adv. financial management assignment

S.P. MANDALI’S

R. A PODAR COLLEGE OF COMMERCE AND ECONOMICS

MATUNGA, MUMBAI-400 019.

A PROJECT REPORT ON

Payback Method and IRR Method

SUBMITTED BY

Rutuja Deepak Chudnaik

M.COM (SEM. IV): Advanced Financial Management

SUBMITTED TO

UNIVERSITY OF MUMBAI

2015-2016

PROJECT GUIDE

Prof. Dhiren Kanabar

S.P. MANDALI’S

R. A PODAR COLLEGE OF COMMERCE AND ECONOMICS

MATUNGA, MUMBAI-400 019.

CERTIFICATE

This is to certify that Mr/Ms. Rutuja Deepak Chudnaik of M.Com ( Business Management/

Accountancy) Semester IV (2015-2016) has successfully completed the project on Payback

Method and IRR Method

under the guidance of Prof. Dhiren Kanabar

Project Guide/Internal Examiner External Examiner

Prof. _______________________ Prof. _______________________

Dr. (Mrs) Vinita Pimpale Dr.(Mrs) Shobana Vasudevan

Course Co-ordinator Principal

Date Seal of the College

ACKNOWLEDGEMENT

I acknowledge the valuable assistance provided by S. P Mandali’s R. A. Podar College of Commerce & Economics, for two year degree course in M.Com.

I specially thank the Principal Dr.(Mrs) Shobana Vasudevan for allowing us to use the facilities such as Library, Computer Laboratory, internet etc.

I sincerely thank the M.Com Co-ordinator for guiding us in the right direction to prepare the project.

I thank my guide Prof. Dhiren Kanabar who has given his/her valuable time,

knowledge and guidance to complete the project successfully in time.

My family and peers were great source of inspiration throughout my project, their support is deeply acknowledged.

Signature of the Student

DECLARATION

I, Rutuja Deepak Chudnaik of R. A. PODAR COLLEGE OF

COMMERCE & ECONOMICS of M.Com SEMESTER I, hereby

declare that I have completed the project Payback Method and IRR

Method in the academic year 2015-2016 for the subject Advanced

Financial Management .

The information submitted is true and original to the best of my

knowledge.

Signature of the Student

Advanced Financial Management Assignment

Index

Sr. No. Particulars Pg. No.

1 Capital Budgeting – Introduction 6

2 Payback Method 15

3 Internal Rate of Return Method 22

4 Reference 32

CAPITAL BUDGETING- INTRODUCTION

A capital investment is defined as an outlay that is expected to result in benefits in the future.

Capital budgeting is the process of selecting capital investments.

Capital budgeting is concerned with manager’s decisions about capital expenditure or capital

investments. It is about whether, when and how to spend money on capital projects, or in other

words, it is about evaluating investment opportunities. Such decisions are important ones for the

firms involved because other large sums of money are committed in an irreversible decision,

with no certain knowledge of the future benefits.

The cornerstone of all investment appraisals is the weighing of benefits against costs for each

individual project, so measuring its worthwhileness. If this measurement is done badly, it can

hamper a firm’s growth and employment prospects for years to come, and may lead to an

inability to attract capital.

Financial institutions and individual investors provide private sector firms with capital in the

expectation of a reasonable rate of return. If a firm invests that money in projects that do not

yield a reasonable return then investors will be wary of that firm in the future. If the firm is a

public sector organization, the appraisal of capital expenditure on projects is equally as important

as appraisals done by private sector organizations. All organizations need to ensure, wherever

possible, that in any project appraisal the benefits exceed the costs by a margin sufficient to

service the interest costs on the capital invested.

There are a number of basic situations where an appraisal method will assist managers in making

a sound decision. Typical investment situations are:

(a) Financing decision. An example would be a lease or buy decision where a choice is made

between an initial one-off payment for outright purchase, or a series of regular payments

under a lease agreement. Both financing options are compared on the basis of their total

cost, after allowing for the time value of money.

