Topic 5:

TECHNIQUES IN CAPITAL
BUDGETING

(Part 2)
 Internal Rate of Return (IRR) Method
IRR is simply the rate of return that the firm earns on its
capital invested in a project.

IRR is the rate of return that makes

PV of the project’s future cash flows = the project’s initial outlay

In other words, IRR is the return that makes the NPV = 0

IRR is very similar to Yield to Maturity (YTM) of a bond. In

fact, YTM is the IRR of a bond.

It is one of the most commonly used techniques in capital

budgeting.
Internal Rate of Return (IRR) Method
Calculation of IRR


FCFt
t = IO
(1 + IRR)
t=1
 Internal Rate of Return (IRR) Method
Decision rule :
ACCEPT the project
if IRR > required rate of return of the firm
REJECT the project
if IRR < required rate of return of the firm

If IRR = required rate of return of the firm

The project should be marginally accepted. In other

words, the investor can accept or reject the project.
Because, in that situation, the total benefit of the
project equals its cost.
 Example: IRR
Suppose your firm is considering project B which
provides the following cash flows.

Year Free cash flows

0 RM(45,000)
1 28,000
2 12,000
3 10,000
4 10,000
5 10,000

a)Calculate IRR of the project.

b)The firm’s required rate of return is 15%. Should
your firm accept the project?
 Example: IRR
Solution:


FCFt = IO
t
(1 + IRR)
t=1
•The IRR is the discount rate that makes the NPV of the
projected cash flows equal to zero (i.e. NPV = 0)
 Example: IRR
Trial and error Method:
Trial and error method can be applied to find out the IRR of the
project as follows:

If we assume that the discount rate is 24%, the NPV of the project
will be-
NPV = 28,000 12,000 10,000 10,000 10,000
+ +
(1+ 0.24) (1+ 0.24) (1+ 0.24) (1+ 0.24) (1+ 0.24)5
1 2 3 4
+ + - 45,000

NPV = 28,000 + 12,000 + 10,000 + 10,000 + 10,000 - 45,000

(1.24)1 (1.24)2 (1.24)3 (1.24)4 (1.24)5

= 43,271 – 45,000 = - $1,729

 Example: IRR
If we assume that the discount rate is 22%, the NPV of the project
will be-
NPV = 28,000 12,000 10,000 10,000 10,000
+ +
(1+ 0.22)1 (1+ 0.22)2 (1+ 0.22)3 (1+ 0.22)4 (1+ 0.22)5 + + - 45,000

NPV = 28,000 + 12,000 + 10,000 + 10,000 + 10,000 - 45,000

(1.22)1 (1.22)2 (1.22)3 (1.22)4 (1.22)5
= 44,734 – 45,000 = - $226
If we assume that the discount rate is 19%, the NPV of the project
will be-
NPV = 28,000 12,000 10,000 10,000 10,000
+ +
(1+ 0.19)1 (1+ 0.19)2 (1+ 0.19)3 (1+ 0.19)4 (1+ 0.19)5 + + - 45,000

NPV = 28,000 + 12,000 + 10,000 + 10,000 + 10,000 - 45,000

(1.19)1 (1.19)2 (1.19)3 (1.19)4 (1.19)5
= 47,114 – 45,000 = $2,114
 Example: IRR
If we assume that the discount rate is 21%, the NPV of the project
will be-
NPV = 28,000 12,000 10,000 10,000 10,000
+ +
(1+ 0.21)1 (1+ 0.21)2 (1+ 0.21)3 (1+ 0.21)4 (1+ 0.21)5 + + - 45,000

NPV = 28,000 + 12,000 + 10,000 + 10,000 + 10,000 - 45,000

(1.21)1 (1.21)2 (1.21)3 (1.21)4 (1.21)5
= 45,502 – 45,000 = $502

Comparison of NPVs at different discount rates:

Discount Rate (%) NPV ($)

19 2,114
21 502
22 - 226
24 - 1,729
 Example: IRR
Interpolation: By applying interpolation, we can get the IRR
of the project as follows:
IRR = L + [ M * (H – L)]
M-N
Where,
L = lower discount rate
H = higher discount rate
M = NPV at lower discount rate
N = NPV at higher discount rate

Therefore,
IRR = L + [ M * (H – L)]
M-N
= 0.21 + [ 502 * (0.22 – 0.21)]
502 – (- 226)

= 0.21 + [ 5.02] = 0.21+ 0.0070 = 0.2170 = 21.70%

728
Since the IRR of the project (21.70%) is higher than the required rate of
return of the firm (15%), the firm should accept the project.
 IRR Method
Advantages:
 Considers all the net cash flows of a project.
 Recognizes the time value of money
 Consistent with the firm’s goal- maximization of
shareholders’ wealth.

