1

Thesis Paper
On

“Effective Capital Budgeting through the Application of Discounted

Cash Flow: A Case Analysis”

A THESIS REPORT SUBMITTED IN PARTIAL FULFILLMENT FOR THE DEGREE OF

MASTER OF BUSINESS ADMINISTRATION

Submitted To
Dr. Mahfuzul Hoque
Professor
Department of Accounting & Information System
Faculty of Business Studies
University of Dhaka

Submitted By
Shaurav Shahriar Imon
ID No: 11737052
EMBA Program, 37th Batch
Department of Accounting & Information System
Faculty of Business Studies
University of Dhaka

Date of Submission: 26nd December, 2019

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Letter of Transmittal

December 26, 2019

Dr. Mahfuzul Hoque

Professor

Accounting and Information System

University of Dhaka

Subject: Submission of Internship Report

Dear Sir,

With due respect we state that, we have prepared this research project on “Effective Capital
Budgeting through the Application of Discounted Cash Flow: A Case Analysis” a project that we
have been asked to submit a research paper on real life situations. The research program and
writing this project has been a great pleasure and an extremely interesting and rewarding
experience. It has enabled us to get an insight into the digital marketing system along with its
importance. We have done our project with our level best to produce a meaningful research
paper within all constraints.
We would be glad to furnish you with any clarifications, if required. We therefore submit it,
hoping that you would excuse the minor flaws.

Thank you,

Sincerely yours

Shaurav Shahriar Imon

ID No: 11737052
EMBA Program, 37th Batch
Department of Accounting & Information System
Faculty of Business Studies
University of Dhaka
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Acknowledgement
First of all we would like express our gratitude to the almighty for being so kind to allow us to
work on this project successively. Then our full of heart goes to our department Accounting and
Information System where we completed our required course to be eligible to prepare a project.
The education learnt from the teachers and the whole infrastructure of our university, truly has
amplified our level of competency and thoughts during our learning period. We are greatly in
debt to our honorable faculty Dr. Mahfuzul Hoque for his support and guidelines which has
enabled us to form a project. Again we have gone through the discussion about our topic to our
friends who are expert in capital budgeting for having a compact idea about this project.
However this kind of project will help us to develop our prospective career and the future.
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Executive Summary
“Don‟t tell me what you value, show me your budget, and I‟ll tell you what you value.”
- Joe Biden
The quote above signifies the importance of preparing capital budgeting. Any action in business
becomes successful by excellent budget planning. The process of evaluating long term
investment proposals is known as „capital budgeting‟. Making optimal capital budgeting
decisions requires recognizing correct accounting and the flexibilities associated with the project.
There are several assumptions on the investment decision. Firstly, the amount of years a
company plans to sustain a project, and after which time the products on that project will be sold
for an estimated salvage value. Secondly, management‟s beliefs on costs, depreciation and
salvage value are some of the most important assumptions by them. Thirdly, other assumptions
are the amount of sales, revenues, amortizations and net cash flows at different years. Again
there are numerous external factors to be in considerations for example political, social,
environmental, cultural factors and so on.

Traditionally, analysis indicates that the companies invest in those projects which seem to be
profitable earlier. But those projects might be rejected before gaining invested capital. Hence,
attributing methods, techniques and approaches have been emerged popularly known as
investment criteria. These criteria provide us the flexibility to choose between alternatives; To
choose between the alternative projects is called flexibility option. The flexibility also includes
investment-timing option which is offered in the timing of the capital budgeting decision. If any
project is delayed, more accurate information will be available that can avoid getting stuck with a
suboptimal choice. However this delay has its costs too. Since money has time value, the after-
tax cash flows forgone during the coming year, will reduce the expected NPV of project. NPV is
greater and positive strength over other methods like IRR or Benefit Cost Ratio. But In the paper
we will also find when over methods will be a better choice over NPV.

Thus we are going to discuss NPV, IRR and Benefit Cost Ratio and Discounted Payback Period
under Discounted Cash Flow criteria in detail with exploratory examples. Two cases for
practical calculations and understanding the topics in-depth have been also attached with this
research paper.
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Letter of Endorsement
The thesis report entitled “Effective Capital Budgeting through the Application of Discounted
Cash Flow: A Case Analysis” has been submitted to the Department of Accounting &
Information system for the degree of Master of Business Administration, faculty of Business
Administration on 26nd December, 2019 by Shaurav Shahriar Imon, ID: 11737052. The report
has been accepted and will be presented to the Internship defense committee for evaluation.

