the rate of returns achieved on the assets. It is
computed with the help of accounting profits (EAT) &
average investment.
 Formula

ARR  Annual Average Return (AAR)

Average Investment s (AI)

AAR  Sum of EAT

Number of years
Initial Investment Salvage Value
AI  2  Salvage Value
Question 3 cont…
 Synthetic Resin

AAR  $ 1,600,000
5

$ 320,000

AI  2 0 
$1,000,000  0$ 500,000

ARR 
 Epoxy Resin
$ 320,000
$ 500,000
64%

$ 180,000
AAR  $ 900,000
5 
$ 400,000
45% 
$ 800,000  0
AI  2  0
ARR  $ 180,000
$ 400,000 
Question 3 cont…
 Based on these computations, the ARR of the project
with Synthetic Resin is higher than ARR of Epoxy Resin
(64% > 45%). From this, we can conclude that project
with Synthetic Resin is worthier than with Epoxy Resin.
Thus, the management shall accept project with
Synthetic Resin.
II. What is wrong with this decision?
 ARR is easy to compute and understand technique.
However, it has solid drawbacks. Some of them are: -
 It doesn’t use cash flows but rather accounting numbers.
 It ignores the time value of money.
 It uses an arbitrarily specified cutoff rate.
 There is no universal acceptance regarding AI formula.
 As a result, it is hard to take it as a decision criteria.
Question 4
I. Calculate the two projects IRR.
 IRR is the discount rate that equates the present value of
a project’s future net cash flows with the project’s initial
cash outlay.
 Formula
( NPV 1)
IRR  D1  [( D 2  D1) X ]
( NPV 1  NPV 2)
Where: -
 D1: - Lower discount rate which arrives at +ve NPV
 D2:- Higher discount rate which arrives at –ve NPV
 NPV1: - NPV at lower discount rate
 NPV2: - NPV at higher discount rate
Question 4 cont…
 Decision Rule
 If IRR > Required rate of return, accept
 IF IRR < Required rate of return, reject
 By using Microsoft Excel, financial calculator or manually
by try and error, we can find the result. In our case, we used
Microsoft Excel and the answers for both projects are:
 IRR of Synthetic Resin= 36.63%
 IRR of Epoxy Resin= 42.91%
 When we compare the two projects based on the result of
IRR, the project with Epoxy Resin has greater IRR. So, if
our decision criteria is IRR, we can conclude that project
with Epoxy Resin is better.
Question 4 cont…
II. How should Tim convince the Board that the IRR measures
could be mislead?
 IRR has numerous pros as a capital budgeting techniques
and mostly practice in the contemporary business
environment. According to Harold Bierman Jr. “Capital-
Budgeting in 1992: A Survey,” around 88% and 11% of
firms using IRR as a primary and secondary decision
criteria, respectively.
 IRR will give the same result as the NPV for independent
projects and for projects with normal cash flows.
 However, it has a solid drawbacks especially in comparing
mutually exclusive projects. The followings are drawbacks of
IRR
Question 4 cont…
 Drawbacks of IRR
 IRR can't be used for exclusive projects or those of different
durations; IRR may overstate the rate of return.
 IRR overstates the annual equivalent rate of return for a project
whose interim cash flows are reinvested at a rate lower than the
calculated IRR.
 IRR does not consider cost of capital; it should not be used to
compare projects of different duration.
 In the case of positive cash flows followed by negative ones and then
by positive ones, the IRR may have multiple values.
 When the IRR is very high relative to the cost of capital it is
unrealistic to assume reinvestment at that high rate.
 IRR is in terms of percentage. It does not indicate addition to
shareholders wealth in terms of currency.
 Therefore, using all these drawbacks of IRR, Tim can
convince the Board not to be mislead by IRR result.
Question 5
I. Calculate the NPV profiles for the two projects and
explain the relevance of the cross over point.
 Simply we can say that NPV is the difference between
present value of future cash inflow and out flow.
 It is considered to be the most theoretically correct
criterion for evaluating capital-budgeting projects.
 Formula
NPV   FCF
(1 r)t
 Initial Outlay
Where: -
 FCF: - Future cash flow
 r: - Discount rate or cost of capital
 t: - Project year
Question 5 cont…
 Decision rule
 NPV greater than or equal to zero : Accept the project
 NPV less than zero: Reject the project
 By using Microsoft Excel, financial calculator or
manually, we can find the result. In our case, we used
Microsoft Excel and the answers for both projects are:
 NPV of Synthetic Resin= $ 903,021
 NPV of Epoxy Resin= $ 562,264
 Both projects have positive NPV, i.e. NPV>0. As a result,
both are acceptable. However, since they are mutually
exclusive, occurrence of any one implies the non-
occurrence of others, we have to choose project with
higher NPV which is project with Synthetic Resin.
Question 5 cont…
II. How should Tim convince the Board that the NPV is the
way to go?
 NPV the best method of capital budgeting technique. It has
numerous advantages over other methods project evaluation.
Advantages of NPV are: -
 It is a direct measure of contribution.
 It measures how investment will increase the firm’s value.
 It considers all the cash flows and time value of money.
 It considers the risks of future cash flow and provides better
forecast.
 It uses the “correct” rate, i.e., the cost of capital, to discount