Disadvantages:
 Requires detailed long-term forecasts of a project’s
free cash flows.
 Possibility of multiple IRRs
 IRR is unreliable with non-conventional cash flows
or mutually exclusive projects.
 IRR Method
IRR and Mutually Exclusive Projects

• Mutually exclusive projects are the projects that

compete with each other. If the firm accepts a
project, then the other project / projects must be
rejected.

• If the projects are mutually exclusive, the firm

should use the following decision rule:

Choose the project with the higher IRR

 IRR Method
IRR and Mutually Exclusive Projects
Exercise: Your firm is considering two mutually exclusive
projects- A and B. The projects will provide the following cash
flows:
Year Free cash flows
Project A Project B
0 RM(5,00) RM(4,00)
1 325 325
2 325 200

a) Calculate IRR of the project A and B.

b) Which project the firm should accept if its required rate of return is
15%.?
 IRR Method
IRR and Non-conventional Cash Flows
• IRR is a good decision-making tool as long as cash
flows are conventional.

Example: conventional cash flow

Year Free cash flows
0 RM(45,000)
1 28,000
2 12,000
3 10,000
4 10,000
5 10,000
 IRR Method
• If the cash flows are non-conventional, we could
get multiple IRRs.
• If there are multiple sign changes in the cash flow
stream, it is called non-conventional cash flows.
Example: Non-conventional cash flow
Year Free cash flows
0 RM(45,000)
1 28,000
2 12,000
3 (28,000)
4 15,000
5 21,000
 IRR Method

IRR and Non-conventional Cash Flows (cont.)

• If the cash flows are non-conventional, there is more

than one IRR.

If you have more than one IRR, which one do you

use to make your decision regarding accept or reject
the project?
 Modified Internal Rate of Return (MIRR)
• The modified internal rate of return (MIRR) is a modification of the
internal rate of return (IRR) and is used in capital budgeting
decisions.

• In other words, MIRR is an improved version of IRR approach to

capital budgeting decisions. 

• The traditional IRR method assumes that the cash flows from a
project are reinvested at the IRR.

• On the other hand, MIRR assumes that cash flows are reinvested
at the required rate of return of the firm.

• The MIRR more accurately reflects the cost and profitability of a

project.
 Modified Internal Rate of Return (MIRR)
Steps in the Calculation of MIRR
Calculate PV of all the cash outflows and add them to get the
total PV.
Use the firm’s cost of capital to calculate PV of the cash
outflows.
Calculate FV of all the cash inflows and add them to get the
total FV. The total FV is called the terminal value (TV).
Use the firm’s required rate of return to calculate FV of the
cash inflows. The firm’s required rate is also known as
reinvestment rate.
Finally, calculate MIRR of the project.
MIRR is the discount rate that makes the PV of the cash
outflows equal to the PV of the cash inflows, i.e.
PVcash outflows = PVcash inflows
 Modified Internal Rate of Return (MIRR)
Steps in the Calculation of MIRR

The following equation can be used to calculate MIRR of a

project:

MIRR =(Total FV of cash inflows ÷ Total PV of cash outflows )(1/n) – 1

Where,
n = number of periods.
 Modified Internal Rate of Return (MIRR)
Decision rule :
ACCEPT the project
if MIRR > required rate of return of the firm
REJECT the project
if MIRR < required rate of return of the firm

If MIRR = required rate of return of the firm

The project should be marginally accepted. In other

words, the investor can accept or reject the project.
Because, in that situation, the total benefit of the
project equals its cost.
 Example: MIRR
Suppose your firm is considering project B which provides
the following cash flows.

Year Free cash flows

0 RM(2,000)
1 1,000
2 1,000
3 (4,000)
4 3,000
5 3,000
6 3,000

a)The firm’s cost of capital and required rate of return is 15%

and 12% respectively. Calculate MIRR of the project.
b)Should your firm accept the project?
 Example: MIRR
solution

The total PV of the cash outflows can be found as follows:

PV = CF1 /(1+r)1 + CF2 /(1+r)2 + CF3 /(1+r)3 + CF4 /(1+r)4
+ -------------- + CFn /(1+r)n

PV = 2,000/ (1+0.15)0 + 4,000/ (1+0.15)3

PV = 2,000/ 1 + 4,000/ (1.15)3
PV = 2,000 + 2,630.06 = RM4,630.06
 Example: MIRR
The total FV of the cash inflows can be found as follows:
FVn = CF1 x (1+r)n-1 + CF2 x (1+r)n-2 + CF3 x (1+r)n-3 + CF4 x (1+r)n-4
+ -------------- + CFn x (1+r)n-n

= 1,000 x (1+ 0.12)6-1 + 1,000 x (1+ 0.12)6-2 + 3,000 x (1+ 0.12)6-4

+ 3,000 x (1+ 0.12)6-5 + 3,000 x (1+ 0.12)6-6

= 1,000 x (1.12)5 + 1,000 x (1.12)4 + 3,000 x (1.12)2 + 3,000 x (1.12)1

+ 3,000 x (1.12)0

= 1,762.34 + 1,573.52 + 3,763.20 + 3,360.00 + 3,000

FVn = RM13,459.06
 Example: MIRR
Now, the MIRR of the project can be found as follows:

