CHAPTER FIVE

INVESTMENT DECISION /CAPITAL BUDGETING

Contents
5.1. Capital Budgeting Defined
5.2. Importance of Capital Budgeting
5.3. Components of Capital Budgeting.
5.4. Capital Budgeting Decision Practices
5.5. Classification of Investment Projects
5.6. Capital Budgeting Decision Methods
5.6.1. The Payback Period (PBP)
5.6.2. The Accounting Rate of Return (ARR)
5.6.3. Discounted Payback Period (DPBP)
5.6.4. Net Present Value (NPV)
5.6.5. Internal Rate of Return (IRR)
5.6.6 The Modified Internal Rate of Return (MIRR)
5.6.7. Conflicting Rankings between the NPV and the IRR Methods
5.6.8. Profitability Index (PI)
5.6.9. Capital Rationing
Chapter Summary
Model Examination Questions
Chapter Objectives: - At the end of this chapter, learners are expected to:
 Understand of the importance of capital budgeting in decision making
 Explain of the different types of investment project.
 Explain the mechanics, advantages and disadvantages of the different investment
decision criteria.
 Describe the capital budgeting techniques to be used for mutually exclusive projects in
times of capital rationing.
 Use the capital budgeting criteria-the non-discounted and discounted methods to evaluate
the worth of the project
Introduction
Business firms regularly make decisions involving capital goods purchases such as equipment
and structures. Capital goods are business assets with an expected use of more than only one
year.
The fixed asset account on a firm’s Balance sheet represents its net investment or capital
expenditure in capital goods. Capital goods represent a major portion of the total assets of
today’s firms.
An investment in capital goods requires an outlay of funds by the firm in exchange for expected
future benefits over a period greater than one year. The proper goal in making capital investment
decision should be maximization of the long-term market value of the firm. Managers attempt to
maximize value by selecting capital investments in which the value created by the project’s
future cash flows exceeds the recurred cash outlay. capital budgeting is the process of planning,
analyzing, selecting, and managing capital investments.
Capital budgeting may involve other investments besides the long term investments in capital
goods. Many other long term investments led themselves to capital budgeting analysis. Such
commitments include outlays for advertising campaigns, research and development (R&D),
employee education and training programs, leasing contracts, and mergers and acquisition. The
focus of our treatment of capital budgeting centers on the decision to acquire capital goods
namely fixed assets used for a firms operation. However, firms can use similar procedures and
processes to analyze various capital expenditures. Capital budgeting analysis also helps analysts
to evaluate existing projects and operations and to decide if a firm should continue to fund
certain projects.
5.1. Capital Budgeting Defined

Capital budgeting refers to the process we use to make decisions concerning investments in the
long-term assets of the firm. There are typically two types of investment decisions: (1) Selection
decisions concerning proposed projects (for example, investments in the long term assets such as
property, plant and equipment or resource commitments in the form of new product development
market research, refunding of long-term debt, introduction of computer, etc); and (2)
replacement decisions for example replacement of existing facilities with new facilities. The
general idea is that the capital or long term funds raised by the firms are used to invest in assets
that will enable the firm to generate revenues several years in to the future. Often the funds
raised to invest in such assets are not unrestricted or infinitely available; thus the firm must
budget how these funds are invested.
5.2 importance of capital budgeting

Capital budgeting decisions are important to a firm for three major reasons.
 Size of outlay. Although a tactical investment decision generally involves a relatively
small amounts of funds, strategic investment decision may require large sum of money
that directly affect the firm’s future course of development. Corporate managers
continually face vexing problem of deciding where to commit the firm’s resources.
 Effect on future direction: The future success of a business largely depends on the
investment decision that corporate managers make today. Investment decision may result
in a major departure from what the company has been doing in the past. Though making
capital investments, firms acquire the long lived fixed assets that generate the firms'
future cash flows and determine its level of profitability. Thus, these decisions greatly
influence of firms ability to achieve its financial objectives.
 Difficulty to reverse; capital investment decisions often commit funds for lengthy
periods rendering such decisions difficult or costly to reverse. Therefore, capital
investments are not only vital to firms’ development but also have the capacity to lock in
periods there by reducing the firm’s flexibility.
Capital budgeting decisions are especially critical in small businesses because they often make
few capital expenditures and often have little margin for error. Making a poor decision may tie
up large amounts of funds for extended periods in fixed assets whole generating little, if any,
value to the company.
Proper capital budgeting analysis is critical to a firms' successful performance because sound
capital investment decisions can improve cash flows and lead to higher stock process. Yet, poor
Decisions can lead to financial distress and even to bankrupt. In summary making the right
capital budgeting decisions is essential to achieving the goal of maximizing shareholder wealth.

5.3. Components of Capital Budgeting.

The incremental (or relevant) after tax cash flows that occur with an investment projects are the
ones that are measured. In general, the cash flows of a project fall in to the following three
categories.
 1. The initial investment
2. The incremental (relevant) cash inflows over the life of the project; and
3. The terminal cash flow
1. Initial Investment (I)
It includes the cash required to acquire the new equipment or build the new plant less any cash
proceeds from the disposal of the replaced equipment only changes that occur at beginning of
the project are included as part of the initial investment outlay. Any additional working capital
needed or no longer needed in a future period is accounted for as cash out flow or cash inflow
during that period. And it can be determined as follows:

Initial investment = Cost of asset +Installation cost + working - proceeds from sale of old assets +
taxes on Sale of old assets