(Any opinions, suggestions made in this report are entirely held by the author of the report. The
university does not conduct nor reject any of these opinions or suggestions.)

______________________________
Dr. Mahfuzul Hoque
Professor
Department of Accounting & Information Systems
University of Dhaka
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Table of Content

Table of Content Page number

Letter of Transmittal 2
Acknowledgement 3
Executive Summary 4
Letter of Endorsement 5
Literature Review 8
Background
Purpose of the study 9-10
Objective of the study

Limitations of the study

Introduction 11

Categories of investment criteria 12

Net present value 12

Benefit Cost Ratio 15

Internal Rate of Return 17

Exceptions in IRR 18

Discounted Payback Period 21

Modified NPV 22

Modified IRR 24

Conclusion 25

Case study 1: Accenture Incorporation 26

Solution to case of Accenture corporation 29

Case study 2: Volkswagen International 37

Solution to case of Volkswagen International 41

Features and limitations of the case 36 & 45

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Literature Review
A good number of studies have been published about capital budgeting through application of
discounted cash flows by scholars who claim that capital budgeting decisions are critical
business performance. Indeed, equity investment plays an important role in the business
competition model. Kwak (1996) stated that capital budgeting is an actual decision. Many
studies have been carried out around the world with attractive yields on capital budgeting
practice (Kester et al., 1999; Graham and Harvey, 2001; Sandahl and Sjogren, 2003).
Remarkable international research focuses on the capital adequacy practices of renowned
companies. There is little research on small and medium sized enterprises (Rossi, 2014).
Experienced leaders use various techniques to facilitate capital investment procedures. In
practice capital differs from industry to industry and country to country.

Kester (1999) claims that discounted cash flow (DCF) techniques such as net present value
(NPV) and internal rate of return (IRR), have become the dominant methods of measuring
capital investment. Rossi (2014) says that NPV is the most common method. But there are
differences between big and small companies. The importance of ARR, IRR, and NPV capital
investment techniques are used to assess the performance and the size of the company‟s value.
Hatfield emphasizes the entrepreneurs research is that NPV techniques do not maximize business
value. He found that only capital budgeting technique is not sufficient for the expected result but
implementing at least two or three methods are essential at the time of evaluating a project.
Block (1997) tested capital budgeting on 232 small business that shows 47.7% companies having
favorable return after using capital budgeting. Gaham and Harvey (2001) evaluated 392 CHIEF
Financial officers on capital costs, capital formation and capital structure. They found that IRR
and NPV have the capital budgeting techniques used most often. Other technique such as
payback period is less popular but it is still used by many companies. Truong (2008) has carried
out an important study on theoretical capital budgeting in Australia. They surveyed 356
companies and found that NPV, IRR and ROI are most popular. Again a larger company seems
to use capital budgeting methods more than the smaller ones.

The main motivation for this study is the small number of empirical research on capital
budgeting application in Bangladesh and other countries such as USA, UK, Canada and so on.
Scientists distinguish two DCF techniques: traditional and modern. Companies can use one of
these techniques. The theoretical budget supports the use of DCF techniques based on time value
of money. Main purpose of using it is to maximize shareholder‟s wealth. If the investment
project produces positive NPV then the project is supportive, otherwise not. Moreover Graham
and Harvey (2001) explain DCF have become determining techniques especially in larger and
structured companies. However, Rossi (2014) concludes that these kind of returned methods are
dominant in capital investment decisions. This paper involves the use of all capital injection
methods under discounted cash flows.
 8

Background
The Evolution of Capital Budgeting Practices: Capital budgeting expenditure has evolved
over the decades and its importance has increased over time. There are some stages of this
evolution. The first stage is the Great Depression years during 1900s which efforts were mainly
focused on designing ways to ensure economic recovery. At the time, public borrowing for
financing capital outlays, except for emergencies, was not favored. In a cautious approach,
Sweden introduced a capital budget that was to be funded by public borrowing and used to
finance the creation of durable and self-financing assets that would contribute to an expansion of
net worth equivalent to the amount of borrowing. This so-called investment budget found
extended application in other Nordic countries in following years.