the cash flows, rather than an “arbitrary” rate, i.e., the IRR,
that makes NPV =0.
 It assumes the reinvestment of the cash flows at cost of capital
rather than arbitrary rate.
Question 6
I. Explain how Tim can show that MIRR is the more
realistic measure to use in the case of mutually
exclusive projects.
 IRR assumes the reinvestment of the cash flows at the highest rate
which is internal rate of return when we relate with cost of capital.
However, it is unrealistic to assume the reinvestment at that high
rate. This is especially damaging when comparing two investments
with very different timing of cash flows.
 As a result, IRR is modified and make it a better indicator of
relative profitability. This modified IRR is called Modified Internal
Rate of Return.
Question 6 cont…
 Formula
Terminal Value
MIRR  N 1
Initial Outlay
Where: -
Terminal Value: - Sum of reinvested cash out flow at cost of capital
N: - Total number of years
 Decision Rule
 If MIRR > Required rate of return, accept
 If MIRR < Required rate of return, reject
 MIRR assumes that cash inflows are reinvested at the cost of capital
which is realistic. For example, if we take the case we are
considering, the cash flow of the project with Epoxy Resin is high at
the early stage and the reverse for Synthetic Resin. Due to this and
since IRR takes higher interest rate for reinvestment which is
unrealistic, IRR of project with Epoxy Resin become higher.
Therefore, Tim can easily reveal that MIRR is the better decision
criteria.
Question 6 cont…
 By using Microsoft Excel, financial calculator or
manually by try and error, we can find the result. In our
case, we used Microsoft Excel and the answers for both
projects are:
 MIRR of Synthetic Resin= 25.11%
 MIRR of Epoxy Resin= 22.36%
 Now, the problem related with IRR is solved and the
product of MIRR is different from that of IRR. Since
their point of difference is acceptable and realistic, it is
indisputable if we use MIRR as a decision criteria.
Therefore, since MIRR of project with Synthetic Resin is
higher than that of Epoxy, Tim can easily choose the one
with higher MIRR.
Question 7
I. Calculate the profitability index (PI) for each proposal.
 PI is the ratio of the present value of the future free cash flows
to the initial outlay.
PVof FCF
 Formula PI
InitialOutlay
where: -
PV of FCF: Present value of future cash flow
 Decision Rule
 PI > 1 = accept
 PI < 1 = reject
 By using calculator or manually, we can find the result. In our
case, we used scientific calculator and the answers for both
projects are:
 PI of Synthetic Resin= 1.90
 PI of Epoxy Resin= 1.70
Question 7 cont…
II. Can this measure help to solve the dilemma? Explain.
 Yes! Somehow PI can solve the dilemma.
 The very important thing is, PI considers the risk of
future cash flows through the cost of capital. Rather than
any other arbitrary rate, it uses WACC for its
computation.
 It always yields the same decision with NPV.
 It tells whether an investment increases the firm's value.
 It considers the time value of money.
 It is useful in ranking and selecting projects when capital
is rationed.
 Due to these, therefore, it can help us to solve the dilemma.
Question 8
I. In looking over the documentation prepared by the two
project teams, it appears to you that the Synthetic Resin
team has been somewhat more conservative in its revenue
projections than the Epoxy Resin team. What impact might
this have on your analysis?
 If the revenue for project with Synthetic Resin is
conservatively forecasted, it means that there is hope for
better future than the project with Epoxy Resin which is not
conservatively forecasted.
 If the worst case may happen in the future, the project whose
revenue is forecasted conservatively affected less or even may
not affected. However, for Epoxy it may be difficult. As a
result, Project with Synthetic Resin is more preferable.
Question 9
I. In looking over the documentation prepared by two project
teams, it appears to you that the Synthetic Resin technology
would require extensive development before it could be
implemented where as Epoxy Resin technology has available
“off the shelf”. What impact might this have on your
analysis?
 This means, it is a matter of time. Extensive development will
take time to be implemented and to become operational.
However, since project with Epoxy Resin is off the shelf, it
can immediately be implemented and become operational.
 When we compare this, we have take time value into
consideration. Early implementation is early operation and
become early cash inflow. As the time goes, the time value of
money eroded.
Question 9 cont…
 Also, it is obviously known, business environment is changing
fast. What demanded today will not be demanded again by
tomorrow. As a result, their will be loss of demand in the
future.
 Also, even if the probability of success is not stated, it should
be taken into consideration. If there is the probability of
failure, it bring great damage.
 Therefore, as our opinion, unless there is/are solution/s for
those doubt and other better future prospect, it is difficult to
only relay on the financial forecast. As a result, we prefer the
implementation of the project with Epoxy Resin.
If there is any question, you
welcome!!
Thank You all!!