Project Report
on
'Capital Budgeting'
SUBMITTED TO: SUBMITTED BY:
Dr. Yashwant Gupta Farhad Rohilai
Professor Class Roll No.  2496
Himachal Pradesh University Business School. University Roll No.  2396
(STUDENTS DECLARATION)
I hereby declare that the project report entitled CAPITAL BUDGETING Submitted in partial
fulfilment
of the requirements for the degree of Masters of Business Administration
To Himachal Pradesh University, this is my original work and not submitted For the award of any other
degree, diploma, fellowship, or any other similar Title or prizes
Place : Shimla FARHAD ROHILAI
Date : University Roll No.: 2396
(EXAMINERS CERTIFICATION)
The project report of
FARHAD ROHILAI
on
CAPITAL BUDGETING
Is approved and is acceptable in quality and form.
Internal Examiner External Examiners
(Name, qualification and designation) (Name, qualification)
(UNIVERSITY STUDY CENTRE CERTIFICATE)
This is to certify that the project report entitled
CAPITAL BUDGETING
Submitted in partial fulfilment
of the requirements for the degree of Masters of Business Administration of Himachal Pradesh
University Business School. Farhad Rohilai has worked under my supervision and guidance and that
no part of this Report has been submitted for the award of any other degree, Diploma, Fellowship or
other similar titles or prizes and that the work has not been published in any journal or magazine.
Certified
(YASHWANT GUPTA)
CONTENTS
TOPICS......................................................................................................................PAGE NO.
1. INTRODUCTION........................................................................................
2. METHODS OF CAPITAL BUDGETING...............................................................
A. NET PREST VALUE................................................................................
B. PROFITABILITY INDEX..............................................................................
C. INTERNEL RATE OF RETURN...............................................................
D. MODIFIED I.R.R..........................................................................................
E. EQUIVELENT ANNUITY.................................................................................
3. OTHER RELATED CONCEPTS OF CAPITAL BUDGETING................................
4. A DETAILED UNDERSTANDING OF MAIN TECHNIQUES OF CAPITAL BUDGETING......
5. CAPITAL BUDGETING: RISK AND UNCERTAINITY..............................................
6. CAPITAL BUDGETING CASES (PREDECIDED)......................................................
A. FALCON AIRLINES INC..........................................................................................
B. PRINCESS CRUISE LINES INC................................................................................
7. CASE STUDIES (SELF ASSESSMENT)......................................................................
A. WIPRO BPO NEW PROCESS PEPBOYS..............................................................
B. WIPRO BPO NEW PROCESS MSN.....................................................................
........... REFRENCES...............................................................................................................
1. INTRODUCTION:
A Perspective from the viewpoint of definitions:
Capital budgeting is the process by which the financial manager decides whether to
invest in specific capital projects or assets. In some situations, the process may entail in
acquiring assets that are completely new to the firm. In other situations, it may mean replacing
an existing obsolete asset to maintain efficiency.
Capital budget may be defined as the firms decision to invest its current funds most
efficiently in the longterm assets in anticipation if an expected flow of benefits over a series of
years. Therefore it involves a current outlay or series of outlay of cash resources in return for
an anticipated flow of future benefits. Capital budgeting is the process of identifying, analyzing
and selecting investment projects whose returns (cash flow) are expected to extend beyond
one year.
Longterm investments represent sizable outlays of funds that commit a firm to some
course of action. Consequently, the firm needs procedures to analyze and properly select its
longterm investments. It must be able to measure cash flows and apply appropriate decision
techniques. As time passes, fixed assets may become obsolete or may require an overhaul; at
these points, too, financial decisions.
Capital budgeting is the process of evaluating and selecting longterm investments that
are consistent with the firms goal of maximizing owner wealth. Firms typically make a variety
of longterm investments, but the most common for the manufacturing firm is in fixed assets,
which include property (land), plant, and equipment. These assets, often referred to as earning
assets, generally provide the basis for the firms earning power and value.
The Meaning Perspective:
Capital budgeting (or investment appraisal) is the planning process used to determine
whether firm's long term investments such as new machinery, replacement machinery, new
plants, new products, and research and development projects are worth pursuing.
A capital expenditure is an outlay of cash for a project that is expected to produce a
cash inflow over a period of time exceeding one year. Examples of projects include
investments in property, plant and equipment, research and development projects, large
advertising campaigns, or any other project that require a capital expenditure and generates a
future cash flow.
Capital expenditures can be very large and have a significant impact on the financial
performance of the firm, great importance is placed on project selection. This is called Capital
budgeting.
Nature of Capital Budgeting:
Nature of capital budgeting can be explained in brief as under
(a) Capital expenditure plans involve a huge investment in fixed assets.
(b) Capital expenditure once approved represents longterm investment that cannot be
reserved or withdrawn without sustaining a loss.
(c) Preparation of coital budget plans involve forecasting of several years profits in advance in
order to judge the profitability of projects.
It may be asserted here that decision regarding capital investment should be taken very
carefully so that the future plans of the company are not affected adversely.
Importance of Capital Budgeting Techniques:
The key function of the financial management is the selection of the most profitable assortment
of capital investment and it is the most important area of decisionmaking of the financial
manger because any action taken by the manger in this area affects the working and the
profitability of the firm for many years to come.
The key function of the financial management is the selection of the most profitable assortment
of capital investment and it is the most important area of decisionmaking of the financial
manger because any action taken by the manger in this area affects the working and the
profitability of the firm for many years to come.
The need of capital budgeting can be emphasised taking into consideration the very nature of
the capital expenditure such as heavy investment in capital projects, longterm implications for
the firm, irreversible decisions and complicates of the decision making. Its importance can be
illustrated well on the following other grounds:
(1) Indirect Forecast of Sales. The investment in fixed assets is related to future sales of the
firm during the life time of the assets purchased. It shows the possibility of expanding the
production facilities to cover additional sales shown in the sales budget. Any failure to make
the sales forecast accurately would result in over investment or under investment in fixed
assets and any erroneous forecast of asset needs may lead the firm to serious economic
results.
(2) Comparative Study of Alternative Projects Capital budgeting makes a comparative study
of the alternative projects for the replacement of assets which are wearing out or are in danger
of becoming obsolete so as to make the best possible investment in the replacement of assets.
For this purpose, the profitability of each projects is estimated.
(3) Timing of AssetsAcquisition. Proper capital budgeting leads to proper timing of assets
acquisition and improvement in quality of assets purchased. It is due to the nature of demand
and supply of capital goods. The demand of capital goods does not arise until sales impinge on
productive capacity and such situation occur only intermittently. On the other hand, supply of
capital goods with their availability is one of the functions of capital budgeting.
(4) Cash Forecast. Capital investment requires substantial funds which can only be arranged
by making determined efforts to ensure their availability at the right time. Thus it facilitates cash
forecast.
(5) WorthMaximization of Shareholders. The impact of longterm capital investment
decisions is far reaching. It protects the interests of the shareholders and of the enterprise
because it avoids overinvestment and underinvestment in fixed assets. By selecting the most
profitable projects, the management facilitates the wealth maximization of equity share
holders.
(6) Other Factors. The following other factors can also be considered for its significance:
(a) It assist in formulating a sound depreciation and assets replacement policy.
(b) It may be useful in considering methods of coast reduction. A reduction campaign may
necessitate the consideration of purchasing most uptodate and modern equipment.
(c) The feasibility of replacing manual work by machinery may be seen from the capital
forecast by comparing the manual cost and the capital cost.
(d) The capital cost of improving working conditions or safety can be obtained through capital
expenditure forecasting.
(e) It facilitates the management in making of the longterm plans an assists in the formulation
of general policy.
(f) It studies the impact of capital investment on the revenue expenditure of the firm such as
depreciation, insure and there fixed assets.
Kinds of Capital Budgeting Decisions:
Capital budgeting refers to the total process of generating, evaluating, selecting, implementing
and following up on capital expenditure alternatives. The firm allocates or budgets financial
resources to new investment proposals. Basically the firm may be confronted with three
types of capital decisions: (i) the accept reject decision; (ii) the capital rationing decision;
and (iii)the mutually exclusive project accepted.
(i) The AcceptReject Decision
This is a fundamental decision in capital budgeting. If the project is accepted, the firm invests
in it;
if the proposal is rejected, the firm does not invest in it. In general, all those proposals, which
yield a rate of return greater than a certain required rate of return or cost of capital is accepted
and the rest, are rejected. Under the acceptreject decision, all the independent projects that
satisfy the minimum investment criterion should be implemented.
(ii) Capital Rationing Decision:
In a situation where the firm has unlimited funds, capital budgeting becomes a very simple
process in that all independent investment proposals yielding return greater than some
predetermined level are accepted. However, this is not the situation prevailing in most of the
business firms in the real world. They have a fix capital budget or limitation of availability of
funds at a given point of time.
A large number of investment proposals compete for these limited funds. The firm must,
therefore, ration them. The firm allocates funds to projects in a manner that it maximizes long
run returns. Thus, capital rationing refers to the situation in which the firm has more acceptable
investments, requiring a greater amount of finance than is available with the firm. Ranking of
the investment projects is employed in capital rationing. Projects can be ranked on the
basis of some pre determined criterion such as the rate of return. The project with the
highest return is ranked first and the project with the lowest acceptable return last. The projects
are ranked in the descending order of the rate of return. It may be noted that only acceptable
projects should be ranked and higher Ranked projects till funds are available should be
selected for implementation.
(iii) Mutually Exclusive Project Decisions
Mutually exclusive projects are projects, which compete with other projects in such a way that
the acceptance of one will exclude the acceptance of the other projects. The alternatives are
mutually exclusive and only one may be chosen. Suppose a company is intending to buy a
new folding machine. There are three competing brands, each with different initial investment
and operating cost. The three machines represent mutually exclusive alternatives, as
only one of the three machines can be selected. Mutually exclusive investment decisions
acquire significance when more than one proposal is acceptable. Then some techniques have
to be used to determine the best one. The acceptance of this best alternative automatically
eliminates the other alternatives.
Criteria for Capital Budgeting Decisions:
Potentially, there is a wide array of criteria for selecting projects. Some shareholders may want
the firm to select projects that will show immediate surges in cash inflow other may want to
emphasize longterm growth with little importance on shortterm performance. Viewed in this
way, it would be quite difficult to satisfy the differing interests of all the shareholders.
Fortunately, there is a solution.
The goal of the firm is to maximize present shareholder value. This goal implies that projects
should be undertaken that result in a positive net present value, that is, the present value of the
expected cash inflow less the present value of the required capital expenditures. Using net
present value(NPV) as a measure, capital budgeting involves selection those projects that
increases the value of the firm because they have a positive NPV. The timing and growth rate
of the incoming cash flow is important only to the extent of its impact on NPV.
Using NPV as the criterion by with to select projects assumes efficient capital markets so that
the firm has access to whatever capital in needed to pursue the positive NPV projects. In
situations where this is not the case, there may be capital rationing and the capital budgeting
process becomes more complex.