(b) Expansion. The expansion of facilities to increase capacity and output requires an

appraisal of the additional investment in buildings, equipment, working capital, etc. offset

by the inflow of cash generated from sales after deducting running costs. Justification is

provided here by the profitability of the investment exceeding the required rate of return.

(c) Diversification. This situation is similar to the expansion type with the exception that a

higher level of risk may be expected here when dealing with the more unknown.

(d) Cost saving. A classic example of a cost saving investment would be an investment in IT

equipment to reduce clerical effort, hence a saving in labour costs if staff are redeployed or

made redundant. This probably applies to literally all organizations in any industry or

sector, but cost saving investments can take many different forms. Justification is again on

the basis of the rate of return earned on the new investment exceeding the target rate set by

the organization.

(e) Replacement. A variation on the cost saving theme when a decision is taken whether and

when to replace old equipment with new equipment. Benefits may include time savings,

less wastage, reduced operating costs, better quality of output, etc.

(f) Alternative choice. Here a choice has to be made between two or more options that

achieve the same end. Such options are referred to as being mutually exclusive on the

grounds that any one option selected automatically precludes the other options. An

example of mutually exclusives might be two machines of different design with varying

capital cost, running costs, life expectancy, etc. In this case, selection is made on the basis

of the present value of the life-cycle costs of each machine or, alternatively, the annual

equivalent of the capital and running costs of each machine.

(g) Capital Rationing. Another choice situation arising where a firm has insufficient capital

available to undertake all proposed projects. Here we need to relate the cash inflow to the

cash outflow, after taking account of the time value of money, in a ratio known as the

profitability index.

For the investment appraisals, we will help our valued clients in the following respects:

Analysis and applications based on sound conceptual and theoretical foundations

appropriate for capital budgeting.

Cash flow forecasting.

Project choice under resource constraints.

Sensitivity and break-even analysis with applications to various industries, each of which

has its unique characteristics.

The plan for long-term financing begins with the amount of money needed for attractive

investment opportunities, both now and in the foreseeable future. The decisions about how much

is needed, what it is needed for, and how to raise that money are interactive. The wealth impact

of a capital investment is affected by the rate of return that must be paid to investors. The rate of

return that must be paid depends on how much money is needed, risk, and how that money will

be raised. The lower the rate of return that must be paid to investors, the greater the number of

attractive investment opportunities by the company will have. In a nutshell, investment and

financing decisions are interrelated. Thus, some familiarity with financing considerations is

required to make investment decisions.

Overview of Capital Budgeting

Capital budgeting is the process of analyzing and ranking proposed projects to determine which

ones are deserving of an investment. The result is intended to be a high return on invested funds.

There are three general methods for deciding which proposed projects should be ranked higher

than other projects, which are (in declining order of preference):

1. Throughput analysis. Determines the impact of an investment on the throughput of an

entire system.

2. Discounted cash flow analysis. Uses a discount rate to determine the present value of all

cash flows related to a proposed project. Tends to create improvements on a localized

basis, rather than for the entire system, and is subject to incorrect results if cash flow

forecasts are incorrect.

3. Payback analysis. Calculates how fast you can earn back your investment; is more of a

measure of risk reduction than of return on investment.

Objectives of Capital Budgeting

The following are the .important objectives of capital budgeting:

(1) To ensure the selection of the possible profitable capital projects.

(2) To ensure the effective control of capital expenditure in order to achieve by forecasting

the long-term financial requirements.

(3) To make estimation of capital expenditure during the budget period and to see that the

benefits and costs may be measured in terms of cash flow.

(4) Determining the required quantum takes place as per authorization and sanctions.

(5) To facilitate co-ordination of inter-departmental project funds among the competing

capital projects.

(6) To ensure maximization of profit by allocating the available investible.

