Capital Budgeting and

Decision Criteria
Chapter 9

Prepared By: Margie Rita B. Celis

Kiernel Gutierrez
Learning Goals
Discuss the difficulty of finding profitable projects in
competitive markets.

Determine whether a new project should be accepted

using
1. PAYBACK PERIOD
2. NET PRESENT VALUE
3. PROFITABILITY INDEX
4. INTERNAL RATE OF RETURN
5. MODIFIED INTERNAL RATE OF RETURN
Discuss the difference between NPV and IRR
techniques
The NPV - IRR Relationship

Net present value profile

Net present value profile

- a graph showing how a project' net

present value changes as
the discount rate changes.

(IRR - the discount rate that equates

the present value of the inflows with
the present value of the outflows )
Illustration 1

Initial outlay : $105,517

Cash flow : $30,000
Duration : 5 years
 DISCOUNT RATE PROJECT’S NPV
0% $ 44, 483
15 % $ 24, 367
10 % $ 8, 207
13% $0
15% -$ 4, 952
20% -$ 15,799
25% -$ 24,839
Modified Internal Rate Of
Return

MIRR
Modified Internal Rate Of Return

the discount rate that equates the

present value of the free cash
outflows with the present value of the
project's terminal value.
What does it mean?

While the internal rate of return (IRR)

assumes the cash flows from a project
are reinvested at the IRR, the modified
IRR assumes that all cash flows are
reinvested at the firm's cost of capital.
Therefore, MIRR more accurately
reflects the profitability of a project.
Steps in calculating the MIRR

1. Determine the PV of the project's free cash

outflows.

2. Determine the terminal value of the project's

free cash inflows.

3. Determine the discount rate that equates the

PV of the terminal value and the present
value of the project's cash outflow.
"The Modified Internal Rate of Return
(MIRR) is used to correct a significant
inherent problem with the IRR
calculation. The IRR formula assumes
that you are reinvesting the annual cash
flow at the same rate as calculated by
the IRR. As a result, when you have a
property that generates significant cash
flow, the calculated IRR will overstate
the likely financial return of the
property.
The MIRR allows you to enter a different rate
that is applied to the property's annual cash
flow. Using the MIRR will more closely mimic
the real rate of return since operating cash
flow is rarely invested at a higher rate than a
bank savings rate. The finance rate is the
annual interest rate paid to borrow money
during years the property experiences a
negative cash flow. The reinvestment rate is
the rate of return earned on the excess cash
flow that is generated by the property."
Sample Problem
Galaxy Angels Company is considering
two mutually exclusive projects. The
firm, which has a 12% cost of capital,
has estimated its cash flows as shown
below.
Requirements:

a. NPV of each project

b. IRR for each project
c. NPV profiles for both projects