Note that it is not the responsibility of the firm to decide whether to please particular groups of
the shareholders who prefer longer or shorter term results. Once the firm has selected the
projects to maximize its net present value, it is up to the individual shareholder to use the
capital markets to borrow or lend in order to move the exact timing of their own inflows forward
or backward. This idea is crucial in the principalagents relations that exists between
shareholders and corporate managers. Even though each may have their own individual
preferences, the common goal is that of maximizing the present value of the corporation.
2. METHODS OF CAPITAL BUDGETING:
There are a number of techniques of capital budgeting. Some of the methods are based on the
concept of incremental cash flows from the projects or potential investments. There are some
other techniques of capital budgeting that are based on the accounting rules and accounting
earnings.
However, the techniques based on the accounting rules are considered to be improper by the
economists. The hybrid and simplified techniques of capital budgeting are also used in
practice. Capital budgeting is the process of managing the longterm capital of a firm in the
most profitable way.
The prime task of the capital budgeting is to estimate the requirements of capital investment of
a business. The capital allocation to various projects depending on their needs and selection of
proper project for the business also fall under the canopy of capital budgeting concept.
Following are the formal methods used in the Capital Budgeting:
Net present value
Profitability index
Internal rate of return
Modified Internal Rate of Return, and
Equivalent annuity.
These methods use the incremental cash flows from each potential investment, or project.
Techniques based on accounting earnings and accounting rules are sometimes used  though
economists consider this to be improper  such as the accounting rate of return, and "return on
investment." Simplified and hybrid methods are used as well, such as payback period and
discounted payback period.
A. NET PRESENT VALUE:
Each potential project's value should be estimated using a discounted cash flow (DCF)
valuation, to find its net present value (NPV)  (see Fisher separation theorem). This valuation
requires estimating the size and timing of all of the incremental cash flows from the project.
These future cash flows are then discounted to determine their present value. These present
values are then summed, to get the NPV. The NPV decision rule is to accept all positive NPV
projects in an unconstrained environment, or if projects are mutually exclusive, accept the one
with the highest NPV.
The NPV is greatly affected by the discount rate, so selecting the proper rate  sometimes
called the hurdle rate  is critical to making the right decision. The hurdle rate is the minimum
acceptable return on an investment. It should reflect the riskiness of the investment, typically
measured by the volatility of cash flows, and must take into account the financing mix.
Managers may use models such as the CAPM or the APT to estimate a discount rate
appropriate for each particular project, and use the weighted average cost of capital (WACC)
to reflect the financing mix selected. A common practice in choosing a discount rate for a
project is to apply a WACC that applies to the entire firm, but a higher discount rate may be
more appropriate when a project's risk is higher than the risk of the firm as a whole
Formula
Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed.
Therefore or shortened:
Where
t  the time of the cash flow
N  the total time of the project
r  the discount rate (the rate of return that could be earned on an investment in the
financial markets with similar risk.)
C
t
 the net cash flow (the amount of cash) at time t (for educational purposes, C
0
is
commonly placed to the left of the sum to emphasize its role as the initial investment.).
The Discount Rate:
The rate used to discount future cash flows to their present values is a key variable of this
process. A firm's weighted average cost of capital (after tax) is often used, but many people
believe that it is appropriate to use higher discount rates to adjust for risk for riskier projects. A
variable discount rate with higher rates applied to cash flows occurring further along the time
span might be used to reflect the yield curve premium for longterm debt.
Another approach to choosing the discount rate factor is to decide the rate which the capital
needed for the project could return if invested in an alternative venture. If, for example, the
capital required for Project A can earn five percent elsewhere, use this discount rate in the
NPV calculation to allow a direct comparison to be made between Project A and the
alternative. Related to this concept is to use the firm's Reinvestment Rate. Reinvestment rate
can be defined as the rate of return for the firm's investments on average. When analyzing
projects in a capital constrained environment, it may be appropriate to use the reinvestment
rate rather than the firm's weighted average cost of capital as the discount factor. It reflects
opportunity cost of investment, rather than the possibly lower cost of capital.
NPV value obtained using variable discount rates (if they are known) with the years of the
investment duration better reflects the real situation than that calculated from a constant
discount rate for the entire investment duration. For some professional investors, their
investment funds are committed to target a specified rate of return. In such cases, that rate of
return should be selected as the discount rate for the NPV calculation. In this way, a direct
comparison can be made between the profitability of the project and the desired rate of return.
To some extent, the selection of the discount rate is dependent on the use to which it will be
put. If the intent is simply to determine whether a project will add value to the company, using
the firm's weighted average cost of capital may be appropriate. If trying to decide between
alternative investments in order to maximize the value of the firm, the corporate reinvestment
rate would probably be a better choice.
Using variable rates over time, or discounting "guaranteed" cash flows different from "at risk"
cash flows may be a superior methodology, but is seldom used in practice. Using the discount
rate to adjust for risk is often difficult to do in practice (especially internationally), and is really
difficult to do well. An alternative to using discount factor to adjust for risk is to explicitly correct
the cash flows for the risk elements, then discount at the firm's rate.
What NPV Means:
NPV is an indicator of how much value an investment or project adds to the value of the firm.
With a particular project, if C
t
is a positive value, the project is in the status of discounted cash
inflow in the time of t. If C
t
is a negative value, the project is in the status of discounted cash
outflow in the time of t. appropriately risked projects with a positive NPV could be accepted.
This does not necessarily mean that they should be undertaken since NPV at the cost of
capital may not account for opportunity cost, i.e. comparison with other available investments.
In financial theory, if there is a choice between two mutually exclusive alternatives, the one
yielding the higher NPV should be selected. The following sums up the NPVs in various
situations.
If... It means... Then...
NPV > 0
the investment would add value to
the firm
the project may be accepted
NPV < 0
the investment would subtract value
from the firm
the project should be rejected
NPV = 0
the investment would neither gain
nor lose value for the firm
We should be indifferent in the decision
whether to accept or reject the project.
This project adds no monetary value. Decision
should be based on other criteria, e.g. strategic
positioning or other factors not explicitly
included in the calculation.
However, NPV = 0 does not mean that a project is only expected to break even, in the sense
of undiscounted profit or loss (earnings). It will show net total positive cash flow and earnings
over its life.
Example
X Corporation must decide whether to introduce a new product line. The new product will have
startup costs, operational costs, and incoming cash flows over six years. This project will have
an immediate (t=0) cash outflow of $100,000 (which might include machinery, and employee
training costs). Other cash outflows for years 16 are expected to be $5,000 per year. Cash
inflows are expected to be $30,000 per year for years 16. All cash flows are aftertax, and
there are no cash flows expected after year 6. The required rate of return is 10%. The present
value (PV) can be calculated for each year:
T=0 $100,000/ 1.10
0
= $100,000 PV.
T=1 ($30,000  $5,000) / 1.10
1
= $22,727 PV.
T=2 ($30,000  $5,000) / 1.10
2
= $20,661 PV.
T=3 ($30,000  $5,000) / 1.10
3
= $18,783 PV.
T=4 ($30,000  $5,000) / 1.10
4
= $17,075 PV.
T=5 ($30,000  $5,000) / 1.10
5
= $15,523 PV.
T=6 ($30,000  $5,000) / 1.10
6
= $14,112 PV.
The sum of all these present values is the net present value, which equals $8,881. Since the
NPV is greater than zero, the corporation should invest in the project.
The same example in an Excel formulae:
NPV(rate,net_inflow)+initial_investment
PV(rate,year_number,yearly_net_inflow)
More realistic problems would need to consider other factors, generally including the
calculation of taxes, uneven cash flows, and salvage values as well as the availability of
alternate investment opportunities.
Common Pitfalls
If some (or all) of the C
t
have a negative value, then paradoxical results are possible. For
example, if the C
t
are generally negative late in the project (eg, an industrial or mining project
might have cleanup and restoration costs), then an increase in the discount rate can make the
project appear more favourable. Some people see this as a problem with NPV. A way to avoid
this problem is to include explicit provision for financing any losses after the initial investment,
i.e., explicitly calculate the cost of financing such losses.
Another common pitfall is to adjust for risk by adding a premium to the discount rate. Whilst a
bank might charge a higher rate of interest for a risky project, that does not mean that this is a
valid approach to adjusting a net present value for risk, although it can be a reasonable
approximation in some specific cases. One reason such an approach may not work well can
be seen from the foregoing: if some risk is incurred resulting in some losses, then a discount
rate in the NPV will reduce the impact of such losses below their true financial cost. A rigorous
approach to risk requires identifying and valuing risks explicitly, e.g. by actuarial or Monte
Carlo techniques, and explicitly calculating the cost of financing any losses incurred.
Yet another issue can result from the compounding of the risk premium. R is a composite of
the risk free rate and the risk premium. As a result, future cash flows are discounted by both
the risk free rate as well as the risk premium and this effect is compounded by each
subsequent cash flow. This compounding results in a much lower NPV than might be
otherwise calculated. The certainty equivalent model can be used to account for the risk
premium without compounding its effect on present value.
FISHER SEPARATION THEOREM
The Fisher separation theorem in economics asserts that the objective of a firm will be the
maximization of its present value, regardless of the preferences of its owners. The theorem
therefore separates management's "productive opportunities" from the entrepreneur's "market
opportunities". It was proposed by and is named after the economist Irving Fisher.
The Fisher Separation Theorem states that:
the firm's investment decision is independent of the preferences of the owner;
the investment decision is independent of the financing decision.
the value of a capital project (investment) is independent of the mix of methods
equity, debt, and/or cash used to finance the project. Fisher showed the above as
follows:
1. The firm can make the investment decision i.e. the choice between productive
opportunities that maximizes its present value, independent of its owner's investment
preferences.
2. The firm can then ensure that the owner achieves his optimal position in terms of
"market opportunities" by funding its investment either with borrowed funds, or internally
as appropriate.
B. PROFITABILITY INDEX METHOD:
Profitability index identifies the relationship of investment to payoff of a proposed project. The
ratio is calculated as follows:
(PV of future cash flows) / (PV Initial investment) = Profitability Index
Profitability Index is also known as Profit Investment Ratio, abbreviated to P.I. and Value
Investment Ratio (V.I.R.). Profitability index is a good tool for ranking projects because it allows
you to clearly identify the amount of value created per unit of investment, thus if you are capital
constrained you wish to invest in those projects which create value most efficiently first.
Nota Bene; Statements below this paragraphy assume the cash flow calculated DOESN'T
include the investment made in the project. Where investment costs are included in the
computed cash flow a PV>0 simply indicates the project creates more value than the cost of
capital which is determined by the Weighted Average Cost of Capital (WACC).
A ratio of one is logically the lowest acceptable measure on the index. Any value lower than
one would indicate that the project's PV is less than the initial investment. As values on the
profitability index increase, so does the financial attractiveness of the proposed project.