Basic Principles of Capital Budgeting

Capital budgeting usually uses the following assumptions:

1. Decisions are based on cash flows not income

2. Timing of cash flows is important

3. Cash flows are based on opportunity cost: Cash flows that occur with an investment compared

to what they would have been without the investment

4. Cash flows are analyzed on after-tax basis:

5. Financing costs are ignored because they are incorporated in WACC – that is why counting

them twice would be considered double counting

Costs Concepts of Capital Budgeting

Some important capital budgeting concepts that managers find very useful are given below:

1. Sunk costs: Costs that already incurred (i.e. paid for marketing research study)– Today costs

should not be affected by sunk costs

2. Opportunity costs: what a resource is worth for next-best use – Those costs should be

considered (i.e. if you use a warehouse, the current market value should be considered)

3. Incremental cash flow: the cash flow that is realized with the project – that is, the cash flow

with a decision minus the cash flow without the decision

4. Externality: the effect of an investment on other things apart from the investment. Those can

be positive or negative and should both be considered.

Cannibalization is an example of an externality where an investment takes customers and sales

from another part of the company – those should be considered in the analysis because they are

incremental cash flows (i.e. they wouldn’t occur unless for the project)

Some important comparisons in capital budgeting are:

1. Conventional versus nonconventional cash flows:

Conventional: Initial outflow followed by series of inflows (i.e. change of sign only occurs

once). That is, you can have – + + + + + +, – - – + + +, or – - – - – + and still be considered

conventional cash flows because the sign changes only once.

Nonconventional: Initial outflow followed by series of inflows and outflows (i.e. change of sign

occurs more than once). Examples of those include – + + + -, – - – + + -, or – + – + – +.

2. Independent versus mutually exclusive projects:

Independent projects: Cash flows are independent of each other. You can use both A and B;

there isn’t overlap between projects. Projects here are being evaluated that could potentially all

be selected as long as their projected cash flows will produce a positive NPV or generate an IRR

greater than the firm’s hurdle rate.

Mutually exclusive projects: Projects that compete directly with each other (i.e. you own some

manufacturing equipment that must be replaced. Two different suppliers present a purchase and

installation

plan for your consideration). Sometimes there are more than two projects and you select one

from group.

3. Unlimited funds versus capital rationing

Unlimited funds: It assumes the company can raise funds for all profitable projects.

Capital rationing: It exists when a company has fixed amounts of funds to invest. If the company

has more project than funds, it must allocate the funds among the projects.

4. Project sequencing:

One last important concept here is project sequencing where many projects are evaluated through

time; that is, investing in one project gives the option to invest for other projects in the future.

For example, you can decide to open a mall this year and if the financial results are favorable

after 5 years, you will build a hotel next to the mall.

CAPITAL BUDGETING PROCESS

The following procedure may be considered in the process of capital budgeting decisions :

(1) Identification of profitable investment proposals.

(2) Screening and selection of right proposals.

(3) Evaluation of measures of investment worth on the basis of profitability and uncertainty

or risk.

(4) Establishing priorities, i.e., uneconomical or unprofitable proposals may be rejected.

(5) Final approval and preparation of capital expenditure budget.

(6) Implementing proposal, i.e., project execution.

(7) Review the performance of projects.

We need to ask ourselves the following questions when evaluating decision criteria:

1. Does the decision rule adjust for the time value of money?

2. Does the decision rule adjust for risk?

3. Does the decision rule provide information on whether we are creating value for the firm?

METHODS OF EVALUATING CAPITAL INVESTMENT PROPOSALS

There are number of appraisal methods which may be recommended for evaluating the

capital investment proposals. We shall discuss the most widely accepted methods. These

methods can be grouped into the following categories :

I. Traditional Methods:

Traditional methods are grouped in to the following :

(1) Pay-back period method or Payout method..

(2) Rate of Return Method or Accounting Rate of Return Method.

II. Time Adjusted Method or Discounted Cash Flow Method

Time Adjusted Method further classified into:

(1) Discounted Pay-back Period Method.

(2) Net Present Value Method.

(3) Internal Rate of Return Method.

(4) Profitability Index Method.

PAYBACK PERIOD METHOD

Pay-back period is also termed as "Pay-out period" or Pay-off period. Payout Period Method is

one of the most popular and widely recognized traditional method of evaluating investment

proposals. It is defined as the number of years required to recover the initial investment in full

with the help of the stream of annual cash flows generated by the project.