The second stage took place during the late 1930s when the colonial government in India
introduced a capital budget to reduce the budget deficit by shifting some items of expenditures
from the current budget. It was believed that the introduction of this dual-budget system would
provide a convenient way to reduce deficits while justifying a rationale for borrowing.

The third stage refers to the growing importance attached to capital budgets as a “vehicle” for
development plans. Partly influenced by the Soviet-style planning, many low-income countries
formulated comprehensive five-year plans and considered capital budgets the main impetus for
economic development. Where capital budgets did not exist, a variant known as the development
budget was introduced.

Capital Budgeting in the 1960s to 1990s

The fourth stage reflects the importance of economic policy choices on the allocation of
resources in government. Capital Budjeting techniques were applied on a wider scale during the
1960s leading to more rigorous application of investment appraisal and financial planning.

For three main reasons, capital budgeting practices have become popular. One reason was that,
finding the best ways taking pragmatic decisions. Second, the information demands were
equivalent to those required to run a centrally controlled economy. Thirdly, the government
demands to control detailed national economy with shortest time.

A fifth stage saw a revival of the debate about the need for a capital budget in government,
particularly in the United States. Along with the growing application of quantitative techniques
during the 1960s came the view that the introduction of a capital budget could be advantageous.
A president‟s commission in 1999 investigating budget concepts in the United States concluded
that a capital budget could lead to greater outlays.

During this sixth stage, the experiences of Australia and New Zealand, in the late 1990s, the
international financial institutions brought the accrual budgeting and accounting to the highest
pick.
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Purpose of the study: The economy of Bangladesh is more or less a mixed economy. For this
reason various measures have been taken since the post liberation war period. Maximum
country‟s annual income is far higher than our country because they are technologically rich. So
our main purpose is to get a clear layout of capital budgeting to happen in our country faster than
before.

Scope of the study:

o This project is about the discounting criteria of capital budgeting. So it is an opportunity

to know this particular method in detail.

￮ To prefer this popular sort of methods and techniques to improve the way of calculation
of proposed projects for the company or industries.

Objectives of the study:

￮ To value a project, business or investment.

￮ To assess the impact of new initiative.

￮ To develop and formulate long term strategic goals.

￮ To decide successfully for the future benefits.

￮ To know how to control and monitor the expenditure

￮ To identify the major problems in techniques of capital budgeting.

￮ To seek out new investment projects.

￮ To facilitate the transfer of information.

Limitations of the study: Every task has some limitations. We faced some usual constraints
during the course of our research. Despite giving utmost effort to our research, there are so me
limitations:

￮ Shortage of time period: There is a very short time period for conducting the research.
So the time period mentioned is very difficult to conduct the research.

￮ Insufficient data: The data required for sufficient analysis for writing project could not
be collected. We had to rely on blog, publications, statistics, web resources.

￮ Lack of sufficient well informed: Our country is not fully conducted on this research.
So some people have no idea about this topic.
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Introduction
Capital Budgeting is an operation of evaluating investment and ranking proposed projects to
determine which ones are deserving of an investment. Again, capital budgeting is also done in order
to obtain highest returns on those investments. There are generally three usual methods for
considering which proposed methods should be ranked higher over other projects. They are:

Throughput Analysis: Throughput analysis determines the impact of an investment on the

throughput of the total system where throughput is the amount of material passing through a system
or process.

Discounted cash flow analysis: A discount rate calculates the present value of all cash flows relating
to a proposed project using the concept of time value of money. Discounted cash flow analysis is
used in investment finance, international financial management, corporate financial management and
so on.

Payback analysis: Payback helps us measuring how fast we can earn back our investments; and it
reduces our risks on return on investment.

Capital budgeting is a complex process which may categorized into six phases. They are planning,
analysis, selection, financing, implementation, and review. The flow chart given below reflects the
main sequence. Planning precedes analysis; analysis precedes selection, selection precedes financing
and so on.

