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Management Accounting Financial Management c

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Management Accounting Financial Management c

Subject: Financial Management

    Chapter no. 11: Capital Budgeting

    Chapter No. 11 Capital Budgeting

    IRR vs. NPV and ranking problems of alternative investment proposals

    So far we have seen that when we have projects that have equal investment at the beginning and equal economic life,

    the different methods give us a tool in selection of the best project. These can be referred to as “independent projects”,

    as execution of the projects does not depend upon other factors. However, there could be “dependent” projects that

    are dependent upon other factors like required civil construction etc Further, as already listed under demerits even in

    the case of “modern methods”, projects that are equal in scale of investment or have equal economic life are rare to

    come by simultaneously. In reality, most of the times we have projects that are not equal with each other. We do

    encounter problems while applying the “DCF” techniques to such projects in ranking them properly.

    A mutually exclusive project is one whose acceptance precludes the acceptance of one or more alternative proposals.

    For example, if the firm is considering investment in one of two computer systems, acceptance of one system will rule

    out the acceptance of the other. Two mutually exclusive proposals cannot both be accepted simultaneously. Ranking

    such projects based on IRR or NPV may give contradictory results. The conflict in rankings will be due to one or a

    combination of the following differences:

    1. Scale of investment cost of projects differ

    2. Cash flow pattern timing of cash flows differs. For example, the cash flows of one project increase over time

    while those of another decrease.

    3. Project life projects have unequal economic lives. It is important to note that one or more of the above constitute a necessary but not sufficient condition for a conflict in

    rankings. Thus it is possible that mutually exclusive projects could differ on all these dimensions (scale, pattern and

    life) and still not show any conflict between rankings under the IRR and NPV methods.

    Scale differences

    Example no. 6 ------------------------------------------------------------------------------

     Net cash flows

     ------------------------------------------

    End of year Project 1 Project 2

    ____________________________________________________

    0 - 1 lac - 100 lacs

    1 0 0

    2 4 lacs 156.25 lacs

    -------------------------------------------------------------------------------

    Suppose the required rate of return is 10%, we can tabulate the IRR and NPV values as under:

    -------------------------------------------------------------------------------

     IRR NPV @ 10%

     -------------------------------------------

    Project 1 100% 2.31 lacs

    Project 2 25% 29.13 lacs

    -------------------------------------------------------------------------------

    Punjab Technical University, Online Virtual Campus 1

Subject: Financial Management

    Chapter no. 11: Capital Budgeting

    Can we see the conflict? If we adopt IRR, we will reject the second project whereas the first project is rejected by the NPV method.

    This is because of the fact that in the case of IRR method, the results are expressed as a %, the scale of investment is ignored in the above case. This could be a serious limitation in applying the IRR method.

Cash flow pattern differences

    Example no. 7 ------------------------------------------------------------------------------

     Net cash flows

     ------------------------------------------

    End of year Project 1 Project 2

    ____________________________________________________

    0 - 12 lacs - 12 lacs

    1 10 lacs 1 lac

    2 5 lacs 6 lacs

    3 1 lac 10.80 lacs

    -------------------------------------------------------------------------------

    IRR for project 1 = 23% and IRR for project 2 = 17%. For every discount rate greater than 10%, project 1’s net present value will be larger than for project 2. If we assume a required rate of return of 10%, each project will have identical net present value of 1,98,000/- . Using these results to determine project rankings we find the following: ------------------------------------------------------------------------------

     r < 10% r > 10%

     ------------------------------------------------------

    Ranking IRR NPV IRR NPV

    ____________________________________________________

    1 Project 1 P 2 P 1 P 1

    2 Project 2 P 1 P 2 P 2

    -------------------------------------------------------------------------------

    Project Life Differences

    Example no. 8 ------------------------------------------------------------------------------

     Net cash flows

     ------------------------------------------

    End of year Project 1 Project 2

    ____________________________________________________

    0 - 10 lacs - 10 lacs

    1 0 20 lacs

2 0 0

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Subject: Financial Management