The payback period is the time required for the amount invested in an asset to be repaid by the

net cash outflow generated by the asset. It is a simple way to evaluate the risk associated with a

proposed project.

The payback period is expressed in years and fractions of years. For example, if a company

invests Rs. 300,000 in a new production line, and the production line then produces cash flow of

Rs. 100,000 per year, then the payback period is 3.0 years (Rs. 300,000 initial investment / Rs.

100,000 annual payback). An investment with a shorter payback period is considered to be

better, since the investor's initial outlay is at risk for a shorter period of time. The calculation

used to derive the payback period is called the payback method.

The formula for the payback method is simplistic: Divide the cash outlay (which is assumed to

occur entirely at the beginning of the project) by the amount of net cash flow generated by the

project per year (which is assumed to be the same in every year).

Calculation of Pay-back Period: Pay-back period can be calculated into the following two different situations :

(a) In the case of constant annual cash inflows.

(b) In the case of uneven or unequal cash inflows.

(a) In the case of constant annual cash inflows : If the project generates constant cash

flow the Pay-back period can be computed by dividing cash outlays (original investment) by

annual cash inflows. The following formula can be used to ascertain pay-back period :

Cash Outlays (Initial Investment)

Pay-back Period = Annual Cash Inflows

Illustration: 1

A project requires initial investment of Rs. 40,000 and it will generate an annual cash

inflows of Rs. 10,000 for 6 years. You are required to find out pay-back period.

Solution:

Calculation of Pay-back period :

Pay-back Period = Cash Outlays (Initial Investment)

Annual Cash Inflows

= Rs. 40,000/ Rs. 10,000

= 4 Years

Pay-back period is 4 years, i.e., the investment is fully recovered in 4 years.

(b) In the case of Uneven or Unequal Cash Inflows: In the case of uneven or unequal cash

inflows, the Pay-back period is determined with the help of cumulative cash inflow. It can be

calculated by adding up the cash inflows until the total is equal to the initial investment.

Illustration: 2

From the following information you are required to calculate pay-back period :

A project requires initial investment of Rs. 40,000 and generate cash inflows of Rs. 16,000,

Rs. 14,000, Rs. 8,000 and Rs. 6,000 in the first, second, third, and fourth year respectively.

Solution:

Calculation Pay-back Period with the help of "Cumulative Cash Inflows"

Year Annual Cash Inflows Cumulative Cash

Inflows

Rs. Rs.

1 16,000 16,000

2 14,000 30,000

3 8,000 38,000

4 6,000 44,000

The above table shows that at the end of 4th years the cumulative cash inflows exceeds the

investment of Rs. 40,000. Thus the pay-back period is as follows :

Payback Period = 3 years + (40000-38000)

6000

= 3.33 years

PAYBACK PERIOD EXAMPLE

Alaskan Lumber is considering the purchase of a band saw that costs Rs. 50,000 and which will

generate Rs. 10,000 per year of net cash flow. The payback period for this capital investment is

5.0 years. Alaskan is also considering the purchase of a conveyor system for Rs. 36,000, which

will reduce saw mill transport costs by Rs. 12,000 per year. The payback period for this capital

investment is 3.0 years. If Alaskan only has sufficient funds to invest in one of these projects,

and if it were only using the payback method as the basis for its investment decision, it would

buy the conveyor system, since it has a shorter payback period.

ACCEPT OR REJECT CRITERION

Investment decisions based on pay-back period are used by many firms to accept or reject an

investment proposal. Among the mutually exclusive or alternative projects whose pay-back

periods are lower than the cut off period, the project would be accepted, if not it would be

rejected.