Example XYZ Corporation is considering the purchase of a new machine for Birr 500,000
which will be depreciated on a straight line basis over five years with no salvage value. In order
to put this machine in operating order, it is necessary to pay installation charges of Birr 100, 000.
The new machine will replace on. Birr 480, 000 that is depreciated on a straight line basis (with
no salvage value) over its 8 years life. The old machine can be sold for Birr 510.000. To a scrap
dealer. The company is in the 40 % tax bracket. The machine will require an increase in WIP
inventory of Br 10, 000 compute the initial investment.
Solution: The key calculation of the initial investment is the taxes on the sale of the old machine.
Basically there are three possibilities:
1. The asset is sold for more than its book value (tax gain)
2. The asset is sold for its book value (no tax gain or loss)
3. The assets is sold for less than its book value (tax loss)

From the given example, the total gain which is the difference between the selling price and the
book value is Br 210.000 (Br 510,000- Br 300,000) The tax on this Br 210.000 total gain is Br
84,000 (40% X Br 210,000).
Initial investment = purchase price + Installation cost + Increased - proceeds
Investment from sale old asset
= Br 500,000 + Br 100,000 + Br 10, 000 – Br 510, 000 + Br 84,000
= Br 184,000.
2. Incremental (Relevant) Cash Inflows
Incremental or operating cash inflows are those cash inflows that the project generates after it is
in operation. For example cash flows that follow a change in sales or expenses are operating cash
flows. Those operating cash flows incremental to the project under consideration are the
relevant to our capital budgeting analysis. Incremental operating cash flows also include tax
changes, including those due to changes in depreciation expense, opportunity cost and
externalities. Incremental after tax cash inflows can be computed using the following formula.

After – tax incremental cash inflows = (increase in revenues) (1-tax rate)

- (Increase in cash) (1-tax rates)

The computation of relevant or incremental cash inflows after taxes involves two basic steps.
1. Compute the after tax cash flows of each proposal by adding back any non-cash charges
which are deducted as expenses on the firms' income statement, to net profits.
After – tax cash inflows = net profits after tax + depreciation
2. Subtract the cash inflows after taxes resulting from the use of the old asset from the cash
inflows generated by the new asset to obtain the relevant cash inflows after taxes.

Example; - Gibe Corporation has provided its revenue and cash operating costs (excluding
depreciation) for the old and the new machine as follows.

Annual
Cash operating Net profit before
Revenue Costs Depreciation and taxes

Old machine Br.300, 000 Br 140.000 Br 160,000

New Machine Br 360, 000 Br 120, 000 Br 240,000

Complete the after tax incremental cash inflows.

After – tax incremental cash inflows = (increase in revenue) (1- Tax rate)
)Tax rate( )increase in depreciation expenses( + )1- Tax rate( )increase in cash charges( -
= (1,360, 000-300,000) (1-40%) – (120,000-140,000) (1-0.4) + (240,000- 160,000) (0.4)
= 36,000 – (-12,000) + 32.000 = 80,000.

 Activity
Moha Soft Drink Company is contemplating the replacement of one of its bottling machines
with new one that will increase revenue from Br50, 000to Br62, 000 per year and reduce cash
operating costs from Br24, 000 to Br 20,000 per year. The new machine will cost Br96, 000 and
have an estimated life of 10years with no salvage value. The firm uses straight line depreciation
and is subject to a 40% tax rate. The old machine has fully depreciated and has no salvage value.
What are the incremental cash inflows generated by the replacement?

3. Terminal Cash Flow (shut down cash flow)

Cash flows associated with the net cash generated from the sale of the assets; tax effects from the
termination of the asset and the release of net working capital.
If a project is expected to have a positive salvage value at the end of its useful life, there will be a
positive incremental cash flow at that time. However, this salvage value incremental cash flow
must be adjusted for tax effects.
5.4. Capital Budgeting Decision Practices

Financial managers apply two decision practices when selecting capital budgeting projects:
accept /reject and ranking. The accept / reject decision focuses on the question of whether the
proposed project would add value to the firm or earn a rate of return that is acceptable to the
company. The ranking decision lists competing projects in order of desire ability to choose the
best one.
The accept / reject decision determines whether the project is acceptable in light of the firm’s
financial objectives. That is, if a project meets the firms' basic risk and return requirements (cost
and benefit requirements), it will be accepted, If not it will be rejected.
Ranking compares perfects to a standard measure and orders the projects based on how well they
meet the measure. If, for instance, the standard is how quickly the project payoff the initial
investment, then the project that pays off the investment most rapidly would be ranked first. The
project that paid off most slowly would be ranked last.
5.5. Classification of Investment Projects
Investment projects can be classified in to three categories on the basis of how they influence the
investment decision process; independent projects mutually exclusive projects and contingent
projects.
An Independent Project is one the acceptance or rejection does not directly eliminate
other projects from consideration or affect the likelihood of their selection. For example,
management may want to introduce a new product line and at the same time may want to
 replace a machine which is currently producing a different product. These two projects
can be considered independently of each other if there are sufficient resources to adopt
both, provided they meet the firm's investment criteria. These projects can be evaluated
independently and a decision made to accept or reject them depending up on whether
they add value to the firm.
Mutually Exclusive Projects are those projects that cannot be perused simultaneously
i.e. the acceptance of one prevents the acceptance of the alternate proposal. Therefore,
mutually exclusive projects involve, either decision – alternative proposals can not be
perused simultaneously. For example, a firm may own a block of land which is large
enough to establish a shoe manufacturing business or a steel fabrication plant. It show
manufacturing is chosen the alternative of steel fabrication is eliminated mutually
exclusive projects can be evaluated separately to select the one which yields the highest
net present value (NPV) to the firm. The early identification of mutually exclusive
alternative is crucial for a logical screening of investments. Otherwise, a lot of hard work
and resources can be wasted if two decision in dependently investigates, develop and
initiate projects which are later recognized to be mutually exclusive
A Contingent Project is one the acceptance or rejection of which is dependent on the
decision to accept or reject one or more other projects. Contingent projects may be
complementary or substitutes. For example, the decision to start a pharmacy may be
contingent up on a decision to establish a doctors’ Surgery in an adjacent building. In
this case the projects are complementary to each other.