    Chapter no. 11: Capital Budgeting

    3 13.75 lacs 0

    -------------------------------------------------------------------------------

    Ranking the projects based on IRR and NPV criteria, we find that:

    ------------------------------------------------------------------------------

    Ranking IRR NPV @ 10%

    ____________________________________________________

    1 Project 2 (100%) P 1 (NPV = 1,53,600)

    2 Project 1 (50%) P 2 (NPV = 81,800)

    -------------------------------------------------------------------------------

    With all the above examples, it is hoped that the concepts of IRR and NPV are clear to the students.

    To sum up, we can say that:

    1. Both the methods are quite reliable

    2. NPV represents wealth maximisation

    3. IRR indicates the rate of return from investment

    4. In case there is any conflict, the scale of investment and the cash flow timing difference have to be considered 5. It is wise not to compare two projects with unequal life

    6. IRR is readily suitable for a finance product like lease, hire purchase or term loan as the lender will decide to

    invest only based on rate of return.

Incremental cash flow principle for evaluation of replacement decisions

    As discussed in the initial paragraphs to this chapter, incremental cash flow principle is the basis on which decisions

    are taken for replacing one machine with another. This is nothing but the cost benefit analysis. The steps involved are:

    1. The investment at the beginning is net of the salvage value of the existing machine 2. While considering depreciation, only the differential should be taken into account, i.e., the difference between

    depreciation on the new machine and depreciation on the existing machine for the remainder of its economic life

    at least (the remainder of economic life of the existing machine is bound to be shorter than for a new machine) 3. There could be additional investment by way of incremental working capital at the beginning besides capital

    cost.

    4. The salvage value of the existing machine at the end also should be taken as cash inflow along with the

    withdrawal of additional working capital as at point no. 3

    5. The incremental value in the cash flow could be due to increase in revenues (very little chances for this) or due to

    reduction in cost (this is more likely to happen replacing increasing the operating efficiency)

    6. Construct the cash flows and on net cash inflow apply the chosen discounting rate

    7. Cash flow = Net inflow after tax + differential depreciation added back

    8. In case the cash inflow is negative, do not calculate tax on that and carry forward the loss to the next year and

    deduct the same from the next year’s net cash inflow before paying taxes.

    Example is not repeated as the working is on the same lines as for any project or capital investment for which

    examples have been given in this chapter.

Questions for reinforcement of learning and numerical exercises for practice:

    Punjab Technical University, Online Virtual Campus 3

Subject: Financial Management

    Chapter no. 11: Capital Budgeting

    1. Discuss the sources if you want to build a canteen for your workers is it external loan or internal accrual? Give

    the reasons for your answer.

    2. Enumerate the steps involved in estimating the cash flow projections for a project starting from financial

    planning till financial ratios.

    3. Explain with examples how conflicts could arise in ranking of different projects based on different parameters

    like NPV and IRR.

    4. How does one overcome the shortcoming in the case of conventional “payback” method? Explain with an

    example.

    5. From the following find out the best project in terms of Net Present Value and profitability index

    Original investment = Rs.500 lacs

    The projected cash flows in lacs of rupees are as under:

     Year of operation Project 1 Project 2 Project 3

     1 180 250 200

     2 250 250 250

     3 300 250 250

     4 320 400 400

     Expected rate of return = 20% p.a.

    6. From the following find out the best project in terms of Net Present Value and profitability index

    Original investment = Rs.1000 lacs and expected rate of return = 17% p.a.

    The projected cash flows in lacs of rupees are as under:

     Year of operation Project 1 Project 2 Project 3

     1 360 250 200

     2 250 250 250

     3 300 250 250

     4 320 400 400

    7. From the following stream, find out the implied rate of return by the method of interpolation.

    Original investment Rs.170 lacs

    Cash inflows

    Year 1 80 lacs

    Year 2 40 lacs

    Year 3 60 lacs

    Year 4 80 lacs

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