PAYBACK METHOD ADVANTAGES AND DISADVANTAGES

The payback period is useful from a risk analysis perspective, since it gives a quick picture of the

amount of time that the initial investment will be at risk. If you were to analyze a prospective

investment using the payback method, you would tend to accept those investments having rapid

payback periods, and reject those having longer ones. It tends to be more useful in industries

where investments become obsolete very quickly, and where a full return of the initial

investment is therefore a serious concern. Though the payback method is widely used due to its

simplicity, it suffers from the following problems:

1. Asset life span. If an asset’s useful life expires immediately after it pays back the initial

investment, then there is no opportunity to generate additional cash flows. The payback

method does not incorporate any assumption regarding asset life span.

2. Additional cash flows. The concept does not consider the presence of any additional cash

flows that may arise from an investment in the periods after full payback has been

achieved.

3. Cash flow complexity. The formula is too simplistic to account for the multitude of cash

flows that actually arise with a capital investment. For example, cash investments may be

required at several stages, such as cash outlays for periodic upgrades. Also, cash outflows

may change significantly over time, varying with customer demand and the amount of

competition.

4. Profitability. The payback method focuses solely upon the time required to pay back the

initial investment; it does not track the ultimate profitability of a project at all. Thus, the

method may indicate that a project having a short payback but with no overall

profitability is a better investment than a project requiring a long-term payback but

having substantial long-term profitability.

5. Time value of money. The method does not take into account the time value of money,

where cash generated in later periods is work less than cash earned in the current period.

A variation on the payback period formula, known as the discounted payback formula,

eliminates this concern by incorporating the time value of money into the calculation.

6. Individual asset orientation. Many fixed asset purchases are designed to improve the

efficiency of a single operation, which is completely useless if there is a process

bottleneck located downstream from that operation that restricts the ability of the

business to generate more output. The payback period formula does not account for the

output of the entire system, only a specific operation. Thus, its use is more at the tactical

level than at the strategic level.

7. Incorrect averaging. The denominator of the calculation is based on the average cash

flows from the project over several years - but if the forecasted cash flows are mostly in

the part of the forecast furthest in the future, the calculation will incorrectly yield a

payback period that is too soon. The following example illustrates the problem.

Payback Method Example #2

ABC International has received a proposal from a manager, asking to spend Rs. 1,500,000 on

equipment that will result in cash inflows in accordance with the following table:

Year Cash Flow

1 +Rs. 150,000

2 +150,000

3 +200,000

4 +600,000

5 +900,000

The total cash flows over the five-year period are projected to be Rs. 2,000,000, which is an

average of Rs. 400,000 per year. When divided into the Rs. 1,500,000 original investment, this

results in a payback period of 3.75 years. However, the briefest perusal of the projected cash

flows reveals that the flows are heavily weighted toward the far end of the time period, so the

results of this calculation cannot be correct.

Instead, the company's financial analyst runs the calculation year by year, deducting the cash

flows in each successive year from the remaining investment. The results of this calculation are:

Year Cash Flow Net Invested Cash

0 -Rs. 1,500,000

1 +Rs. 150,000 -1,350,000

2 +150,000 -1,200,000

3 +200,000 -1,000,000

4 +600,000 -400,000

5 +900,000 0

The table indicates that the real payback period is located somewhere between Year 4 and Year

5. There is Rs. 400,000 of investment yet to be paid back at the end of Year 4, and there is Rs.

900,000 of cash flow projected for Year 5. The analyst assumes the same monthly amount of

cash flow in Year 5, which means that he can estimate final payback as being just short of 4.5

years.

Summary

The payback method should not be used as the sole criterion for approval of a capital investment.

Instead, consider using the net present value or internal rate of return methods to incorporate the

time value of money and more complex cash flows, and use throughput analysis to see if the

investment will actually boost overall corporate profitability. There are also other considerations

in a capital investment decision, such as whether the same asset model should be purchased in

volume to reduce maintenance costs, and whether lower-cost and lower-capacity units would

make more sense than an expensive "monument" asset.

INTERNAL RATE OF RETURN (IRR)

INTERNAL RATE OF RETURN - A CAPITAL BUDGETING DECISION METHOD

Financial managers and business owners usually like performance measures expressed in

percentages instead of dollars. As a result, they tend to like capital budgeting decisions expressed

as a percentage, like internal rate of return (IRR) instead of in a dollar amount, like net present

value (NPV). However, there is a problem. Even though internal rate of return is usually a

reliable method of determining whether or not a capital investment project is a good investment

for a business firm, there are conditions under which it is not reliable but net present value is.

