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Capital Budgeting Summary Notes and Q’s

MODULE REVISION
Independent Versus Mutually Exclusive Investment Projects

• An independent investment project is one


that stands alone and can be undertaken
without influencing the acceptance or
rejection of any other project.

• A mutually exclusive project prevents another


project from being accepted.

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Evaluating Independent Investment Opportunities

• Independent projects are evaluated based on the


method of evaluation (obviously).
• If the NPV method is used, the decision rule is as
follows:
• Decision rule: If NPV is positive, accept the
project. Otherwise, reject it.
• If the Profitability Index (PI) is used:
• Decision rule: If PI > 1, accept the project.
Otherwise, reject it.

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Evaluating Mutually Exclusive Investment Opportunities

• There are times when a firm must choose the


best project or set of projects from the set of
positive NPV investment opportunities.
• These are considered mutually exclusive
opportunities as the firm cannot undertake all
positive NPV projects.

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Evaluating Mutually Exclusive Investment Opportunities (cont.)

• Following are two situations where firm is


faced with mutually exclusive projects:
1.Substitutes – Where firm is trying to pick
between alternatives that perform the same
function. For example, a new machinery for
the new project. While there might be many
good machines, the firm needs only one.

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Evaluating Mutually Exclusive Investment Opportunities (cont.)

2. Firm Constraints –
Firm may face constraints such as limited
managerial time or limited financial capital
that may limit its ability to invest in all the
positive NPV opportunities.

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Choosing Between Mutually Exclusive Investments

1. If mutually exclusive investments have equal


lives, we will calculate the NPVs and choose
the one with the higher NPV.
2. If mutually exclusive investments do not have
equal lives, we must calculate the Equivalent
Annual Cost (EAC), the cost per year. We will
then select the one that has a lower EAC.

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Net Present Value
• Net present value (NPV) is the excess of the present value
(PV) of cash inflows generated by the project over the
amount of the initial outlay (IO):

NPV = PV (of cash flows) - IO

The present value of future cash flows is computed using


the so-called cost of capital (or minimum required rate of
return) as the discount rate.

Decision rule: If NPV is positive, accept the project. Otherwise, reject it.

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Q2:- NPV Calculation
You have been asked to consider the viability of the
following project

Initial investment $12,950


Estimated life 10 years
Annual cash inflows $3,000
Cost of capital
(minimum required rate of return) 12%

What would be your advice to management?


What are the advantages of this method?
Internal Rate of Return (IRR)

Internal rate of return (IRR) is defined as the rate of


interest that equates the initial capital outlay (IO)
with the PV of future cash inflows.

In other words, at IRR,


IO = PV
or
NPV = 0

Decision rule: Accept the project if the IRR exceeds


the cost of capital. Otherwise, reject it.
Internal Rate of Return (IRR)

Advantages
The advantage of using the IRR method is that it
does consider the time value of money

Disadvantages
The shortcomings of this method are:
• it is time-consuming to compute, especially when the cash inflows are
not even, although most business calculators and spreadsheet software
have a program to calculate IRR
• it fails to recognize the varying sizes of investment in competing
projects and their respective dollar profitabilities.
• it sometimes generate multiple IRRs
Advantages and Disadvantages of the NPV and IRR Methods

Advantages:
With the NPV method, the advantage is that it is a direct
measure of the dollar contribution to the stockholders.
With the IRR method, the advantage is that it shows the
return on the original money invested.
Disadvantages:
With the NPV method, the disadvantage is that the project
size is not measured.
With the IRR method, the disadvantage is that, at times, it
can give you conflicting answers when compared to NPV for
mutually exclusive projects. The 'multiple IRR problem' can
also be an issue, as discussed below.
Multiple Internal Rate of Return (IRR)

Multiple Internal Rates of Return

In nonconventional (mixed) projects that


have one or more periods of cash
outflows (inflows) with periods of cash
inflows (outflows), there may be
multiple internal rates of return.
Q3: Multiple Internal Rate of Return (IRR)

Consider a strip-mining project with the following cash flows:

Time 0 1 2
Cash flow -$60,000 155,000 -100,000

Find the NPV if the required yield is:

(a) 25%

(b) 33.33%.
Profitability Index PI
Profitability Index (Benefit/Cost Ratio)

The profitability index is the ratio of the total PV of future


cash inflows to the initial investment, that is, PV/I. This
index is used as a means of ranking projects in descending
order of attractiveness. If the profitability index is greater
than 1, then accept the project.

Decision rule: If the profitability index is greater than 1,


then accept the project.
Q4: Index PI
You have been asked to consider the viability of the
following project using the PI method.

Initial investment $12,950


Estimated life 10 years
Annual cash inflows $3,000
Cost of capital
(minimum required rate of return) 12%

What would be your advice to management?


What are the advantages of this method?
THE MODIFIED INTERNAL RATE OF RETURN (MIRR)
When the IRR and NPV methods produce a contradictory ranking for
mutual exclusive projects, the modified IRR, or MIRR, overcomes
the disadvantage of IRR

The MIRR is defined as the discount rate which forces


I = PV of terminal (future) value compounded at the cost of capital

The MIRR forces cash flow reinvestment at the cost of capital rather
than the project’s own IRR, which was the problem with the IRR.

• MIRR avoids the problem of multiple IRRs.

• Conflicts can still occur in ranking mutually exclusive projects with


differing sizes. NPV should again be used in such a case.
More Questions
Q5: THE MODIFIED INTERNAL RATE OF RETURN (MIRR)

A project entails an initial investment of $1,000, and offers cash


returns of $400, $500, and $300 at the end of years one, two and
three respectively. The company’s cost of capital is 10%.

Determine the MIRR


Q6: THE MODIFIED INTERNAL RATE OF RETURN (MIRR)

a) The UWI has sought your expertise as they are considering


undertaking a $47,800 project that is expected to have an after-tax
cash flow of $14,200 for two years, $10,200 for the next two years,
and $8,300 for the fifth year? If the discount rate were 8% what
would your advice to the UWI be?
Q6: THE MODIFIED INTERNAL RATE OF RETURN (MIRR)

a) Your company is considering a project that it wants to mirrors the


yield of one of its portfolios. The project promises the cash flows
shown below.

Year Cash Flows


0 ($80,000)
1 ($65,000)
2 $45,000
3 $65,000
4 $110,000

If the portfolio’s beta is 2, the expected return of the market 6% and


the risk-free rate 3%, Calculate the MIRR.
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