Rules for selection or rejection of a project:
If PI > 1 then accept the project
if PI < 1 then reject the project
For Example
Given: Investment = 40,000 life of the Machine = 5 Years
CFAT
Year
CFAT
1 18000
2 12000
3 10000
4 9000
5 6000
Calculate NPV @10% and PI
Year CFAT PV@10% PV
1 18000 0.909 16362
2 12000 0.827 9924
3 10000 0.752 7520
4 9000 0.683 6147
5 6000 0.621 3726
Total present value 43679
() Investment 40000
NPV 3679
PI = 43679 / 40000
= 1.091
= >1
= so accept the project
C. INTERNAL RATE OF RETURN:
The internal rate of return (IRR) is a capital budgeting metric used by firms to decide whether
they should make investments. It is an indicator of the efficiency of an investment, as opposed
to net present value (NPV), which indicates value or magnitude.
The IRR is the annualized effective compounded return rate which can be earned on the
invested capital, i.e., the yield on the investment.
A project is a good investment proposition if its IRR is greater than the rate of return that could
be earned by alternate investments (investing in other projects, buying bonds, even putting the
money in a bank account). Thus, the IRR should be compared to any alternate costs of capital
including an appropriate risk premium.
Mathematically the IRR is defined as any discount rate that results in a net present value of
zero of a series of cash flows.
In general, if the IRR is greater than the project's cost of capital, or hurdle rate, the project will
add value for the company.
Method
To find the internal rate of return, find the value(s) of r that satisfies the following equation:
Example
Internal Rate of Return (IRR)
IRR = r,
IRR = 17.09%
Net Present Value (NPV)
Thus using r = IRR = 17.09%,
Year Cash Flow
0 595
1 39
2 59
3 55
4 19
Graph of NPV as a function of r for the example
Problems with using internal rate of return (IRR)
As an investment decision tool, the calculated IRR should not be used to rate mutually
exclusive projects, but only to decide whether a single project is worth investing in two mutually
exclusive projects.
In cases where one project has a higher initial investment than a second mutually exclusive
project, the first project may have a lower IRR (expected return), but a higher NPV (increase in
shareholders' wealth) and should thus be accepted over the second project (assuming no
capital constraints).
IRR makes no assumptions about the reinvestment of the positive cash flow from a project. As
a result, IRR should not be used to compare projects of different duration and with a different
overall pattern of cash flows. Modified Internal Rate of Return (MIRR) provides a better
indication of a project's efficiency in contributing to the firm's discounted cash flow.
The IRR method should not be used in the usual manner for projects that start with an initial
positive cash inflow (or in some projects with large negative cash flows at the end), for
example where a customer makes a deposit before a specific machine is built, resulting in a
single positive cash flow followed by a series of negative cash flows (+    ). In this case the
usual IRR decision rule needs to be reversed.
If there are multiple sign changes in the series of cash flows, e.g. ( +  + ), there may be
multiple IRRs for a single project, so that the IRR decision rule may be impossible to
implement. Examples of this type of project are strip mines and nuclear power plants, where
there is usually a large cash outflow at the end of the project.
In general, the IRR can be calculated by solving a polynomial equation. Sturm's Theorem can
be used to determine if that equation has a unique real solution. Importantly, the IRR equation
cannot be solved analytically (i.e. in its general form) but only via iterations.
A critical shortcoming of the IRR method is that it is commonly misunderstood to convey the
actual annual profitability of an investment. However, this is not the case because intermediate
cash flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of
return (akin to the one that would have been yielded by stocks or bank deposits) is almost
certainly going to be lower. Accordingly, a measure called Modified Internal Rate of Return
(MIRR) is used, which has an assumed reinvestment rate, usually equal to the project's cost of
capital.
Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR
over NPV. Apparently, managers find it easier to compare investments of different sizes in
terms of percentage rates of return than by dollars of NPV. However, NPV remains the "more
accurate" reflection of value to the business. IRR, as a measure of investment efficiency may
give better insights in capital constrained situations. However, when comparing mutually
exclusive projects, NPV is the appropriate measure.
In addition if the NPV of one project is higher than another and the other project has a higher
IRR, then the cross over point method can be used to solve this dispute.
Cross Over Point > IRR = Accept project with higher NPV and if the Cross Over Point < IRR =
Accept project with higher IRR
D. MODIFIED INTERNAL RATE OF RETURN
(MIRR) is a financial measure used to determine the attractiveness of an investment. It is
generally used as part of a capital budgeting process to rank various alternative choices. As
the name implies, MIRR is a modification of the financial measure Internal Rate of Return
(IRR). The main difference is that rather than ignoring the investment rate of the positive cash
flow, MIRR makes an explicit assumption about the rate of return of investment of those flows.
The modified internal rate of return assumes all positive cash flows are reinvested (usually at
the WACC) to the terminal year of the project. All negative cash flows are discounted and
included in the initial investment outlay. MIRR ranks project efficiency consistent with the
present worth ratio (variant of NPV/Discounted Negative Cash Flow), considered the gold
standard in many finance textbooks. (Principles of Corporate Finance, Brealey, Myers, and
Allen; or Economic Evaluation and Investment Decision Methods, Stermole and Stermole)
Problems with IRR
There are a few misconceptions about the IRR calculation. The major one is that IRR
automatically assumes that all cash outflows from an investment are reinvested at the IRR
rate. IRR is the "internal rate of return" with "internal" meaning each dollar in an investment. It
makes no assumptions about what an investor does with money coming out of an investment.
Whether the investor gives it away or puts it in a coffee can, the IRR stays the same. The IRR
does, however, reflect reinvestment at the IRR.
It does however have a few drawbacks. First, IRR is not made to calculate negative cash flows
after the initial investment. If an investment has an outflow of $1,000 in year three and an IRR
of 30%, the $1,000 is discounted at 30% per year back to a present value. You would have to
put this PV amount in an investment earning 30% per year for the IRR to reflect the true yield.
Also, IRR ignores the reinvestment potential of positive cash flows. Since most capital
investments have intermediate (nonterminal) positive cash flows, the firm will reinvest these
cash flows. Unless a better number is known, the firm's cost of capital is a reasonable proxy for
the return to be expected. Investments with large or early positive cash flows will tend to look
far better with IRR than with MIRR for this reason.
To illustrate: a firm has investment options with returns that are generally moderate. An
unusually attractive investment opportunity comes up with much higher return. The cash spun
off from this latter investment will probably be reinvested at the moderate rate of return rather
than in another unusually highreturn investment. In this case, IRR will overstate the value of
the investment, while MIRR will not.
Formula
E. EQUIVALENT ANNUAL COST:
In finance the equivalent annual cost (EAC) is the cost per year of owning and operating an
asset over its entire lifespan.
EAC is often used as a decision making tool in capital budgeting when comparing investment
projects of unequal life spans. For example if project A has an expected lifetime of 7 years, and
project B has an expected lifetime of 11 years it would be improper to simply compare the net
present values (NPVs) of the two projects, unless neither project could be repeated.
EAC is calculated by dividing the NPV of a project by the present value of an annuity factor.
Equivalently, the NPV of the project may be multiplied by the loan repayment factor.
EAC=
The use of the EAC method implies that the project will be replaced by an identical project
A practical example
A manager must decide on which machine to purchase:
Machine A
Investment cost $50,000
Expected lifetime 3years
Annual maintenance $13,000
Machine B
Investment cost $150,000
Expected lifetime 8 years
Annual maintenance $7,500
The cost of capital is 5%.
The EAC for machine A is: ($50,000/A
3,5
)+$13,000=$31,360
The EAC for machine B is: ($150,000/A
8,5
)+$7,500=$30,780
Where A is the loan repayment factor for t years and 5% cost of capital.
The conclusion is to invest in machine B since it has a lower EAC.
Alternative method:
The manager calculates the NPV of the machines:
MachineA EAC = $85,400/A
3,5
=$31,360
Machine B EAC = $198,474/A
8,5
=$30,708
The result is the same, although the first method is easier it is essential that the annual
maintenance cost is the same each year.
Alternatively the manager can use the NPV method under the assumption that the machines
will be replaced with the same cost of investment each time. This is known as the chain
method since 8 repetitions of machine A are chained together and 3 repetitions of machine B
are chained together. Since the time horizon used in the NPV comparison must be set to 24
years (3*8=24) in order to compare projects of equal length, this method can be slightly more
complicated than calculating the EAC. In addition, the assumption of the same cost of
investment for each link in the chain is essentially an assumption of zero inflation, so a real
interest rate rather than a nominal interest rate is commonly used in the calculations.
3. OTHER RELATED CONCEPTS OF CAPITAL
BUDGETING:
CAPITAL EXPENDITURE
Capital expenditures (CAPEX or capex) are expenditures creating future benefits. A capital
expenditure is incurred when a business spends money either to buy fixed assets or to add to
the value of an existing fixed asset with a useful life that extends beyond the taxable year.
Capex are used by a company to acquire or upgrade physical assets such as equipment,
property, or industrial buildings. In accounting, a capital expenditure is added to an asset
account ("capitalized"), thus increasing the asset's basis (the cost or value of an asset as
adjusted for tax purposes). Capex is commonly found on the Cash Flow Statement as
"Investment in Plant Property and Equipment" or something similar in the Investing subsection.
For tax purposes, capital expenditures are costs that cannot be deducted in the year in which
they are paid or incurred, and must be capitalized. The general rule is that if the property
acquired has a useful life longer than the taxable year, the cost must be capitalized. The
capital expenditure costs are then amortized or depreciated over the life of the asset in
question. As stated above, capital expenditures create or add basis to the asset or property,
which once adjusted, will determine tax liability in the event of sale or transfer. In the US,
Internal Revenue Code 263 and 263A deal extensively with capitalization requirements and
exceptions. Included in capital expenditures are amounts spent on:
3. acquiring fixed assets
4. fixing problems with an asset that existed prior to acquisition
5. preparing an asset to be used in business
6. legal costs of establishing or maintaining one's right of ownership in a piece of property
7. restoring property or adapting it to a new or different use
8. starting a new business
An ongoing question of the accounting of any company is whether certain expenses should be
capitalized or expensed. Costs that are expensed in a particular month simply appear on the
financial statement as a cost that was incurred that month. Costs that are capitalized, however,
are amortized over multiple years. Capitalized expenditures show up on the balance sheet.
Most ordinary business expenses are clearly either expensable or capitalizable, but some
expenses could be treated either way, according to the preference of the company.
The counterpart of capital expenditure is operational expenditure ("OpEx").
CORPORATE FINANCE
Corporate finance is an area of finance dealing with the financial decisions corporations make
and the tools and analysis used to make these decisions. The primary goal of corporate
finance is to maximize corporate value while reducing the firm's financial risks. Although it is in
principle different from managerial finance which studies the financial decisions of all firms,
rather than corporations alone, the main concepts in the study of corporate finance are
applicable to the financial problems of all kinds of firms.