WHAT IS INTERNAL RATE OF RETURN

In the language of finance, internal rate of return is the discount rate (or the firm's cost of capital,

that forces the present value of the cash inflows of the project to equal the initial investment

which is equivalent to forcing the net present value of the project to equal Rs. 0. Pretty

confusing. I can also say that internal rate of return is an estimate of the rate of return on the

project.

Clearly, internal rate of return is a more difficult metric to calculate than net present value. With

an Excel spreadsheet, it is a simple function. In the past, financial managers had to calculate it

using trial and error which was a long and complex calculation. Here is an online calculator that

you can use to calculate IRR anytime you need it.

First, in English, what is internal rate of return? It is a way of expressing the value of a project in

a percentage instead of in a dollar amount. It is usually correct, except there are some exceptions

that will make it wrong.

DECISION RULES FOR INTERNAL RATE OF RETURN

If the IRR of a project is greater than or equal to the project's cost of capital, accept the project.

However, if the IRR is less than the project's cost of capital, reject the project. The rationale is

that you never want to take on a project for your company that returns less money than you pay

than you pay to borrow money (cost of capital).

Just like for net present value, you have to consider whether you are looking at independent or

mutually exclusive project. For independent projects, if the IRR is greater than the cost of

capital, then you accept as many projects as your budget allows. For mutually exclusive projects,

if the IRR is greater than the cost of capital, you accept the project. If it is less than the cost of

capital, then you reject the project.

An Example of Internal Rate of Return and Why Net Present Value is Better

Let's take a look at an example in this article on net present value. First, take a look at Project S.

You can see that, when you calculate net present value, and since these are mutually exclusive

projects, Project S loses. It has a lower net present value than Project L, so the firm would

choose Project L over Project S. However, if you use the online calculator and plug the cash

flows for the two projects into it, the internal rate of return for Project S is 14.489%.

Now, let's look at Project L. Project L is the project you would choose under the net present

value criteria as its net present value is Rs. 1,004.03 as compared to Project S's net present value

of Rs. 788.20. Again, if you use the online calculator and plus Project L's cash flows into it, you

will get an IRR for Project L of 13.549%. Under the IRR decision criteria, Project L has a lower

IRR and the firm would choose Project S.

Why do the decision criteria of internal rate of return and net present value give different

answers in a capital budgeting analysis? Here lies one of the problems with internal rate of return

in capital budgeting. If a firm is analyzing mutually exclusive projects, IRR and NPV may give

conflicting decisions. This will also happen if any of the cash flows from a project are negative

except the initial investment.

DEFINITION:

The internal rate of return is the rate of return at which the present value of a series of future cash

flows equals the present value of all associated costs. This measure is commonly used in capital

budgeting, where the IRR of a proposed investment should be higher than an entity's cost of

capital before the investment will be accepted.

If the IRR for the cash flows associated with a proposed project is unusually high, then it is

reasonable to invest in the project, subject to the availability of a sufficient amount of cash.

Conversely, if a business cannot locate any projects with an IRR higher than the rates to be

earned on investment-grade securities, then a reasonable alternative is to invest excess cash in

the securities until better internal projects can be devised.

The IRR is not applicable when a business is forced to make an investment for safety or legal

reasons, in which case no rate of return at all is acceptable.

This analysis method provides no guidance on which project to select when there are two or

more proposed projects having identical rates of return. In this situation, other analysis methods

must be used. This method also provides no guidance when deciding whether to invest in the

bottleneck operations of an entity (known as constraint analysis).

Internal Rate of Return Method is also called as "Time Adjusted Rate of Return Method." It is

defined as the rate which equates the present value of each cash inflows with the present value of

cash outflows of an investment. In other words, it is the rate at which the net present value of the

investment is zero.