Stages in Capital Budgeting Process

The capital budgeting process has four major stages
I. Finding projects
II. Estimating the incremental cash flows associated with projects
III. Evaluating and selecting projects
IV. Implementing and monitoring projects

This chapter focuses on stage 3- how to evaluate and choose investment projects. It is assumed
that the firm has found projects in which to invest and has estimated the projects cash flows
effectively.
5.6. Capital Budgeting Decision Methods

The capital budgeting techniques are of two types. They are the non-discounted methods
(traditional approach) and the discounted methods (Modern approach). Each of these methods is
discussed below.
 Capital budgeting methods

Discounting methods
Non discounting
- Discounted Payback Period (DPBP) - Payback Period (PBP)
- Net Present Value (NPV) - Accounting Rate of Return- (ARR)
-Internal Rate of Return (IRR)
- Modified Internal Rate of Return (MIRR)
- Profitability Index (PI)

Note - Capital Budgeting techniques are usually used only for projects with large cash outlays.
Small investment decisions are usually made by the “seat of the pants”
Non Discounting Methods
5.6.1. The Payback Period) (PBP)
The payback period is the number of years needed to recover the initial investment of a project.
It is the number of years required for an investment’s cumulative cash flows to equal its net
investment. Thus, payback period can be looked up on as the length of time required for a project
to break even on its net investment i.e. the number of time period it will take before the cash
inflows of a proposed project equal the amount of the initial project investment (a cash out
flow).
How to Calculate the Payback Period: To calculate the payback period, simply add up a
projects projected positive cash flows, one period at a time, until the sum equals the amount of
the project’s initial investment. That number of time periods it takes for the positive cash flows
to equal the amount of the initial investment is the payback period.
Decision Rule;- To apply the payback decision method, firms must first decide what payback
time period is acceptable for long term projects and the calculated payback period should be less
than some pre-specified (decided) number of periods. The shorter the payback period, the less
risky the project and the greater the liquidity.
Methods of Calculation of Payback Period (PBP)
 On the basis of uniform cash inflow (annuity form)
 On the basis of non-uniform cash inflow (non annuity form)
Uniform cash inflows:-
PBP = Net initial investment

Uniform increase in annual cash flows

Non uniform
Unresolved Cost at full re cov ery
the start of the Year
PBP= Year before full Recov ry+
cash inflows: Cash flow during the year
Example: An investment has a net investment of Br 12,000 and annual cash flows of Br. 4, 000
for five years. If the project has a maximum desired payback period of 4 years, compute the
payback period and what would be the decision rule?
Solution: - Sine the investment has uniform cash inflows
The PBP = Net initial investment
Uniform increase in annual cash flows
= Br 12, 000 = 3 years
4.0
Decision Rule: - Accept the project because the calculated payback period is less than the
specified payback period.
Example 2: Compute the payback period for the following cash flows, assuming a net
investment of Br 20, 000
Year(t) 0 1 2 3 4 5
Yearly cash flows(Br) 0 8,000 6,000 4,000 2,000 2,000
What would be the decision rule if the specified PBP be three years?
Solution: - the investments cash flows are not uniform (in annuity form), the cumulative cash
flows are used in computing the payback period in the following table.
Year 0 1 2 3 4 5
Yearly cash flows 0 8,000 6,000 4,000 2,000 2,000
Cumulative cash flows 0 8000 14,000 18,000 20,000 22,000
The payback period is 4 years because four years are required before the cumulative cash flows
equal the project net investment. And the decision rule is to reject the project be cause the
calculated payback period is greater than the pre specified payback period.
Example: 3 BAKO Company is considering investing in a project that has the following cash
flows.
Year(t) 0 1 2 3 4 5
Expected after-tax net cash flows (CF t) (5000) 800 90 1,500 1,200 3,200
(Br) 0

Required: compute, (a) The PBP and (b) What would be the decision rule if the company
specified the PBP to be 3. 5 years?

Solution
Year Cash flow Cumulative CF
(+ ) or ( -)
0 (5000) Br (5000) Br (5,000)
1 800 800 (4,200)
2 900 1700 (3,300)
3 1500 3200 (1,800)
4 1200 4400 (600)
5 3,000 7,600 2,600

[Number of year ¿][ before recov ery ¿]¿¿¿

Pay back period = ¿ [
+
Amount of investment remaining to be recaptured
Total cash flow during the pay back period ]
Br 600
= 4 Years + =4 . 19 Years
Br 3700

The above table shows that payback period is between four years and five years.
(b) The decision rule is to reject the project because the calculated payback period is greater
than the specified payback period.
Advantage and disadvantages of the payback period
Advantages Disadvantages
- It is easy to use and understand - It does not recognize the time value of money
- Adjusts for uncertainty of later cash flows - It ignores the impact of cash inflows received
-Biased to ward liquidity after the payback period
- Handles investment risk effectively - Biased against long term projects such as
research and development and new projects.