The discipline can be divided into longterm and shortterm decisions and techniques. Capital
investment decisions are longterm choices about which projects receive investment, whether
to finance that investment with equity or debt, and when or whether to pay dividends to
shareholders. On the other hand, the short term decisions can be grouped under the heading
"Working capital management". This subject deals with the shortterm balance of current
assets and current liabilities; the focus here is on managing cash, inventories, and shortterm
borrowing and lending (such as the terms on credit extended to customers).
The terms Corporate finance and Corporate financier are also associated with investment
banking. The typical role of an investment banker is to evaluate investment projects for a bank
to make investment decisions.
PERSONAL FINANCE
Personal finance is the application of the principles of finance to the monetary decisions of an
individual or family unit. It addresses the ways in which individuals or families obtain, budget,
save and spend monetary resources over time, taking into account various financial risks and
future life events. Components of personal finance might include checking and savings
accounts, credit cards and consumer loans, investments in the stock market, retirement plans,
social security benefits, insurance policies, and income tax management.
Personal financial planning
A key component of personal finance is financial planning, a dynamic process that requires
regular monitoring and reevaluation. In general, it has five steps:
1. Assessment: One's personal financial situation can be assessed by compiling
simplified versions of financial balance sheets and income statements. A personal balance
sheet lists the values of personal assets (e.g., car, house, clothes, stocks, bank account),
along with personal liabilities (e.g., credit card debt, bank loan, mortgage). A personal income
statement lists personal income and expenses.
2. Setting goals: Two examples are "retire at age 65 with a personal net worth of
$200,000 American" and "buy a house in 3 years paying a monthly mortgage servicing cost
that is no more than 25% of my gross income". It is not uncommon to have several goals,
some short term and some long term. Setting financial goals helps direct financial planning.
3. Creating a plan: The financial plan details how to accomplish your goals. It could
include, for example, reducing unnecessary expenses, increasing one's employment income,
or investing in the stock market.
4. Execution: Execution of one's personal financial plan often requires discipline and
perseverance. Many people obtain assistance from professionals such as accountants,
financial planners, investment advisers, and lawyers.
5. Monitoring and reassessment: As time passes, one's personal financial plan must be
monitored for possible adjustments or reassessments.
Typical goals most adults have are paying off credit card and or student loan debt, retirement,
college costs for children, medical expenses, and estate planning.
An operating expense, operating expenditure, operational expense, operational
expenditure or OPEX is an ongoing cost for running a product, business, or system. Its
counterpart, a capital expenditure (CAPEX), is the cost of developing or providing non
consumable parts for the product or system. For example, the purchase of a photocopier is the
CAPEX, and the annual paper and toner cost is the OPEX. For larger systems like businesses,
OPEX may also include the cost of workers and facility expenses such as rent and utilities.
In business, an operating expense is a daytoday expense such as sales and administration,
or research & development, as opposed to Production, costs, and pricing. In short, this is the
money the business spends in order to turn inventory into throughput. Operating expenses
also include depreciation of plants and machinery which are used in the production process.
On an income statement, "operating expenses" is the sum of a business's operating expenses
for a period of time, such as a month or year.
In throughput accounting, the cost accounting aspect of Theory of Constraints (TOC),
operating expense is the money spent turning inventory into throughput. In TOC, operating
expense is limited to costs that vary strictly with the quantity produced, like raw materials and
purchased components. Everything else is a fixed cost, including labour unless there is a
regular and significant chance that workers will not work a fulltime week when they report on
its first day.
In a real estate context, operating expenses are costs associated with the operation and
maintenance of an income producing property. Operating expenses include accounting
expenses license fees maintenance and repairs, such as snow removal, trash removal,
janitorial service, pest control, and lawn care, advertising, office expenses, supplies, attorney
fees and legal fees, utilities, such as telephone insurance, property management, including a
resident manager, property taxes, travel and vehicle expenses
Travel expenses are defined as those incurred in the event of travel required for professional
purposes.
For this purpose, travel is defined as the simultaneous absence from the residence and from
the regular place of employment. It is prompted by professional or company purposes and
likely does not concern the travellers private life, or concerns it only to a small degree. Travel
expenses include travel costs and fares, accommodation expenses, and socalled additional
expenses for meals. For the selfemployed (contractors and freelancers), the expenses
constitute business expenses.
4. A DETAILED UNDERSTANDING OF THE MAIN TECHNIQUES OF
CAPITAL BUDGETING:
A variety of measures have evolved over time to analyze capital budgeting requests. The
newer methods use time value of money concepts. Older methods, like the payback period,
have the deficiency of not using time value techniques and will eventually fall by the wayside
and be replaced in companies by the newer, superior methods of evaluation.
The newer methods have one thing in common: they conduct a test to see if the benefits (i.e.,
cash inflows) are large enough to repay the company for three things: (1) the cost of the asset,
(2) the cost of financing the asset (e.g., interest), and (3) a rate of return (called a risk
premium) that compensates the company for potential errors made when estimating cash flows
that will occur in the distant future.
Let's take a look at the most popular techniques for analyzing a capital budgeting proposal.
1. Net Present Value (NPV)
Using the hurdle rate as the required rate of return, the net present value of an investment is
the present value of the cash inflows minus the present value of the cash outflows. A more
common way of expressing this is to say that the net present value (NPV) is the present value
of the benefits (PVB) minus the present value of the costs (PVC)
NPV = PVB  PVC
By using the hurdle rate as the discount rate, we are conducting a test to see if the project is
expected to earn our minimum desired rate of return. Here are our decision rules:
If the NPV is: Benefits vs. Costs Should we expect to earn
at least our minimum rate
of return?
Accept the
investment?
Positive Benefits > Costs Yes, more than Accept
Zero Benefits = Costs Exactly equal to Indifferent
Negative Benefits < Costs No, less than Reject
Very important: Notice that, if the NPV is positive, it says that the company expects to receive
benefits that are large enough to repay the company for (1) the asset's cost, (2) the cost of
financing the project, and (3) a rate of return that adequately compensates the company for the
risk found in the cash flow estimates. If the NPV is negative, the benefits are not large enough
to cover all three of the above, and therefore the project should be rejected.
2. Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is the discount rate that will cause the present value of the
benefits to equal the present value of the cost. In other words, the IRR is the situation
described in the middle line of the above table. We use a trialanderror process to find this
percentage rate.
We generally start by conducting a test using the hurdle rate. This will tell us whether the
project is expected to earn us more than or less than the hurdle rate.
Test
Results
Interpretation of Results Next percentage
to be tested?
PVB > PVC
The project is expected to earn
more than the percentage rate
used for the test
A higher rate
PVB < PVC
The project is expected to earn
less than the percentage rate
used for the test
A lower rate
It isn't necessary to test in increments of one percent (e.g., 10%, 11%, 12%, etc.). Once you
have conducted the test using the hurdle rate, compare the PVB and PVC. If the two numbers
are relatively close to one another, the IRR is relatively close to the hurdle rate. If the PVB is
well away from the PVC, you will need to choose a percentage rate that is well away from the
hurdle rate for your second test.
We continue the testing until we find a range of values for the IRR. In other words, we need to
know that the IRR is greater than some percentage number and less than some percentage
number (e.g., greater than 10% and less than 15%). In the interest of accuracy, keep this
range to 5% or less, e.g., greater than 12% and less than 13% is ideal, greater than 10% and
less than 15% is O.K., greater than 10% and less than 20% is not acceptable for the range.
We then set up a proportion and interpolate to find the IRR.
Calculation of the IRR
Assume that we are evaluating a project that has a cost of $100,000. Using the hurdle rate, we
obtain a PVB of $103,000. Comparing the PVB of $103,000 to the PVC of $3,000, this tells us
that the project is expected to earn a rate higher than 10%. So we choose a higher rate for our
second test. Since the gap between $103,000 and $100,000 is small (in relative terms), we
shouldn't have to go far.
Let's choose 15% for our second test. Using this as our discount rate, we obtain a PVB of
$98,000. Since the PVB is now less than the PVC, the IRR is less than 15%. We now have our
range: the IRR is between 10% and 15%.
We are searching for the discount rate that will cause the PVB to equal the PVC. Here is what
we know so far:
Percentage Tested PVB
10% $103,000
IRR $100,000
15% $ 98,000
Notice that we place the smaller percentage number on top (to simplify the arithmetic later). On
the middle row, the IRR is the discount rate that will give us a PVB exactly equal to the PVC of
$100,000.
Let's call the distance between 10% and the IRR (above) a distance of x. The ratio of this
distance to the distance between the outside two numbers (i.e., 10% and 15%) should be the
same for both columns. In other words, we can set up a proportion using this: the ratio of the
difference between the top two numbers and the outside two numbers is the same for both
columns. That is: x is to 5% as $3,000 is to $5,000.
x/ 5%
=
$3,000 / $5,000
X = $3,000 / $5,000 * 5%
X = 0.60 * 5%
X = 3.0%
If x is 3.0%, then the IRR is 3% away from 10% and is larger than 10% (since we know that the
IRR is between 10% and 15%); therefore, the IRR must be 13.0%.
WHICH METHOD IS BETTER: THE NPV OR THE IRR?
Surveys show that the IRR method is the more popular of the two methods (by a small
margin). However, the NPV is superior to IRR for at least two reasons:
9. The NPV assumes that the cash inflows are reinvested to earn the hurdle rate; the IRR
assumes that the cash inflows are reinvested to earn the IRR. Of the two, the NPV's
assumption is more realistic in most situations.
2. It is possible for the IRR to have more than one solution. If the cash flows experience a
sign change (e.g., 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 number that will cause the PVB to equal the PVC. (When this occurs, we
simply don't 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.
3.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 cash inflows (which are received at the end of each year)
are assumed to be reinvested at the hurdle rate for the remainder of the project's life.
Using the hurdle rate, the MIRR technique calculates the present value of the cash outflows
(i.e., the 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 future value of the benefits. In this
way, the two problems mentioned previously are overcome:
1. the cash inflows are assumed to be reinvested at the firm's hurdle rate, and
2. there is only one solution to the technique.
Calculation of the MIRR
Assume that we are evaluating a project that has a cost of $30,000, aftertax cash inflows of
$10,000 per year for four years, and a hurdle rate of 10%.
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 1st year's cash inflow is assumed to be
reinvested for 3 years, so we multiply it times the future value factor for 10% and year 3 (i.e.,
1.331). The 2nd year's cash inflow is assumed to be reinvested for 2 years, so we multiply it
time the future value factor for 10% and year 2 (i.e., 1.210). Year 3's cash inflow is invested for
1 year and year 4's cash inflow is received at the end of the 4th year, so it is not available for
reinvestment since it coincides with the end of the project's life.
Year Years
Reinvested
Cash
Inflow
Future Value Factor
(at 10%)
Future
Value
1 3 $10,000 1.331 $13,310
2 2 $10,000 1.210 $12,100
3 1 $10,000 1.100 $11,000
4 0 $10,000 1.000 $10,000
Total $46,410
Now, the only question remaining is: If I invest $30,000 in an account today and receive the
equivalent of $46,410 in four years, what rate would be earned on the investment? We can find
the MIRR in one of two ways:
1. The trialanderror technique that was used earlier to find the IRR. Using any discount
rate, like 10%, take the present value of the $46,410 received four years from now.