Horngren and Foster define Internal Rate of Return as the rate of interest at which the present

value of expected cash inflows from a project equals the present value of expected cash outflows

of the project.

The Internal Rate of Return can be found out by Trial and Error Method. First, compute the

present value of the cash flow from an investment, using an arbitrarily selected interest rate, for

example 10%. Then compare the present value so obtained with the investment cost.

If the present value is higher than the cost of capital, try a higher interest rate and go through the

procedure again. On the other hand if the calculated present value of the expected cash inflows is

lower than the present value of cash outflows, a lower rate should be tried. This process will be

repeated until and unless the Net Present Value becomes zero. The interest rate that brings about

this equality is defined as the Internal Rate of Return.

Alternatively, the internal rate can be obtained by Interpolation Method when we come across 2

rates. One with positive Net Present Value and other with negative Net Present Value. The IRR

is considered as the highest rate of interest which a business is able to pay on the funds borrowed

to finance the project out of cash inflows generated by the project.

Evaluation

A popular discounted cash flow method, the internal rate of return criterion has several virtues :

(I) It takes into account the time value of money.

(2) It considers the cash flows over the entire life of the project.

(3) It makes more meaningful and acceptable to users because it satisfies them in terms of

the rate of return on capital.

Limitations

(1) The internal rate of return may not be uniquely defined.

(2) The IRR is difficult to understand and involves complicated computational problems.

(3) The internal rate of return figure cannot distinguish between lending and borrowings and

hence high internal rate of return need not necessarily be a desirable feature.

HOW TO CALCULATE THE INTERNAL RATE OF RETURN

The internal rate of return (IRR) is the rate of return at which the present value of a series of

future cash flows equals the present value of all associated costs. IRR is commonly used in

capital budgeting, to discern the rate of return on the estimated cash flows arising from a

prospective investment. A project having the highest IRR is selected for investment purposes

(subject to other considerations).

As an example of an internal rate of return calculation, a company is reviewing a possible

investment, for which there is an initial expected investment of Rs. 20,000 in the first year,

following by incoming cash flows of Rs. 12,000, Rs. 7,000 and Rs. 4,000 in the next three years.

If you input this information into the Excel IRR function, it returns an IRR of 8.965%.

The IRR formula in is extremely useful for quickly deriving a possible rate of return. However, it

can be used for a less ethical purpose, which is to artificially model the correct amounts and

timing of cash flows to produce an IRR that meets a company's capital budgeting guidelines. In

this case, a manager is fudging the results in his or her cash flow model in order to gain

acceptance of a project, despite knowing that it may not be possible to achieve those cash flows.

While the internal rate of return is useful for estimating the return on projected cash flows, it

does not account for other factors, which may be more important to someone evaluating capital

budgeting proposals. For example, it may be more important to upgrade the capacity of a

bottleneck operation, irrespective of any related cash flows, or to comply with a legal

requirement to reduce pollution emissions. In these cases, the presence of IRR information does

not influence the final investment decision made, and does not even need to be calculated.

Illustration: 13

The cost of a project is Rs. 32,400. It is expected to generate cash inflows of Rs. 16,000, Rs.

14,000 and Rs. 12,000 through it three year life period. Calculate the Internal Rate of Return of

the Project.

Solution:

Calculation of Internal Rate of Return (IRR)

To begin with let us try a rate of 20% and calculate the present value of cash inflows on this rate.

The following table will give the calculations:

Year Cash inflows Discounted Factor Present Value of Cash Inflows

1 2 at 20% (2 x 3) = 4

Rs. 3 Rs.

1 16,000 0.833 13,328

2 14,000 0.694 9,716

3 12,000 0.579 6,948

Total Present Value of Cash

Inflows =

Rs.29,992

Net Present Value = Present Value of

Cash Inflows -

Value of Cash Outlays

= Rs. 29,992 - Rs. 32,400 = (-) Rs. 2408

Net Present Value

(NPV)

= - Rs. 2408

The Net Present Value in this case is negative indicating that 20% is the higher rate and so a

lower rate should be tried. Let us try 18%, 16% and 14% respectively. On these rates we

will get the following results:

Year Cash Discounted Present Discount Present Discount Present

1 Inflows Factor Value Factor Value Factor Value

2 18% (2 x 3) 16% (2 x 5) 14% (2 x 7)

3 4 5 6 7 8

Rs. Rs. Rs. Rs.