 Activity
1. Compute the payback period for the following cash inflows assuming an
Investment of Br 3700.

Year 0 1 2 3 4
Cash flow (3,700) 1,000 2,000 1,500 1,000

5.6.2. The Accounting Rate of Return (ARR)

Finding the average rate of return involves a simple accounting technique that determines the
profitability of a project. This method of capital budgeting is perhaps the oldest technique used in
business. The basic idea is to compare net earnings (after tax profits) against initial cost of a
project by adding all future net earnings together and dividing the sum by the average
investment.
Decision Rule: - a project is acceptable if its average accounting return exceeds a target average
accounting return otherwise it will be rejected.
Since income and investment can be measured in various ways there can be a very large number
of measures for ARR. The measures that are employed commonly in practice are;
a. ARR= Average in come after tax
Initial investment
b. ARR = Average income after tax
Average investment
c. ARR = Average in come after tax before interest
Initial investment
d. ARR= Average income after tax before interest
Average in vestment
e. ARR= Total income after tax but before
Deprecation – initial investment
(Initial investment ) X years
2
Example: - suppose the net earnings for the next four years are estimated to be Br 10, 000, Br
15, 000, Br 20, 000 and Br 30, 000, respectively. If the initial investment is Br 100, 000, find the
average rate of return.
Solution: - The accounting rate of return can be calculated as follows
1. Average net earnings= Br 10, 000 + Br 15, 000 + Br 20,000 + Br 30,000
4 years
Br 75 , 000
4 = Br 18,750

2. Average investment = Br 100,000/ 2 =Br 50, 000

Br 18,750 X 100
3. ARR= Br 50,000 =38 %
Advantages and Disadvantages of ARR
Advantages

 It is simple to calculate.
 It is based on accounting information, which is readily available, and familiar to business
man.
 It considers benefits over the entire life of the Project.
 Since it is based on accounting measures, which can be readily obtained from financial
accounting system of the firm, it facilities post auditing of capital expenditures.
 While income data for the entire life of the project is normally required for calculating
the ARR, one can make do even if the complete income data is not available.

Disadvantages
 Not a true rate of return, time value of money is ignored
 Uses an arbitrary bench mark cut off rate
 Based on accounting (book) values not cash flows and market value

 Activity:
1. Why the ARR is not recommended for financial analysis?
2 The McDonald is a fast food restaurant chain potential franchisees are given the following
revenue and cost information
Building and equipment ------------------ Br 980,000
Annual revenue --------------------------- Br 1,040,000
Annual Cash operating costs -------------Br 760,000
The building and equipment have a useful life of 20 years. The straight – line method for
depreciation is used. The income tax is 40%. Based on this information, compute.
(a) The payback period (PBP)
(b) The accounting rate of return (ARR)

The Discounted Methods (Modern Approaches)

5.6.3. Discounted Payback Period (DPBP)
Out of the serious shortcomings of the payback period method is that it does not consider time
value of money. There is a variation of the payback period, the discounted payback period that
tries to do away with this serious shortcoming by discounting the cash flows before aggregating
them. The discounted payback period is the length of time it takes for the discounted cash flows
equal to the amount of initial investment.

(Number of years ¿)(before ful recovery ¿)¿¿¿ PV of investment to be capitured

Discounted payback period (DPBP )=¿
(
+ PV of total cash flow during year of pay
)
Example: Satcon Construction Company is considering investing in a project that has the
following cash flows.

Year (t) 0 1 2 3 4 5

Expected cash flow (in Birr) (5000) 800 900 1500 1200 3200

And the required rate to purchase the asset is 12% .Compute the discounted payback period
Solution; - the cash flow time line for the asset is:-
- -1 2- 3- 4- 5-

(Br 5, 000) 800 900

1,500 1,200 3200
714.29
17.47
1,067.67
762.62
1815.77

We can use the present values of the future cash flows to compute
the discounted payback. To do so, we simply apply the concept of the traditional payback
to the present values of the future cash flows.

Year Cash flow PV of CF Cumulative PV

0 Br (5, 000) (5,00) Br (5,000)
1 800 714. 29 (4285. 71)
2 900 717. 47 (4284.71)
3 1500 1,067.67 (2,500.57)
4 1,200 762.62 (1,737.95)
5 3,200 1,815.77 77.82

(Number of years ¿)(before ful recovery ¿)¿¿¿ PV of investment to be capitured

That’s DPB is = ¿
(
+ PV of total cash flow during year of pay
)
4 + Br 1, 737.95
Br. 1, 815. 77
= 4. 96 years
Decision rule: A project is acceptable if its payback less than its life. In this case, 4.96
Years are less than five years, so, the project is acceptable
Problems with Discounted Payback Period:
A. The discounted payback period solves the time value problem, but it still ignores the cash
flows beyond the payback period.
 B. You may reject projects that have large cash flows in the outlying years that make it very
profitable.
C. Any measure of payback can lead to focus on short run profits at the expense of larger
long-term profits.
5.6.4. Net Present Value (NPV)
The project selection method that is most consistent with the goal of owner wealth maximization
is the net present value method. It is the sum of the present values of the net investments i.e. it is
the difference between the present value of the cash flows (the benefits) and the cost of the
investment (ICo)
NPV= the sum of the present value (PV) of after tax cash flows – initial investment