(This is $31,699.) Since the present value of the benefits ($31,699) is larger than the
present value of the cost ($30,000), we need to use a higher discount rate, like 12%. At
12%, the present value is $29,494. Since the PVB is now less than the PVC, the MIRR
is less than 12%. We now have our range: the MIRR is between 10% and 12%.
We are searching for the discount rate that will cause the PVB to equal the PVC. Here is
what we know so far:
Percentage Tested PVB
10% $31,699
MIRR $30,000
12% $29,494
On the middle row, the MIRR is the discount rate that will give us a PVB equal to the
PVC of $30,000.
Let's call the distance between 10% and the MIRR (above) a distance of x. The ratio of
this distance to the distance between the outside two numbers (i.e., 10% and 12%)
should be the same for both columns. In other words,
x / 2%
=
$1,699 / $2,205
x = $1,699 / $2,205 * 2%
x = 0.7705 * 2%
x = 1.54%
If x is 1.54%, then the MIRR is 1.54% away from 10% and is larger than 10% (since we
know that the MIRR is between 10% and 12%); therefore, the MIRR must be 11.54%.
2. As an easier alternate method, we can solve for the geometric mean return.
a. Divide the future value by the present value (i.e., $46,410/$30,000) to get a value
of 1.547. Notice that this is the value that $1.00 would grow to in 4 years if
invested at the hurdle rate of 10%.
b. Set the result to the 1/n power (where n = 4 years). If you have a ytothex key
on your calculator, simply enter 1.547 as the yvalue and 0.25 (i.e., 1/4) as the x
value, and solve. The result is 1.1153.
c. Subtract 1.0 from the answer and place the answer (0.1153) in percentage form.
The answer is the MIRR of 11.53%.
4. Payback Period
The Payback Period is the weakest of the capital budgeting methods discussed here. By
definition, the payback period is the length of time that it takes to recover your investment. The
payback period of the illustration immediately above is 3.0 years. (To recover $30,000 at the
rate of $10,000 per year would take 3.0 years.)
Other Issues
1. Sunk Costs  Costs that have been incurred in the past and cannot be recovered are
not relevant to the analysis. These costs are called sunk costs. The only cash flows that
matter are those that will change if we decide to accept the project. These cash flows
are called incremental cash flows (or relevant cash flows).
2. Inflation  With the passage of time, inflation will have an impact on the cash flows
(e.g., wage rates will likely increase in the future as a result of inflation). Should the cash
flows be adjusted for the impact of inflation? The answer is: You have to be consistent
in the relationship between the discount rate and the cash flows.
a. If the discount rate includes an inflation premium (as it almost always will), then
the cash flows should reflect the impact of inflation as well.
b. If the cash flows do not include the impact of inflation, then the inflation rate
should be deducted from the discount rate.
3. Scale Effect  If we are considering mutually exclusive proposals and the assets (e.g.,
machines) cost different amounts, there is a potential bias in favor of accepting the more
expensive asset, simply because of the larger size of the price tag. For example, we
may consider investing in either:
Asset A, which cost $100,000 and has an NPV of $3,000, or
Asset B, which cost $300,000 and has an NPV of $3,100.
If we make our decision based solely on the NPV's dollar amount, we would choose
asset B since it has the higher NPV. However, per dollar invested, asset A obviously
has the higher return. If the cost of the two assets differ by a considerable amount, we
should use the profitability index instead of the NPV to make our decision.
The profitability index, by definition, is the ratio of the present value of the benefits
(PVB) to the present value of the cost (PVC). This will remove the scale effect's bias.
We obviously prefer the asset that has the higher value for the profitability index.
4. Unequal Lives  If we are comparing mutually exclusive proposals and the assets (e.g.,
machines) have different lives, there is a bias in favor of accepting the longerlived
asset. To see how to eliminate this bias, read this coverage of replacement chains.
5. Capital Budgeting Uncertainty and Risk:
1. While the riskadjusted discount rate method provides a means for adjusting the riskiness
of the discount rate, the certainty equivalent method adjusts the estimated value of the
uncertain cash flows.
The riskadjusted discount rate method extends the cash flow valuation model under certainty
to the uncertainty case as follows:
1
(1 )
N
t
t
t t
X
V
r
=
=
+
,
where
V = value of Capital budgeting project,
t
X
= median or mean of the expected risky cash flow t distribution X
t
,
r
t
= the risk adjusted discount rate appropriate to the riskiness of the uncertain cash flows
t
X
,
N = the life of the project.
The certainty equivalent method uses the rationale that given a risky cash flow, the decision
maker will evaluate this cash flow according to an expected utility, the utility estimate being
hypothesized to be equal to utility derived from some certain cash flow amount. The decision
maker performs this process for each cash flow. The valuation model is as follows:
1
(1 )
N
t
t
t
C
V
i
=
=
+
,
where
C
t
= certainty equivalent cash flow at period t,
i = riskless interest rate.
C
t
can be expressed as a fraction of the expected value of the cash flow as follows:
t t t
C X o =
,
where
t
o
= some fractional value.
The valuation formula becomes
1
(1 )
N
t t
t
t
X
V
i
o
=
=
+
.
Since both models evaluate future uncertain cash flows, they should yield the same value for a
given cash flow stream. The present value of each periods cash flows should be the same.
(1 ) (1 )
t t t
t
t t
t
X X
PV
i R
o
= =
+ +
(1 )
(1 )
t
t
t
t
i
r
o
+
=
+
(1/ ) (1/ 1)
1
1
(1 ) (1 )
1 1
( ) ( )
t t
t t
t t
i i
r r
o o
+
+
+
( ( + +
= =
( (
From the 2 values of r at time t and t + l, the riskadjusted discount rate r
t
s will be a function of
(1) the investors attitude toward risk measured by r
t
, (2) the riskfree interest rate, and (3) the
time period t.
2. a. The risk adjusted discount rate method (RADR) is similar to the NPV. It is defined as
the present value of the expected or mean value of future cash flow distributions
discounted at a discount rate, k, which includes a risk premium for the riskiness of the
cash flows from the project. It is defined by the following equation:
0
1
(1 )
N
t
t
t
X
NPV I
k
=
=
+
b. The certainty equivalent method (CE) adjusts for risk directly through the expected
value of the cash flow in each period and then discounts these risk adjusted cash flows by the
risk free rate of interest, R
f
. The formula for this method is given as follows:
0
1
(1 )
N
t t
t
t
f
X
NPV I
R
o
=
=
+
c. Simulation is a method in which the specific capital budgeting decision is modeled with
all uncertain variables being treated as random variables. A detailed discussion of this method
is given on pp.520 thru 524.
d. A decision tree approach is used to analyze investment opportunities involving a
sequence of decisions over time. A detailed discussion of the method is given in pp.515520.
3. The major difference between the RADR and CE methods is that the RADR method
adjusts for risk in the discount rate while the CE method adjusts the cash flows for risk and
then discounts at a riskfree rate of interest.
4. Net present value and standard deviation of NPV are estimated in performing capital
budgeting using a probabilistic distribution approach. The mean and standard deviation of
the NPV distribution are defined as
0
1
(1 ) (1 )
N
t t
t N
t
C S
NPV I
k k
=
= +
+ +
1
2 2
2
1 1 1
( )
(1 )
N N N
t
NPV t T T t
t
t T t
WW Cov C C
k
o
o
= = =
(
= +
(
+
where C
t
= uncertain net cash flow in period t,
k = risk adjusted discount rate,
S
t
= salvage value,
I
0
= initial outlay,
2
= variance of the cash flow,
W
T
, W
t
= discount factors in the T
th
and t
th
periods.
Cov(C
T
C
t
) is used to measure the co variability between the cash flow in the T
th
and 5
th
periods. Cov(C
T
C
t
) can also be written
Tt
t
, where
Tt
is the correlation coefficient.
Furthermore, we can define equations that can be used to analyze investment proposals in
which some of the expected cash flows are closely related (significantly correlated) and others
are fairly independent. The standard deviation of NPVs for each case are:
1
1
N
t
t
t
NPV
k
=
=
+
perfect correlation
1
2 2
2
1
(1 )
N
t
NPV
t
t
k
o
o
=
(
=
(
=
mutually independent
If cash flows show less than perfect correlation, this model is inappropriate and the problem
must be handled with a series of conditional probability distributions. In Boninis model, cash
flow amounts are uncertain but probabilities associated with cash flows in a given period are
assumed to be known. Laterperiod expected cash f1ows aye highly dependent on what
occurs in earlier time periods. Joint probabilities are found for the various cash flow series.
Finally, the NPV for each cash f1ow series is calculated using the conditional probabi1ities.
These series of NPVs are then multiplied by each joint probability and assumed. The result is
the NPV and associated standard deviation for the project as a whole.
The decisiontree method of capital budgeting analyzes investment opportunities involving a
sequence of decisions over time. Various decision points are defined in relation to subsequent
chance events. The NPV for each decision stage is computed on the series of NPVs and
probabilities that branch out or follow the decision point in question. In other words, once the
range of possible decisions and chance events are laid out in treediagram form, the NPVs
associated with each decision are computed by working backwards on the diagram from the
expected cash flows defined for each path on the diagram.
The optimal decision path is chosen by selecting the highest expected NPV for the first
stage decision. Standard deviations for each firststage NPV should be computed to determine
risks associated with each decision. If there is no dominant decision (e.g., if NPV is highest,
but so is standard deviation), the decision becomes a function of the risk attitudes of
management.
Both capital budgeting methods described use expected NPVs and risk measures
associated with the NPVs.
In the probability distribution method, risk is defined in terms of the correlation among cash
flows in the various time periods throughout the projects life. With each subsequent time
period, later cash flow distributions are influenced by prior CF distributions. This model
assumes that the CF distributions are known as are the probabilities associated with each flow,
and that once an investment decision is made, the management is locked into that project
decision.
In the decisiontree method, there is a sequence of investment decisions whose probability
distributions can take on several values. The manager does not become locked into one
decision but rather has a range of possible outcomes as a result of a prior choice from among
several alternatives. Cash flows and NPVs are computed for each alternative series of possible
decisions. An optimal decision path is chosen by evaluating the NPV and associated standard
deviations of that NPV for each of the alternative firststage decisions.
5. Because the number of random variables associated with capital budgeting under
uncertainty may be large, it may be impossible to represent these in a model. To simulate
the distribution of NPV or IRR, simulation analysis explicitly uses ranges of values for
inputs such as market, investment cost, operating, and fixed cost information. The
manager is better able to incorporate detailed information into the decision process
through simulation methods.