1 16000 0.847 13552 0.862 13792 0.877 14032

2 14000 0.718 10,052 0.743 10402 0.769 10766

3 12000 0.609 7308 0.641 7692 0.675 8100

Present Value of Cash

Inflows

30912 31886 31898

Less: Value of Cash

Outflows

32400 32400 32400

Net Present Value

(NPV) = (-)

1,488 (-)

514

(-) 498

From the above table of Calculation is can be observed that the real rate lies in between

14% and 16%. Therefore let us select 15% as the internal rate to ascrtain its applicability.

Year Cash inflows Discounted

Factor

Present Value of Cash

Inflows

1 2 15% (2 x 3) 4

Rs. Rs.

1 16,000 0.870 13,920

2 14,000 0.756 10,584

3 12,000 0.658 7,896

Present Value of Cash Inflows = 32,400

Less: Value of Cash Outflow 32,400

Net Present Value 0

Thus, the Net Present Value at 15% rate is zero. It indicates that the present value of cash

inflows is equal to the present value of cash outflows. Thus, internal rate of return 15% for the

project under review.

Example : Bright Metals Ltd. is considering two different investment proposals, a and B. The details are as under:

Proposal A Proposal B

Investment cost Rs. 9,500 Rs. 20,000

Estimated income Year 1 4,000 8,000

Year 2 4,000 8,000

Year 3 4,500 12,000

Suggest the most attractive proposal on the basis of the NPV method considering that the future incomes are discounted at 12%. Also find out the IRR of the two proposals.

Solution

Evaluation of investment proposal (net present value method)

Year Cash inflows (Rs.) PVF (12%,n) Present value (Rs.)

A B A B

0 -9,500 -20,000 1.000 -9,500 -20,000

1 4,000 8,000 0.893 3,572 7,144

2 4,000 8,000 0.797 3,188 6,376

3 4,500 12,000 0.712 3,204 8,544

Net present value (NPV) 464 2,064

NPV is more in proposal B and therefore, it should

be accepted.

Calculation of Internal Rate of Return

In case of Proposal A, the discount factor should be raised from 12% and tested at, say,

14% and 15%. Similarly, for B the same should be tried at, say, 17% and 18%. The

purpose is to find out at which point the present value of inflows are equal to Rs. 9500 and

Rs. 20,000.

Project A Project B

NPV @ 12% Rs. 464 NPV @ 12% Rs. 2064

NPV @ 14% Rs. 122 NPV @ 17% Rs. 176

NPV @ 15% Rs. -35 NPV @ 18% Rs. -172

Interpolation between 14% and 15% Interpolation between 17% and 18%

IRR = 14% + 122 / 122+35 IRR = 17% + 176 / 176+172

= 14.78% = 17.51%

SUMMARY

Everything points to the net present value decision method being superior to the internal rate of

return decision method. One last issue that business owners have to consider is reinvestment rate

assumption. IRR is sometimes wrong because it assumes cash flows from the project are

reinvested at the project's IRR. However, net present value assumes cash flows from the project

are reinvested at the firm's cost of capital which is correct.

REFERENCE

Advanced Financial Management Mcom Part II – Manan Prakashan

http://cfatutor.me/2013/07/27/capital-budgeting-rules-npv-irr-payback-discounted-payback-aar/

www.futurumcorfinan.com

www.investopedia.com

http://www.accountingformanagement.org/capital-budgeting-techniques/

http://www.accountingformanagement.org/capital-budgeting-techniques/

http://www.investopedia.com/

http://www.futurumcorfinan.com/

http://cfatutor.me/2013/07/27/capital-budgeting-rules-npv-irr-payback-discounted-payback-aar/

adv. financial management assignment

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