Implementation
Planning  Analysis  Selection  Financing  Review


The key steps involved in determining whether a project is worthwhile or not are:

-Estimate the costs and benefits of the project

-Assess the riskiness of the project

-Calculate the cost of capital

-Compute the criteria of merit and judge whether the project is good or bad.

For academic purposes, we find it more convenient to start with discussion of the criteria of merit,
referred to as achievement criteria or capital budgeting techniques. A familiarity with these criteria
will facilitate an easier understanding of costs and benefits, risk analysis, and cost of capital.
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Any investment decision depends upon the decision rule that is applied under circumstances.
However, the decision rule itself considers following inputs:
 Cash flows
 Project Life
 Discounting Factor

The effectiveness of the decision rule depends on how these three factors have been properly
evaluated. Estimation of cash flows requires immense understanding of that project before it is
implemented; particularly macro and micro view of the economy, state and the company. Project
life is very important; otherwise it will change the entire perspective of the project. Cost of
capital is being considered as discounting factor which has undergone a change over the years.
Cost of capital has different connotations in different economic philosophies.

Particularly, India has undergone a change in its economic ideology from a closed economy to
open-economy. Hence determination of cost of capital would carry greatest impact on the
investment evaluation.

This chapter is focusing on various techniques available for evaluating capital budgeting
projects. All DCF investment evaluation criteria from its economic viability point of view and
how it can help in maximizing shareholders‟ wealth will be discussed here. We will also look for
following general virtues in each technique.

Firstly, it should consider all cash flows to determine the true profitability of the project.
Secondly, it should provide for an objective and unambiguous way of separating good projects
from bad projects. Thirdly, it should help ranking of projects according to its true profitability.
Again, it should recognize the fact that bigger cash flows are preferable to smaller ones and early
cash flows are preferable to later ones. However, the techniques should help to choose among
mutually exclusive projects which maximize the shareholders‟ wealth.
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Categories of investment criteria

A number of capital budgeting techniques are used in practice. Capital budgeting techniques
(Investment appraisal criteria) under certainty can be divided into following two groups:
1. Discounted Cash Flow Criteria: -
(a) Net Present Value (NPV)
(b) Internal Rate of Return (IRR)
(c) Benefit Cost Ratio (BCR)
(d) Discounted PayBack Period

2. Non-Discounted Cash Flow Criteria: -

(a) Pay Back Period (PBP)
(b) Accounting Rate Of Return (ARR)

Discounted Cash Flow Criteria:

These are also known as traditional techniques and in this paper we are going to discuss only
discounted cash flow criteria:

(a) Net Present Value (NPV):

The net present value is one of the discounted cash flow criteria or time-adjusted techniques of
capital budgeting. The NPV of a project is the sum of present values of all the cash flows –
positive as well as negative - that are expected to occur over the life of the project.

Meaning:

The NPV is the difference between the present value of future cash inflows and the present value
of the initial firm‟s cost of capital. The general formula for NPV is:

𝑛 𝐶𝑡
NPV = 𝑡=1 (1+𝑟)𝑡 – Initial investment

Where 𝐶𝑡 is the cash flow at the end of year t, n is the life number of the project, and r is
the discount rate.

Characteristics:

1. On the basis of cash flow: Net present is based on cash flow and so it is a better
measurement technique than accounting rate of return which is based on accounting
profit because accounting profit can be subjective and does not carry true and fair result.
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2. Appropriate results: Net present value considers absolute results and this information is
very useful while dealing with huge investment proposals.

3. The time value of money: This method is a fundamental concept in investment

appraisal. Therefore it is better than ARR and payback period which neglect the time
value of money.

4. Require special knowledge: This technique requires knowledge of appropriate

calculation and it also requires understanding skills. Therefore this method is considered
to be difficult to calculate and understanding.

5. Discount rate determination: Moreover net present value needs discount rate and
sometimes it is extremely difficult to determine the exact discount rate. That can be used
calculate the NPV.

Process:

The procedure for determining the present values consists of two stages. The first stage involves
determination of an appropriate discount rate. With the discount rate so selected, the cash flow
streams are converted into present values in the second stage.

The important steps for calculating NPV are given below:

1. Cash flows of the investment project should be forecasted based on realistic assumptions.
These cash flows are the incremental cash inflow after taxes and are inclusive of depreciation
(CFAT) which is assumed to be received at the end of each year. CFAT should take into account
salvage value and working capital released at the end.