Procedure steps:
a) Random and deterministic variables are defined.
b) Value ranges for random variables are defined.
c) By mean of a random number generator, random numbers are chosen for each
random variable.
d) From these random numbers, a set of values is created for each random variable.
e) For each simulation, a series of cash flows and NPVs is calculated.
f) Mean NPV, variance, and standard deviation are calculated from the NPVs from each
simulation.
g) Sensitivity analysis can be performed if ranges or distributions require change.
6. The statistical distribution method requires that the probability distribution of cashflows
be specified for each period of the projects life. Using these probability distributions, the
mean and variance of the projects NPV can be calculated. A detailed discussion of this
method and examples are presented on pp.509 thru 515 and in Section 13.5.1.
7. Inflation can introduce bias into the accept/reject decision when the cost of capital rate
contains an element recognizing expected future rates of inflation whereas the cash flow
estimates dont include a similar component.
There is a need to adjust the discount rate for inflation in that the noninflationary required
rate of return should be grossed up by the expected rate of inflation.
Present prices for physical goods cant be viewed as already accounting for future inflation;
hence we need to derive estimates of the impact of future inflation on prices.
The need to adjust depreciation levels for inflation is critical, because depreciation is based
on the historical cost of the asset. The adjustment is to keep the firms tax shield in line with
current price levels so that inflation doesnt have an adverse impact on capital investment.
(See also Nelsons 5 propositions in question 6 Chapter 9.)
A variety of adjustments can be made to account for inflationary effects. These include the
riskadjusted discount rate, the certainty equivalent method, adjustments to the inflation
adjustment term used in the riskadjusted discount rate and the certainty equivalent methods,
solving for the optimal level of investment given anticipated changes in price levels, and
estimating future cash flows by taking inflation into account.
8. The multi period capital budgeting decision problem can be solved by the product life
cycle (PLC) approach, the Capital Asset Pricing Model method, or by using the mean
variance framework.
A products life cycle can be broken up into 4 stages: development, growth, stabilization, and
decline. Using this framework we can examine cash flows associated with each stage in the
life cycle so that even verylongterm projects becomes easier to analyze.
Beyond forecasting future cash flows, the PLC approach aids financial planning in terms of
determining financing needs and the ability of the firm to implement given dividend policies.
PLC facilitates cashflow smoothing so as to reduce the firms business risk.
From PLC, risk is embedded into the estimated cash flows according to what stage the
product is in. In the introductory phase, market acceptance or rejection of the product
determines what cash flows will follow. During the growth stage cash flows increase, whereas
at maturity they level off, and during decline they fall. This sequence can be modeled using a
decisiontree format by estimating future cash flows and attaching probabilities to those
estimates. NPVs can then be computed along with expected variances. Projects at different
lifecycle phases can be combined to smooth the aggregate cash flow stream.
The CAPM can be extended for multi period use with several assumptions concerning
homogeneous expectations relating to the investment projects success and the assumption
that there exists a single price of risk. With perfect capital markets for physical capital, the multi
period project can be thought of as a series of singleperiod projects where the physical capital
employed could be sold at its endofperiod market value. The critical point here is whether the
oneperiod return is considered favorable. If perfect secondary markets dont exist, expected
salvage value must be built into the model. Depending on the degree of market imperfection,
projects may be rejected on the basis of this revised secondary market value estimate. To the
extent that the capital is resalable at perfect market prices, the singleperiod procedure is
viable.
9. Black and Scholes Option Pricing Model (OPM) has enabled financial planners to use
statepreference models in realworld decision making. The basic model is:
1 1
n s
st st
s s
PV V Z
= =
=
,
where PV = present value of the project,
V
st
= current value of a dollar for state s and time t,
Z
st
= present value of cash flow for state s and time t.
The following steps are involved in solving this equation: Expected cash flows and prices of
money are formulated for different possible states of the economy (i.e., boom, normal, or
recession). The state prices (V
st
) are estimated using the OPM. The only changes in the option
values formula are that here there is no exercise price and that the payoff is limited to $1. The
above equation is solved and the PV obtained is compared with the initial level of investment. If
the present value is greater than the investment, the project is accepted. This can be extended
to a multiperiod framework.
10. a) Yes, Project A is less risky than Project B, since the coefficient of variation of Project A
is smaller than that of Project B.
b) NPV(A) = ($15,000)(3.791) $60,000
= $56,865 $60,000
= $3,135
NPV(B) = ($25,000)(3.791) $80,000
= $94,775 $90,000
= $4,775
If cash flows over time are positively perfectly correlated, then
(A) = (.2)($15,000)(3.791) = $11,373
(B) = (.4)($25,000)(3.791) = $37,910
c) Information from (b) can be used to do internal inferences; e.g.,
Pr. ( $3,135 2($11.373)) = 99.45%
Pr. ($4,775 2($37,910)) = 99.45%
d) Capital budgeting under uncertainty is a generalized case of capital budgeting under
certainty; thus basic financial capital budgeting theory and methodology is useful in both cases.
11.
5
1
600
2000
1 ( )
t
t
i
NPV
E R =
= +
+
( ) 5 10 15%
i
E R = + =
5
1
2000 521.73 433.68 394.51
600
2000
(1
343.05 298.31
1 .28
1
1
. 5)
t
t
NPV
=
= + + + + +
+
=
=
+
12.
a. E(R
i
) = 5 + 1.8(7) = 17.6%
b.
2 3
1000 1000 1000
2200
(1 .176) (1 .176) (1 .176)
NPV = + + +
+ + +
2200 850.34 723.08 614.86
11.72
+ + +
=
=
Since the NPV is less than zero, the project should be rejected.
c. If net income in the third year is certain, the relevant required rate of return is equal to
the risk free rate for the third period. Thus,
3
850.34 723.08
1000
2200
(1 .05)
NPV = + + +
+
2200 850.34 723.08 863.84
237.26
= + + +
=
Since the NPV is larger than zero, the project would be acceptable.
13.
a. Expected cash flow = (.3)(1000) + (.4)(3000) + (.3)(4000)
= 300 + 1200 + 1200 = 2700
Required rate of return = 5% + 2(10% 5%) = 15%
2700
2000 347.83
(1 .15)
NPV = =
+
b. NPV = 347.83 = I +
2500
(1 .05) +
Thus,
I = 347.83 + 2427.18 = 2079.35
The initial cost for project B is 2079.35 so that project B has the same NPV as project A.
14.
Recall that E(R
i
) = R
f
+
i
[E(R
m
) R
f
]
Thus,
E(R
i
) R
f
=
i
[E(R
m
) R
f
]
E(
i
X
V
) .05 =
i
[E(R
m
) .05]
E(R
m
) = .1
E(X
i
) = (400)[.2/(.2 + .1 + 0)] + (600)[.1/(2 + .1 + 0)] = 466.67
Eq.(1): E(
i
X
V
) .05 =
466.67
V
.05 = (.1 .05)
E(R
m
) = .15
E(X
i
) = (400)[.1/(.1 + .2 + .1)] + (600)[.1/(.1 + .2 + .1] + (800)[.1/(.1 + .2 + .1)] = 600
Eq.(2):
600
V
.05 = (.15 .05)
E(R
m
) = .20
E(X
i
) + 400[0/(0 + .1 + .2 + ] + 600[.1/.3] + 800[.2/.3] = 733.33
Eq.(3):
733.33
V
.05 = (.20 .15)
Solving for and V in equations (1), (2), and (3) we find that V = $6666.67 which is greater
than 6500. Thus, accept the opportunity.
15.
( )
( ) 15%
i
o
E X
E R
V
= =
1000
$6667
.15
o
V = =
1
( ) [ ( ) ]
1000 6667(.15 .05)
333.33
.05
o m f
f
E X V E R R
CE
R

= = =
16.
a. E(R
A
) = (.3)(25) + (.4)(15) + (.3)(5) = 15%
E(R
B
) = (.3)(30) + (.4)(15) + (.3)(0) = 15%
Var(R
A
) = (.3)(25 15)
2
+ (.4)(15 15)
2
+ (.3)(5 15)
2
= 30 + 0 + 30 = 60
Var(R
B
) = (.3)(30 15)
2
+ (.4)(15 15)
2
+ (.3)(0 15)
2
= 6.75 + 0 + 6.75 = 135
Project A has the same expected return as project B, but has a lower variance. Thus, project A
is preferred.
b. E(R
m
) = (.3)(20) + (.4)(10) + (.3)(0) = 10%
Var(R
m
) = (.3)(20 10)
2
+ (.4)(0) + (.3)( 10)
2
= 30 + 0 + 30 = 60
Project A:
C0V(R
A
, R
M
) = (.3)(25 15)(20 10) + (.4)(15 15)(10 10)
+ (.3)(5 15)(0 10)
= 30 + 0 + 30 = 60
60
1.00
60
A
 = =
E(R
A
) = 7 + 1.00(10 7) = 10.00%
Project B:
E(R
m
) = 10 %
COV(R
B
, R
m
) = (.3)(30 15)(20 10) + (.4)(15 15)(10 10)
+ (.3)(0 15)(0 10) = 90
90
1.5
60
A
 = =
Thus,
E(R
B
) = 7 + 1.5(10 7) = 11.5%
17.
a.
1
1
( , )
[ ( ) ( ( ) )]
m
m f f
m
X R
CE E X COV E R R R
VarR
=
50
[450 (.12 .06)] .06
.02
(450 150) 0.06 5000 the firm's value
=
= = =
b.
1
0
( , )
( ) [ ( ) ]
m
i f m f
m
X
COV R
V
E R R E R R
VarR
= +
50 5000
6 (12 6)
.02
6 3 9%
= +
= + =
c. It implies a good opportunity for investors to invest in this company.
18.
a. Expected Value of Annual Cash Flows:
Project L
Yr.1
1 CF
= (.4)(300) + (.6)(400) = 360
Yr.2
2 CF
= (.2)(200) + (.5)(500) + (.3)(700) = 500
Project K
Yr. 1
1 CF
= (.5)(400) + (.5)(600) = 500
Yr. 2
2 CF
= (.3)(400) + (.4)(600) + (.3)(800) = 600
b. 1) RADR
R
L
= 6 + 0.9(12 6) = 11.4%
R
k
= 6 + 1.2(12 6) = 13.2%
1 2
360 500
323.16 402.90 726.06
(1 .114) (1 .114)
L
NPV = + = + =
+ +
1 2
500 600
441.70 468.23 909.93
(1 .132) (1 .132)
K
NPV = + = + =
+ +
NOTE: There is no initial investment in this project. Since NPV
k
> NPV
L
project K is preferred.
2) CE
Project L:
2
1 2 2
(1.06) (1.06)
0.9515 0.9054
(1 .114) (1 .114)
o o = = = =
+ +
Project K:
2
1 2 2
1.06 (1 .06)
0.9364 .8768
1 .132 (1 .132)
o o
+
= = = =
+ +
3) CE CAPM
There is a problem with applying the CE CAPM formulation for this problem in that the CE
CAPM is a oneperiod model and/or assumes an annuity. Students might try to apply the
formulation on page 222 of the text (in the discussion under equation 84) which relies on the
initial investment to arrive at an estimate of the COV(X
1
, R
m
). It is restated below:
2
2
1
[1 ( )( )( )[ ( ) ]]
(1 )
t M o M f
o t
t
f
X I E R R
V
R
 o
=
=
+
Since I
0
= 0, then V
0
is just the PV of
X
discounted at the R
f
rate.