[ CF 1
] [
CF 2
] [
CF 3 CF 4
][ ]
CFn
(1+k )1 + (1+k )2 + (1+k )3 + (1+k )4 + …………. + (1+k )n - Ico [ ]
= CF1 (PVIFk,1) + CF2 (PVIFk,2) + CF3 (PVIFk, 3 ) + CF4 (PVIFk4) + …(CFNk, n) – Ico.
Where
CF = cash inflow per period
K = Discount rate
ICO= Initial cash outlay (initial investment)
K = Investors required rate of return
Decision rule:
For Independent Projects: Accept the project if the NPV > 0
Reject the project if the NPV < 0
For Mutually Exclusive Projects: choose projects with the highest NPV.
Example A project has a net investment of Br 5, 000 and a cash flow of Br800, Br900, Br 500,
Br1200 and Br 3, 200 for period 1,2,3,4, and 5 .Compute the NPV and comment on the decision
rule.
Solution:-
CF 1
[+
CF 2
+
CF 3
+
CF 4
+
CF 5
NPV = (1+ K ) (1+K )2 (1+ K )3 (1+K )4 (1+ K )5
] - Ico

= (F[
800
+12 )1
+
Br 900 Br 500 Br 1200 Br 1200 Br 3200
(1 .12 )2
+
(1. 12)3
+
(1 .12 )4
+
(1 .12 )5
+
(1 .12 )5
− Br 5 ,000
]
= Br 77.82
 The result of this computation is the same as the cash flow time line diagram as follows.
- -1 2- 3- 4- 5-

(5,000)
(Br 5, 000) 800
900 1,500
714.29
12% 1,200 3200
714.29
12 %
12%
12%
717.47 1,815.77

762.62

Decision rule: - Accept the project since the NPV > 0 i.e. Br 77. 82>0 and the positive NPV of
Br 77.82 indicates that the projects rate of return is greater than the required 12% but how much
greater? The NPV criterion does not provide a direct answer. Rather, the positive NPV indicates
that the profits over and above the cash flows needed to earn 12% have a present value of Br 77.
82.
E xample
Investment initial cost CF1 CF2
2.G iven the
A Br 10, 000 0 Br 14,400

B Br 10,000 Br 10,000 Br 2, 400

following cash flow, and investors required rate of return (K) is 10%

Compute the NPV if,

(a) Project A and project B are independent projects.
(b) Project A and project B are mutually exclusive.
(C) Comment on the Decision rule.
Solution

CFt CFt
( A ) NPV = n
∑ t=1 (1+k)t ∑ t=1 (1+k)t
- ICo B) n - ICo
t=1 t=1

=
[ CF 1
+
CF 2
(1+ K )1 (1+K )2 - ICo ] CF 1
[
+
CF 2
(1+ K )1 (1+K )2 - ICo ]
=
[ Br 0 Br 14 ,400
+
]
(1.1)1 (1.1)2 - Br 10,000
Br
[
Br 10 ,000 Br 2400
(1 .1 )2
+
(1 .1 )2 Br 10,000 ]
= Br 1,901 Br 1,074

C) - if projects are independent; accept both projects since their NPV is greater than zero.
- If projects are mutually exclusive; accept project A since it has the highest NPV
Advantages and Disadvantages of NPV
Advantages

 Time value of money is considered

 Direct measure of the benefit
 It is an objective method of selecting and evaluating of the project.

Disadvantages
 The NPV is expressed in absolute terms rather than relative terms and hence does not
factor is the scale of investment.
 The NPV does not consider the life of the project.

 Activity
Adidas Company is considering two investment project proposals, project X and project Y Br
.5,000. The finance department estimates that the project will generate the following cash flows
Year 0 1 2 3 4
Project
X (5,000) 2,000 3,000 500 0
Y (5000) 2000 2000 1, 000 2000
Assume that the required rate of return is 10% and the two projects are independent projects,
what would be the decision Rule?
5.6.5. Internal Rate of Return (IRR)
The internal rate of return (IRR) is the estimated rate of return for a proposed project given the
projects incremental cash flows. Just like the NPV method, the IRR method considers all cash
flows for a project and adjusts for the time value of money. However, the IRR results are
expressed as a parentage, not a dollar figure. In short, the internal rate of return (IRR) of an
investment proposal is defined as the discount rate that produces a Zero NPV.
n
∑ CFt
(1+IRR)t
NPV = t=1 - ICo = 0

[ CF1
+
CF 2
+
CF 3
+
CF 4
= (1+IRR )1 (1+IRR )2 (1+IRR )3 (1+IRR )4
+.. . .+
CFn
(1+IRR )n - ICo= 0 ]
Where
NPV= Net present value of the project proposal
IRR = Internal rate of return
CF= Cash flow
ICO = Initial cash outlay
As in the case of the payback criterion, different procedures are available for computing
investments IRR depending on whether or not its cash flows are in annuity form.
i. When the Cash Flows are in Annuity Form: when the cash flows of an investment are in
annuity form, its IRR can be computed very easily when cash flows are in annuity form IRR is
found by dividing the value of one cash flow in to the net investment and then locating the
resulting quotient in the present value annuity table.
Example, A project required a net investment of Br 100, 000 produced 16 annual cash flows of
Br 14, 000 each, required a 10 percent rate of return, and had a NPV of Br 9, 536. Compute the
IRR.
Solution
Steps