MIRR =(Total FV of cash inflows ÷ Total PV of cash outflows )(1/n) – 1

=(13,459.06 ÷ 4,630.06)(1/6) – 1

= 0.1946 = 19.46%

Since the MIRR of the project (19.46 %) is higher than the required rate of
return of the firm (12%), the firm should accept the project.
 Capital Rationing
Firm’s often operate under conditions of capital
rationing—they have more acceptable
independent projects than the availability of
fund.
In practice, most firms operate under capital
rationing.
Generally, firms attempt to isolate and select
the best acceptable projects subject to a capital
expenditure budget set by management.
 Capital Rationing (cont.)
The internal rate of return approach is an
approach to capital rationing that involves graphing
project IRRs in descending order against the total
dollar investment to determine the group of
acceptable projects.

The graph that plots project IRRs in descending

order against the total dollar investment is called the
investment opportunities schedule (IOS).

The problem with this technique is that it does not

guarantee the maximum dollar return to the firm.
 Capital Rationing (cont.)
Example: Tate Company, a fast growing plastics
company with a cost of capital of 10%, is
confronted with six projects competing for its fixed
budget of $250,000.
 Capital Rationing (cont.)
Figure 1. Investment Opportunities Schedule
 Capital Rationing (cont.)
• According to the schedule, only projects B, C, and E
should be accepted. Together, they will absorb
$230,000 of the $250,000 budget.

• Projects A and F are acceptable but cannot be

chosen because of the budget constraint.

• Project D is not worthy of consideration because its

IRR is less than the firm’s 10% cost of capital.
 Problems with Project Ranking
Mutually Exclusive Projects with Unequal Size
• If the projects are mutually exclusive and unequal size, the
firm should use the following decision rule:
Choose the project with the higher NPV

Example: Suppose your firm is considering the following

projects. If the projects are mutually exclusive, which one
should be selected by your firm?

Project A Project B
year cash flow year cash flow
0 $(135,000) 0 $(30,000)
1 60,000 1 15,000
2 60,000 2 15,000
3 60,000 3 15,000
required return = 12% required return = 12%
 Problems with Project Ranking
Solution: The NPV of the project A can be computed as follows:
NPV = 60,000 60,000 60,000
+
(1+ 0.12)1 (1+ 0.12)2 (1+ 0.12)3
+ - 135,000

NPV = 60,000 + 60,000 + 60,000 - 135,000

(1.12)1 (1.12)2 (1.12)3

NPV = $9,110

The NPV of the project B can be computed as follows:

NPV = 15,000 + 15,000 + 15,000 - 30,000
(1+ 0.12)1 (1+ 0.12)2 (1+ 0.12)3
NPV = 15,000 + 15,000 + 15,000 - 30,000
(1.12)1 (1.12)2 (1.12)3
NPV = $6,027

Since the NPV of project A is greater than that of project B,

the firm should accept the project A.
 Problems with Project Ranking
Mutually Exclusive Projects with Unequal Lives
• If the projects are mutually exclusive with unequal lives, a
firm can not simply use the NPV criterion to select the suitable
project for investment.
• In that situation, the firm will calculate the Annualized Net
Present Value (ANPV) of the project. ANPV is also known
as Equivalent Annual Annuity (EAA) or Equivalent
Annual Cost (EAC).
• ANPV can be computed as follows: ANPV = NPV/PVIFAr,n
Where,
PVIFAr,n = present value interest factor of annuity for a
specific interest rate (r) and time period (n)

• The firm should use the following decision rule:

Choose the project with the higher ANPV
 Problems with Project Ranking
Example: Sunrise corporation is currently considering two
mutually exclusive projects- X and Y. The projects will
provide the following cash flows:

Year Project X Project Y

0 - $70,000 - $85,000
1 28,000 35,000
2 33,000 30,000
3 38,000 25,000
4 - 20,000
5 - 15,000
6 - 10,000
Assume a required return of 10%. Which project should the
firm select for investment?
 Problems with Project Ranking
Solution: The NPV for project X and Y are as follows:
NPV× = $11,277.24
NPVY = $19,013.27
According to NPV criterion, project Y is preferable to the firm as it
provides higher NPV than that of project X. However, the firm
shouldn’t rely on NPV because the projects have unequal lives. In
this situation, the firm can choose suitable project based on ANPV.
The ANPV for project X and Y can be computed as below:
ANPV× = NPV/ PVIFAr,n= $11,277.24/ PVIFA10%, 3yrs
= $11,277.24/2.4869 = $4,534.70

ANPVY = NPV/ PVIFAr,n= $19,013.27/ PVIFA10%, 6yrs

= $19,013.27/4.3553 = $4,365.55
The firm should select project X as it provides higher ANPV
than that of project Y.
Thank You For Your Attention !!!