2
500 600
1005.70
(1 .06) (1 .06)
K
NPV = + =
+ +
2
360 500
784.62
(1 .06) (1 .06)
L
NPV = + =
+ +
It should be pointed out to the students that an approximation of the CE CAPM formulation for
more than one period is given as follows:
2
1
[ ( , ) ][ ( ) ]
(1 )
n
t t Mt m M f
t
t
f
X COV X R E R R
NPV
R
o
=
=
+
If a COV(X
1
, R
m
) = COV(X
2
, R
M
) = 50 for both projects is assumed, then the projects NPVs
would be as follows:
2
[ ( ) ]
[ ( , )] (50)(.06) .02 150
m f
t Mt
M
E R R
COV X R
o
= =
Then,
1 2
360 150 500 150
509.61
(1 .06) (1 .06)
L
NPV
= + =
+ +
1 2
500 150 600 150
730.69
(1 .06) (1 .06)
K
NPV
= + =
+ +
19.
a. CE coefficients
Project L:
1
200
0.5555
360
o = =
2
300
0.6000
500
o = =
Project K:
1
300
.6000
500
o = =
2
400
.6670
600
o = =
b. CE Method
1 2
200 300
188.68 267.00 455.68
(1 .06) (1 .06)
L
NPV = + = + =
+ +
1 2
300 400
283.02 356.00 639.02
(1 .06) (1 .06)
K
NPV = + = + =
+ +
20.
The certainly equivalent and the RADR methods give the same present value whenever:
(1 )
(1 )
t
f
t t
R
k
o
+
=
+
where k represents the risk adjusted discount rate.
21.
a.
1 2
700 900
( ) 500 880.16
(1 .10) (1 .10)
E NPV = + + =
+ +
2 2
1/
/
4
1 2
2
2
[33, 057.53 61, 471.21
(200) (300)
[ ]
] [94528.74
(1 .10) (1 .1
]
$307.45
0)
NPV
o
= +
=
= +
+
=
+
b.
1 2
700 900
( ) 500 880.16
(1 .10) (1 .10)
E NPV = + + =
+ +
1 2
200 300
[ ]
(1
181.82 247.93
429.7
.10) (1 10
5
. )
NPV
o
= +
=
= +
+ +
c. Since the projects have the same expected NPV, the one with the lower amount of risk
should be accepted.
22.
a. Project:
1 CF
= (.1)(4000) + (.8)(6000) + (.1)(8000) = 6000
2
1
o
= 800,000
1
= 894.43
2 CF
= (.3)(4000) + (.4)(6000) + (.3)(8000) = 6000
2
2
o
= 2,400,000
2
= 1549.19
2
1
6000
( ) ( ) 10, 000 699.8
(1 .08)
A B
t
E NPV E NPV
=
= = =
+
1 2
1 2
1 2
(1 ) (1 )
894.43 1549.19
(1 .08) (1 .08)
2156.27
NPVA
i i
o o
o = +
+ +
= +
+ +
=
2 2
1/ 2 1 2 1 2
2 4 3
1/ 2
2 4 3
2 0.5
[ ]
(1 ) (1 ) (1 )
800, 000 2, 400, 000 (05)(894.43)(1549.19)(2)
[ ]
(1 .08) (1 .08) (1 .08)
1884.08
NPVB
i i i
o o o o
o = + +
+ + +
= + +
+ + +
=
b. Portfolio
1) A and existing (E):
E(NPV)
pE+A
= E(NPV)
E
+ E(NPV)
A
= 10,000 + 699.8 = $10,699.80
pE+A
= [(5,000)
2
+ (2,156.27)
2
+ 2(5,000)(2,156.27)(0)]
1/2
= $5,445.13
2) B and existing
E(NPV)
PE+B
= E(NPV)
E
+ E(NPV)
B
= 10,000 + 699.8
= $10,699.8
PE+B
= [(5,000)
2
+ (1,884.08)
2
+ 2(5,000)(1,884.08)(0.3)]
1/2
= 5,848.25
c. Project A is preferred since E(NPV)
PE+A
equals E(NPV)
PE+B
but
PE+A
is less than
PE+B
.
23.
Without Phase II:
10 10
1 1
3, 000 5, 000
( ) 0.3[ ] 0.7[ ] 5, 000 $22, 036.24
(1 0.1) (1 0.1)
t t
t t
E NPV
= =
= + =
+ +
With Phase II:
3 7
3
1 4
3 7
3
1 4
3
1
5, 000 10, 000 1
( ) (0.7)(0.8)[ [ ] ]
(1 0.1) (1 0.1) (1 0.1)
5, 000 6, 000 1
(0.7)(0.2)[ [ ] ]
(1 0.1) (1 0.1) (1 0.1)
3, 000
(0.3)(0.5)[
(1 0.1)
t t
t t
t t
t t
t
t
E NPV
= =
= =
=
= +
+ + +
+ +
+ + +
+ +
+
7
3
4
3 7
3
1 4
3
4, 000 1
[ ] ]
(1 0.1) (1 0.1)
3, 000 1, 000 1
(0.3)(0.5)[ [ ] ]
(1 0.1) (1 0.1) (1 0.1)
7, 000
5, 000
(1 0.1)
26, 981.61
t
t
t t
t t
=
= =
+ +
+ +
+ + +
+
=
Since the expected NPV with Phase I is larger than that without it the implementation of two
stages is more profitable.
6. CAPITAL BUDGETING CASES (PREDECIDED):
A. FALCON AIRLINES, INC.
As owner of Falcon Airlines, you are considering the purchase of a new deicing machine.
The machine will be used to remove ice from the wings of Falcons planes during winter. The
new machine will cost $98,000, shipping costs of $2,000, and also will require $3,000 in
working capital to support the new machines operation. The equipment will be depreciated
over a 3year period using MACRS and will have an expected salvage value of $4,000 at the
end of its expected economic life of four years. The annual savings associated with the
machine are expected to be $25,000 per year for the next four years. The company will not
deduct the salvage value from the machines cost when calculating depreciation. The existing
deicing machine is one year old but is not adequate for the companys needs; it can be sold
today for $40,000. The equipment was purchased for $60,000 and was being depreciated over
a threeyear period using the MACRS method.
Falcon uses a hurdle rate of 11% for its capital budgeting projects and has a marginal tax rate
of 30%.
Determine whether you should purchase the new deicing machine.
CHANGE IN DEPRICIATION
DETRIMENTS OF CASH INFLOWS
Yr. Net Savings x (1 TR) + Change in x Tax Rate = Cash
Deprec. Inflow
1. $25,000 x 0.70 + $6,600 x $19,480
2. 25,000 x 0.70 + 35,620 x 28,186
3. 25,000 x 0.70 + 10,360 x 20,608
CASH OUTFLOWS (OR INITIAL INVETMENT)
Cost of New Assets $98,000
Shipping 2,000
Working Capital 3,000
Sale Proceeds (40,000)
Tax on Sales of Old Assets(see below) (6)
Total Cash Outflows (Initial Investment) $62,994
TAX ON SALE OF OLD ASSET
Original Cost $60,000 Selling Price $40,000
Acc. Depreciation 19,980  Book Value 40,020
Book Value $40,020 Gain (loss) $20
Tax Gain = Gain * Tax rate = ($20) x 30% = ($6)
4. 25,000 x 0.70 + 7,400 x 19,720
5. 0 x 0 + 0 x 0
6. 0 x 0 + 0 x 0
7. 0 x 0 + 0 x 0
8. 0 x 0 + 0 x 0
9. 0 x 0 + 0 x 0
10. 0 x 0 + 0 x 0
Does not include the Terminal Cash Flow( Shown below) Of $5,800
TERMINAL CASH INFLOWS (Year 4)
Working Capital $3,000
+ Salvage value of New Asset 4,000
 Tax on sale of New Asset
Salvage Value of New Asset $4,000
 Book Value 0
Gain/ Loss 4,000
x Tax Rate 30%
Tax on salvage Value  1,200
Total Terminal Cash Inflows $5,800
CASH OUTFLOWS CASH INFLOWS
(0) Cost of New Assets $98,000
Shipping 2,000
Working Capital 3,000
Sale Proceeds (40,000)
Tax on Sale of Old Assets (6)

P.V. OF COSTS= $62,994
Cash Flow x PVF PVB
(1) $19,480 x 0.901 = $17,550
(2) 28,186 x 0.812 = 22,876.
(3) 20,608 x 0.731 = 15,068
(4) 25,520 x 0.659 = 16,811
(5) 0 x 0.000 = 0
(6) 0 x 0.000 = 0
(7) 0 x 0.000 = 0
(8) 0 x 0.000 = 0
(9) 0 x 0.000 = 0
(10) 0 x 0.000 = 0

P.V OF BENEFITS $72,305
SUMMARY OF FINDINGS
Net Present Value $9,311
Internal Rate of Return 17.57%
Profitability Index = 1.15
MODIFIED INTERNAL RATE OF RETURN
CASH OUT FLOWS CASH INFLOWS
Cost of New Asset $98,000
Shipping $2,000
Working Capital $3,000
Sale Proceeds ($40,000)
Tax on Sale of Old Asset ($6)

PV of COST = $62,994
Cash Flow x FVF = Future Value
(1) 19,480 x 1.368 = $26,641
(2) 28,186 x 1.232 = $34,728
(3) 20,608 x 1.110 = $22,875
(4) 25,520 x 1.000 = 25,520
(5) 0 x 0 = 0
(6) 0 x 0 = 0
(7) 0 x 0 = 0
(8) 0 x 0 = 0
(9) 0 x 0 = 0
(10) 0 x 0 = 0

FV of BENEFITS = $1,09,764
INTERPOLATION FOR IRR
First Conduct the trail and error calculations to find the proper range of value
Discount
Rate PVB
17 63,726
732
I.R.R. 62,994 1,269
18 62,457
Then set up the Proportion.
X 732
 = 
1% 1,269
Solve for the value of X
X = 58%
Solve for the Internal Rate of Return
Internal Rate of Return = 17.57%
INTERPOLATION FOR IRR
Payback Period
Cash Cash Amount No. of
Year Outflows Inflows Owed Years
1 $62,994 62,994
2 19,480 43,514 1
3 28,186 15,328 1
4 20,608 0 1.74
5 25,523 0 0
6 0 0 0.00
7 0 0 0.00
8 0 0 0.00
9 0 0 0.00
10 0 0 0.00
Payback Period 2.74Yrs.
B. PRINCESS CRUISE LINES, INC.
Princess Cruise Lines owns five cruise ships that operate continuously in the Carribean Sea.