1) Identify the closest rates of return

2) Compute the Net present Value (NPV) for each of these two closest rates.
3) Compute the sum of the absolute values of the NPV obtained in step 2
4) Dived the sum obtained in Step3 in to the NPV of the smaller discount rate.
Step 1; Br 100, 000
7.379¿ 1 %¿
Table value¿ ¿ IRR¿ ¿
Br 14, 000 = 7.143 6.974¿ 12%¿
Steps 2; (NPV, 11%) = Br 14, 000 (7.379) – Br 100,000 = Br 3,306
(NPV, 12%) = Br 14,000 (6,974) – Br 100,000 = Br 2. 364
The project’s IRR occurs between the two discount rates that produce changes in the sign of the
NPV coefficients. In this example the NPV is positive at 11 percent and negative at 12%.
Therefore, the projects IRR is between these two rates.
Steps3. Compute the sum of the absolute values of the NPVs obtained in steps2.
Br 3, 306 + Br 2, 364= Br 5, 670
Steps 4; Divide the sum obtained in steps 3 in to the NPV of the smaller discount rate identified
in step1. Then add the resulting quotient to the smaller discount rate.
Br 3,306
IRR = 11% +
= IRR = 11% +Br 3,306 Br 5,670
Br 5 , 680 = 11% +0.58 %
= 11 +0. 58 %
= 11.58%
ii. When the cash flows are of mixed stream
Example: project X has the following cash flows
Cash flows
Initial
Investment year1 Year2 year3 Year4
Project X (Br 5, 000) Br 2000 Br 3000 Br 5000 Br 0
And project X’s Cost of capital is 6%. Calculate the IRR for project X and comment on the
decision rule.
First, we insert project Xs cash flows and the times they occur in to the equation.

[ ][
Br 2, 000 Br 3 ,000
][
Br 5 ,000
(1+K )1 + (1+K )2 + (1+K )3 - Br 5,000]
Next, we try various discount rates until we find the value of k those results
in a NPV of zero. Let’s begin with the discount rate of 5%
 [ ][ ][
Br 2, 000 Br 3 ,000 Br 5 ,000
]
Br 2000
[ ][
Br 3 ,000 Br 5 ,000
][
= (1+05 )1 + (1+05 )2 + (1+05 )3 -Br 5, 000 (1+05)1 + (1+05 )2 + (1+05 )3 -Br 5,000
]
Br 1, 904.76+ Br 2,721.09+Br 431.92- Br 5000 = Br 57.77
These are close but not quite zero and let’s try second time using the discount rate of 6%
Br 2000 Br 2000 Br 5000 Br 2000 Br 2000 Br 5000
= (1 . 06)1 + (1 . 06)2 + (1 .06 )3 -- Br 5,000 (1 . 06)1 + (1 . 06)2 + (1 .06 )3 - Br
5000

= Br 1, 886 .79 + Br 2,669.99+Br 419.81 –Br5000

= - Br 23.41
This is close enough for our purpose. We conclude the IRR for the project X is slightly less than
6 percent. Although calculating IRR by trial and error is time consuming the guess does not have
to be made entirely in the dark. Remember that the discount rate and NPV are inversely related
when an IRR quests is too high, the resulting NPV will be too low when an IRR guess is too low,
the NPV will be too high.
Note; - we could estimate the IRR more accurately through more trial and error. However,
carryings, the IRR computation to several decimal points may give a false sense of accuracy as
in the case in which the cash flow estimates are in error.
Decision rule
If the IRR of a project is greater than the firms cost of capital (the Hurdle rule) accept the
project, if IRR is less than the cost of capital, reject the project
Advantages and Disadvantages of IRR
Advantages: - A number of surveys have shown that in practice the IRR method is more popular
than the NPV approach. The reason may be that the IRR is straightforward like the ARR but it
Recognizes the time value of money
Recognizes income over the whole life of the project
The percentage return allows a sound basis for ranking projects

Disadvantages
1. It often gives unrealistic rates of return:
Suppose the cut-off rate (cost of capital) is 11% and the IRR is calculated as 40%, does this
mean that management should immediately accept the project because its IRR is 40%? The
answer is no! An IRR 40% assumes rate a firm has the opportunity to reinvest future cash flows
at 40%
2. Give different rates of return.

Note: cut of rate, cost of rate, required rate of return, and hurdle rule have similar meaning.
Which Method is better: the NPV or the IRR?
The NPV is superior to the IRR method for at least two reasons.
1. Reinvestment of Cash flows: The NPV method assumes that the projects cash in flows
are reinvested to earn the hurdle rate; the IRR assumes that the cash inflows are
reinvested to earn the IRR of the two NPV’s assumption is more realistic in most
situations since the IRR can be very high on some projects.
2. Multiple Solutions for the IRR: It is possible for the IRR to have more than one solution.
If the cash flow experience a sign change (eg. Positive cash flow in one year, negative in
the next), the IRR method will have more than one solution. In other words, there will be
more than one percentage member that will cause the present value benefits to equal the
present value cash flows. When this occurs, we simply do not use the IRR method to
evaluate the project since no one value of the IRR is theoretically superior to the others.
The NPV method does not have this problem.