As the chief financial officer, you are considering the purchase of a new machine to remove
barnacles from the bottom of the ships when they are in dry dock. The new machine will cost
$3,300,000, shipping costs of $18,000, and also will require $37,000 in working capital to
support the new machines operation. The equipment will be depreciated over a 3year period
using MACRS and will have an expected salvage value of $120,000 at the end of its expected
economic life of four years. The annual savings associated with the machine are expected to
be $1,000,000 per year for the next four years. (The company will not deduct the salvage value
from the machines cost when calculating depreciation.)
Princess currently owns a machine which will provide this same function, but the machine is
old (4 years old) and tends to break down a lot. This machine can be sold today for $160,000.
The equipment was purchased four years ago for $2,800,000 and was being depreciated over
a threeyear period using the MACRS method.
Princess uses a hurdle rate of 8% for its capital budgeting projects; its marginal tax rate is
40%.
Determine whether you should purchase the new barnacle removing machine by conducting a
capital budgeting analysis using various measures of profitability.
CASH OUTFLOWS (OR INITIAL INVESTMENT)
Cost of New Assets $3,300,000
Shipping $18,000
Working Capital $37,000
Sale Proceeds ($1,60,000)
Tax on sale of Old Assets 64,000
Total Cash Outflows(Initial Investment) $32,59,000
TAX ON SALE OF OLD ASSET
Original Cost $2,80,000
Accumulated Dep. 2,80,000
Book Value 0
Selling Price $1,60,000
Book Value 0
Gain/ Loss $1,60,000
Tax Gain = Gain * Tax rate = $1,60,000 * 40% = $64,000
CHANGE IN DEPRECIATION
Depreciation Depreciation Change
on New Assets  on Old Assets = in Dep.
Next Year = $11,04,894  0 = $11,04,894
Year2 = $14,76,510  0 = $14,76,510
Year3 = 4,91,064  0 = 4,91,064
Year4= 2,45,532  0 = 2,45,532
Year5= 0  0 = 0
Year6= 0  0 = 0
Year7= 0  0 = 0
Year8= 0  0 = 0
Year9= 0  0 = 0
Year10= 0  0 = 0
DETERMINATION OF CASH INFLOWS
Change in Cash
Yr. Net Savings x (1 TR) + Depreciation x Tax Rate = Inflow
1. $10,00,000 x 0.60 + $11,04,894 x 0.40 = 10,41,958
2. 10,00,000 x 0.60 + 14,76,510 x 0.40 = 11,90,604
3. 10,00,000 x 0.60 + 4,91,064 x 0.40 = 7,96,426
4. 10,00,000 x 0.60 + 2,45,532 x 0.40 = 6,98,213
5. 0 x 0 + 0 x 0 = 0
6. 0 x 0 + 0 x 0 = 0
7. 0 x 0 + 0 x 0 = 0
8. 0 x 0 + 0 x 0 = 0
9. 0 x 0 + 0 x 0 = 0
10. 0 x 0 + 0 x 0 = 0
Does not include the Terminal Cash Flows (Shown Below) of $1,09,000
TERMINAL CASH INFLOW YEAR 4
CASH OUTFLOWS CASH INFLOWS
(0) Cost of New Asset $33,00,000
Shipping 18,000
Working Capital 37,000
Sale Proceeds (1,60,000)
Tax on Sale of Old Assets 64,000

P.V. OF COSTS = $32,59,000
Cash Inflow x PVF = PVB
(1) 10,41,958 x 09.26 = 964776
(2) 11,90,604 x 0.857 =1020751
(3) 7,96,426 x 0.794 = 632228
(4) 8,07,213 x 0.735 = 593326
(5) 0 x 0 = 0
(6) 0 x 0 = 0
(7) 0 x 0 = 0
(8) P.V. OF BENEFITS
$32,11,080
SUMMARY OF FINDINGS
Net Present Value = ($47,920)
Internal Rate Return = 7.30%
Modified Int. Rate of Return = 7.60%
Profitability Index = 0.99
Payback Period(Yrs) = 3.28
0 x 0 = 0
(9) 0 x 0 = 0
(10) 0 x 0 = 0

MODIFIED INTERNAL RATE OF RETURN
CASH OUTFLOWS CASH INFLOWS
Cost of New Assets $33,00,000
Shipping $18,000
Working Capital $37,000
Sale Proceeds ($1,60,000)
Tax on Sale of Old Asset $64,000

P.V. OF COSTS = $32,59,000
Cash Flow x FVF = Future Value
(1) 10,41,958 x 1.260 = $13,12,566
(2) 11,90,604 x 1.166 = 13,88,721
(3) 7,96,426 x 1.080 = 8,60,140
(4) 8,07,213 x 1.000 = 8,07,213
(5) 0 x 0 = 0
(6) 0 x 0 = 0
(7) 0 x 0 = 0
(8) 0 x 0 = 0
(9) 0 x 0 = 0
(10) 0 x 0 = 0

F.V. OF BENEFITS = $43,68,639
INTERPOLATION FOR IRR
First, Conduct the trialanderror calculations to find the proper range of values.
Discount
Rate P.V.B.
7 32,79,651
I.R.R. 32,59,000
8 32,11,080
Then set up the proportion.
X 20,651
 = 
1% 68,571
Solve for the Value of X
X = 0.30%
Solve for the Internal Rate of Return
Internal Rate of Return = 7.30%
PAYBACK PERIOD
Cash Cash Amount No. of
Year Outflow Inflow Owed Years
0 32,59,000 32,59,000
1 10,41,958 22,17,042 1.00
2 11,90,604 10,26,438 1.00
3 7,96,426 2,30,013 1.00
4 8,07,213 0 0.28
5 0 0 0
6 0 0 0
7 0 0 0
8 0 0 0
9 0 0 0
10 0 0 0
Payback Period = 3.28Yrs.
.
7. CASE STUDIES (SELF ASSESSMENT)
A. WIPRO BPO  NEW PROCESS  PEPBOYS
WiproBPO considering the purchase of a new Workstations 40No. These will cost $67,000,
transportation (or freight) of $3,000, and also will require $4,000 in working capital to support
the new process operation. The equipment will be depreciated over a 3year period using
MACRS and will have an expected salvage value of $1,500 at the end of its expected
economic life of four years. The annual savings associated with the Assets are expected to be
$30,000 per year for the next three years and $20,000 in the fourth year.
The company will not deduct the salvage value when calculating depreciation.
The existing workstations were almost worn out but can still be sold for $12,000. The
equipment was purchased three years earlier for $50,000 and was being depreciated over a
threeyear period using the MACRS method.
WiproBPO uses a hurdle rate of 12% for its capital budgeting projects and has a marginal tax
rate of 30%.
For setting up this process and for Capital budgeting purpose following questions are
supposed to solved:
a. Determine the depreciation associated with the new equipment, as well as the unused
depreciation on the old equipment.
b. Determine the cash inflows (after depreciation and taxes) associated with the new
equipment.
c. Determine the cash outflows associated with the equipment. Show each of the items that
would appear in the Taccount. Then show both the cash inflows and cash outflows in the T
account.
d. Determine (1) the net present value, (2) the profitability index, (3) the internal rate of return,
and (4)the payback period of the proposed project.
PepBoys Process Solution.
The cash outflows for WiproBPO in case of PepBoys new workstations are as follows:
Cost of new asset $67,000
Freight 3,000
Working Capital 4,000
Sale Proceeds of the old asset (12,000)
Tax on Sale of Old Asset 2,490
Present value of the Cash Outflows $64,490
The cash inflows are:
Year 1 $26,883
Year 2 30,345
Year 3 24,108
Year 4 (including terminal cash flows of
$5,050.)
20,604
Using the hurdle rate of 12%, the present value of these cash inflows is $78,461.
The net present value of the new asset is $13,971.
The profitability index is 1.22.
The internal rate of return is 22.45%.
The payback period is 2.30 years.
(Small differences caused by rounding errors are allowable,)
B. WIPRO BPO  NEW PROCESS  MSN
Considering the purchase of a new computer network for the companys office staff. The
existing computer equipment can be sold for a total of $17,000. The equipment was purchased
four years earlier for $97,000 and was being depreciated over a fiveyear period using the
MACRS method.
The new computer equipment will cost a total of $83,000, require modifications to the buildings
electrical wiring of $2,300, and also will require $3,500 in working capital to support the new
equipments operation. The equipment will be depreciated over a 5year period using MACRS
and will have an expected salvage value of $4,500 at the end of its expected economic life of
six years.
The company will not deduct the salvage value when calculating depreciation. The annual
savings are expected to be $20,000 per year for each year of the equipments expected six
year life.
Current Recording Studios uses a hurdle rate of 14% for all potential capital budgeting projects
and has a marginal tax rate of 35%.
Now the Question raised for solving this problem were:
a. Determine the depreciation associated with the new equipment, as well as the unused
depreciation on the old equipment.
b. Determine the cash inflows (after depreciation and taxes) associated with the new
equipment.
c. Determine the cash outflows associated with the equipment. Show each of the items that
would appear in the Taccount. Then show both the cash inflows and cash outflows in the T
account.
d. Determine (1) the net present value, (2) the profitability index, (3) the internal rate of return,
and (4) the payback period of the proposed project.
Solution
The cash outflows of the new computer network are:
Cost of new asset $83,000
Modifications to wiring 2,300
Working Capital 3,500
Sale Proceeds of the old asset (17,000)
Tax on Sale of Old Asset 77
Present value of the Cash Outflows $71,877
The cash inflows are:
Year 1 $15,067
Year 2 20,585
Year 3 18,732
Year 4 16,433
Year 5 16,433
Year 6 (including terminal cash flows of
$6,425.)
21,157
At 14%, the present value of these cash inflows is $69,592.
The net present value of the new computer network is ($2,285).
The profitability index is 0.97.
The internal rate of return is 12.86%.
The payback period is 4.06 years.
(Small differences caused by rounding errors are allowable,)
.................References............................................................
 www.lehigh.edu/~sgb2/L04%20Risk%20and%20Uncertainty.pdf
 educ.jmu.edu/~drakepp/principles/module6/cbrisk.pdf
 www.ukm.my/penerbit/jurnal_pdf/jp2901.pdf
 www.iif.edu/the_institute/iif_pubcbduru.htm
 www.rhsmith.umd.edu/faculty/gphillips/courses/.../caprisk.pdf
 www.fao.org/docrep/W4343E/w4343e07.htm
 forexmanagementonline.blogspot.com/.../importanceofcapitalbu...
 centerforpbbefr.rutgers.edu/.../...
 18.7.29.232/bitstream/handle/1721.../proceduresforcap00myer.pdf?...
 Finance dept. Wipro ltd.
 Financial Management by Khan and Jain.
 Financial Management by I M Pandey
 Corporate Finance by Van Horne
 http://www.wipro.com/services/businessprocessoutsourcingBPOservices/
 http://www.wipro.com/