5.6.6 The Modified Internal Rate of Return (MIRR)

The modified internal rate of return (MIRR) is an attempt to overcome the above two
deficiencies in the IRR method. The person conducting the analysis can choose whatever rate
he or she wants for investing the cash inflows for the remainder of the projects life.
For example, if the analyst chooses to use the hurdle rate for the reinvestment purposes, the
MIRR techniques calculates the present value of the cash out flows ( i.e. PVC) the future value
of the cash inflows ( to the end of the project’s life) and then solves for the discount rate that will
equate the PVC and the FVB . In this way the two problems mentioned previously are overcome;
 1. The cash inflows are assumed to be reinvested at reasonable rate chosen by the analyst.
2. There is only one solution to the technique.
In general the modified internal rate of return (MIRR) has a significant advantage over the
regular IRR. MIRR assumes that cash flows from all projects are reinvested at the cost of capital,
while the regular IRR assumes that the cash flows from each project are reinvested at the
project’s own IRR. Since reinvestment at the cost of capital is generally more correct, the
modified IRR is better indicator of a projects true profitability. Algebraically it can be expressed
as:

MIRR =
Where
n
√ FVC
PVC -1

MIRR = Modified internal rate of return

FVC = Future value of the cash inflows
PVC = Present value of the cash out flows
Example: Assume that we are evaluating a project that has a cost of Br 30,000 after tax cash
inflows of Br 10,000 per year for four years and a hurdle rate of 10%. Computer the MIRR and
comment on the decision rule
Solution
Since the cash inflows are assumed to be received at the end of each year, the cash inflows
would be reinvested as shown below Notice that the 1 st year’s cash inflow is assumed to be
reinvested for three years, so we multiply time the feature value factor for 10%. The second
year’s cash flow is assumed to be reinvested for two year. Year 3‘s cash inflow is invested for 1
year and year 4’s cash inflow is received at the end of the 4 th year. So, it is not available for
reinvestment it concedes with the end of the projects life.
Year Years reinvested Cash inflow Future value factor of 10% Future value
1 3 Br 10,000 1,331 Br 13,310
2 2 10,000 1,210 Br 12,100
3 1 10,000 1,100 Br 11,000
4 0 10,000 1,000 Br10,000
Total Br 46,410
Now, the only question remaining is: if we invest Br 30,000 in an account to day and receive the
equivalent of Br 46, 410 in four years what rate would be earned on the investment? We can
illustrate the calculation using time line as shown

1 2 3 4

Cash flows (30,000) 10,000 10, 000 10, 000

10,000
K=10% 11,000
K=10%
12, 100

K= 10%
13,310
Terminal value
(TV) 46,410
MIRR = 11.53%
PV of TV = 30,000
NPV =0

5.6.7. Conflicting Rankings between the NPV and the IRR Methods
As long as proposed capital budgeting projects are in dependent both the NPV and IRR methods
will produce the same accept / reject indication that is a project that has a positive NPV will also
have an IRR that is greater than the discount rate (hurdle rate). As a result the project will be
acceptable based on both the NPV and IRR values. However, when mutually exclusive projects
are considered and ranked, a conflict occasionally arises. For instance, one project may have a
higher NPV than another project but a lower IRR.
Example: GEDA company own a piece of land that can be used in different ways on the one
hand this land has mineral beneath it that could be mined, So GEDA could invest in mining
equipment and reap the benefits retrieving and selling the minerals. On the other hand, the land
has perfect soil conditions for growing grapes that could be used to make wine, so the company
could use it to support vinegar. Clearly, these two uses are mutually exclusive .The mine can not
be dug if there is a vineyard and the vineyard can not be planned if the mine is dug. The
acceptance of one project means that the other must be rejected
Example 2: Now let’s suppose that GEDA finance department has estimated the cash flows
associated with each use of the land. The estimates are as follows.

Time Cash flows for the mining project Cash flows for the vineyard project
To (Br 736,369) ( Br 736,369)
T1 Br. 500,000 0
T2 300,000 0
T3 100,000 0
T4 20,000 50,000
T5 5,000 200,000
T6 5,000 500,000
T7 5,000 500,000
T8 5,000 500,000

Required: Which project should GEDA choose? If the required rate of return be 10%?
Solution: Note that although the initial outlays for the two projects are the same the incremental
cash flows associated with the project differ in amount and timing. The mining projects
generate its greatest cash flows early in the life of the project where as the vineyard projects
generate its greatest positive cash flows later. The differences in the projects cash flow timing
have considerable effects on the NPV and IRR for each venture. The NPV and IRR results for
each project given its cash flow are summarized as follows.
NPV IRR
Mining project Br 65, 727, 39 6.05%
Vineyard and project be 194,035.65 14.0%
The NPV and IRR results show that the vineyard project has a higher NPV than the mining
project but the mining project has a higher IRR than the vineyard project GEDA faced with the
conflict between NPV and IRR results because the projects are mutually exclusive, the firm can
accept only one.
In the cases of conflict among mutually executive projects the one with the highest NPV should
be chosen because NPV indicates the dollar amount of value that will be added to the firm if the
project is undertaken. In our example, GEDA should choose the vineyard project if its primary
financial goal is to maximize firm value. Algebraically it is computed as:

MIRR =
n
√ FVC
PV -1
=
4
√ Br 46,410
Br 30,000
= 11.53%
Decision rule: since the MIRR (11.53%) is greater than the hurdle rule (10%) so we have to
accept the project

5.6.8. Profitability Index (PI)

The Profitability Index (PI): Sometimes called benefit cost ratio method compares the present
value of future cash inflows with the initial investment on a relative basis Therefore; the PI is the
ratio of the present value of cash flows (PVCF) to the initial investment of the project. This index
is used as a means of ranking profits in descending order of attractiveness.

PVCF
PI =
Inifial investemtn
Decision rule
In this method, a project with PI greater than 1 is accepted but a project is rejected when its PI is
less than 1.
Note that the PI method is closely related to the NPV approach .In fact if the net present value of
the project is positive, the PI will be greater than 1. On the other hand if the NPV is negative the
project will have PI of less than 1. The same conclusion is reached, therefore, whether the NPV
or PI is used. In other words, if the NPV of the cash flows exceeds the initial investment there
are a positive net present value and a PI greater Ethan 1 indicating that the project is acceptable.

Example: Zuma Co. is considering a project with annual predicted cash flows of $ 5, 000,
$3,000 and $ 4,000 respectively for three years. The initial investment is $ 10,000 using the PI
method and a discount rate of 12%, determine the PI if the project is acceptable.
Solution to determine the PI, the present value of the cash flows should be divided by the initials
cost.
 CF 1 CF 2 CF 3
PVCF = (1+K )1 + (1+K )2 + (1+K )3
$5000 $ 3000 $4000
= (1.12)1 + (1 .12 )2 + (1.12)3 , PVCF= $9,704
Initial investment (Io) = $ 10,000
PVIF $ 9 , 704
PI = ( IO ) = $ 10 , 000 = 0.0704. Since the PI value is less than 1, the project is rejected

 Activity
1. Do the NPV and PI methods give the same answers in terms of accepting or rejecting
projects? Discuss:
1.1. Which method is superior NPV or payback period? Why?
1.2. Which method is superior NPV or IRR

5.6.9. Capital Rationing

Capital rationing refers to the situation where a budget constraint is imposed and the firm may
not invest in all acceptable projects. Given the set of projects that are acceptable, what subsets of
projects should the firm select? In this situation the firm is still trying to maximize shareholders
wealth. So, it should invest in that group of projects that collectively has the largest net present
value. How do we identify that best group? That is, what investment criterion will identify this
group?
If capital rationing is imposed, then financial managers should seek the combination of projects
that maximizes the value of the firm with in the capital budget limit. If the firm decides to
impose a capital constraint an investment projects, the appropriate decision criterion is to select
the set of projects that will result in the highest net present value subject to the capital constraint.
Example: - consider a firm with a budget constraint of Br 1,000, 000 and five projects available
to it, as given below.
Project Initial Profitability Net present
Outlay index Value
A Br. 400,000 2.4 Br 560,000
B Br. 400, 000 2.3 320,000
C 1,600, 000 1.7 1,200,000
D 600,000 1.3 180,000
E 600,000 1.2 120,000
Where there is no capital constraints, all projects were acceptable. However, due to capital
constraint we have to ration the available capital.
[Link] Projects: If the projects are indivisible, the firm cannot invest in a portion
project. A project is either taken in full (100%), if not, it is dropped in such a case when projects
are indivisible, there is no guide line to be followed in picking the sets of project that will
maximize the total NPV of the firm .Thus we are left with trial and error. therefore, try different
combinations of the alternative projects without surpassing the capital constraint which will
maximize overall NPV and that mix of projects is the optimal mix. From the given example
higher total net present value is provided by the combination of projects be selected from the sets
of projects available.
Case2 Divisible Projects: If projects are divisible that means an investor can invest in any
portion of a project. In such case of project divisibility the selection of the best projects is
straight forward. It is to allot the available capital starting from the project with the highest
profitability index (not necessarily the project with highest NPV)
Project Initial out NPV PI Ranking
A 200,000 280,000 2.4 1st
B 200,000 260,000 2.3 2nd
C 600,000 420,000 1.7 3rd
Total 1,000,000 960,000

Note: - project C is not fully taken. This is because the amount of money left after project A and
B are taken is only Br 600,000 but project C requires Br 800,000. Thus, just the amount that is
available, which is Br 600.000 is invested in project C which is 75% of the total. The NPV is
expected to be proportionate to the amount of investment in C thus equals 75% of Br 560,000.

 Activity
1. What is the meaning of the term “capital rationing”?
2. What are some common reasons for capital rationing with in a firm?
 3. What is the preferred method for choosing among indivisible projects under capital
constraints? Explain in why?
Summary
This chapter focused on the capital investments and cash flow analysis. The key point of the
chapter is as follows.
 Capital budgeting is the process of planning, analyzing, selecting and managing capital
investments. Capital budgeting decisions are crucial to a firm’s welfare because they often
involve large expenditures, have a long-term impact on performance, and are not easily
reversed once started, and are vital to a firm’s ability to achieve its financial objectives.
 The capital budgeting process requires identifying project proposals, estimating project cash
flows, evaluating, selecting, implementing projects, and monitoring performance results.
 Capital budgeting analysis uses only a project’s incremental after tax cash flows. Cash flows
from accepting projects can be both direct (the purchase price of equipment and installation
costs) and indirect (change in net working capital, opportunity costs. Projects relevant cash
flows consists of three components: initial investment, operating cash flows, and terminal
cash flow.
 Financial managers use many different techniques to evaluate the economic attractiveness of
making capital investments because each method provides additional information about the
project.
 Discounted cash flow (DCF) methods (NPV, PI, IRR and MIRR) are superior to the pay back
methods (PBP, DPB) because the latter techniques use time value of money principle to
discount all project cash flows and offer project estimates past recovery of the initial
estimate.
 For single, independent projects with conventional cash flows, the four DCF methods give
the same accept-reject signal when firms do not face a capital constraint.
 Conflicting rankings may occur among the DCF methods when comparing mutually
exclusive projects with differing initial investments (size or scale) and cash flow patterns.
And when conflicts occur due to size or timing differences, the NPV is the preferred ranking
method because it enables management to choose from among mutually exclusive
investments with the objective of maximizing the firm’s value and therefore, shareholder
wealth.
 Capital rationing, due to market or management imposed constraints, may not allow a firm to
undertake all acceptable projects. When projects are indivisible, the preferred method to
maximize shareholder wealth is to choose that combination of projects offering the highest
NPV within the limits imposed by the constraints.