2. Appropriate discount rate should be identified to discount the forecasted cash flows. The
appropriate discount rate is the firm‟s opportunity cost of capital which is equal to the required
rate of return expected by investors on investments of equivalent risk.

3. Present value (PV) of cash flows should be calculated using opportunity cost of capital as the
discount rate.

4. NPV should be found out by subtracting present value of cash outflows from present value of
cash inflows. The project should be accepted if NPV is positive (i.e. NPV >0) The NPV can be
calculated with the help of equation.

NPV = Present value of cash inflows – Initial investment

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Decision Rule:

The present value method can be used as an accept-reject criterion. The present value of the
future cash inflows would be compared with present value of capital or expenditure. The present
value outlays are the same as the initial investment.

If the NPV is greater than 0, accept the project.

If the NPV is less than 0, reject the project.

Symbolically, accept-reject criterion can be shown as below:

PV > C → Accept [NPV > 0]

PV < C → Reject [NPV < 0]

Where, PV is present value of inflows and C is the outlays

This method can be used to select between mutually exclusive projects also. Using NPV the
project with the highest positive NPV would be ranked first and that project would be selected.
The market values of the firm‟s share are supposed to increase if projects with positive NPVs are
accepted.

Merits:

This method is considered as the most appropriate measure of profitability due to following
virtues.

1. It explicitly recognizes the time value of money.

2. It takes into account all the years cash flows arising out of the project over its useful life.

3. It is an absolute measure of profitability.

4. A changing discount rate can be built into NPV calculation. This feature becomes important as
this rate normally changes because the longer the time span, the lower the value of money &
higher the discount rate.

5. This is the only method which satisfies the value-additivity principle. It gives output in terms
of absolute amount so the NPVs of the projects can be added which is not possible with other
methods. For example, NPV (X+Y) = NPV (X) + NPV (Y). Thus, if we know the NPV of all
projects undertaken by the firm, it is possible to calculate the overall value of the firm.

6. It is always consistent with the firm‟s objectives and goal of shareholders wealth
maximization.
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Demerits:

1. This method requires estimation of cash flows which is very difficult due to uncertainties
existing in business world due to so many uncontrollable environmental, political or external
factors.

2. It requires the calculation of the required rate of return to discount the cash flows. But the
different discount rates will give different present values. The relative desired amount of the
proposal will change with the changes in the different discount rates.

3. When projects under consideration are mutually exclusive, it may not give dependable results
if the projects are having unequal lives, different cash flow pattern, and different cash outlay and
so on.

4. It does not explicitly deal with uncertainty when valuing the project and the extent of
management‟s flexibility and decision to respond to uncertainty over the life of the project.

5. It avoids the value of creating options. Sometimes, an investment that appears uneconomical
when viewed in isolation may, in fact, create options that enable the firm to undertake other
investments in the future should have market conditions.

6. Not having proper accounting for the options that investments in emerging technology may
yield, naive NPV analysis can lead firms to invest too little.

7. NPV is excessive in use capital budgeting practice being a true profitability measure.

(b) Benefit Cost Ratio:

Benefit-cost ratio (B/C) is similar to the NPV approach. Benefit-cost ratio measures the present
value of returns per dollar/rupee invested. It is observed in shortcoming of NPV that, being an
absolute measure, it is not a reliable method to evaluate projects requiring different initial
investments. The B/C method provides solution to this kind of problem.

How Benefit-Cost Ratio Works

Benefit-cost ratios (BCRs) are most often used in capital budgeting to evaluate the overall value
for money of undertaking a new project. However, the cost-benefit analyses for large projects
can be hard to get correct, because there are so many assumptions and uncertainties that are hard
to quantify. This is why there is usually a wide range of potential BCR outcomes.

The BCR also does not provide answer of how much economic value will be created, and so the
BCR is usually used to get a rough idea about the viability of a project and how much the
internal rate of return (IRR) exceeds the discount rate, which is the company‟s weighted-average
cost of capital (WACC) – the opportunity cost of that capital.
 16

The BCR is calculated by dividing the proposed total cash benefit of a project by the proposed
total cash cost of the project. Prior to dividing the numbers, the net present value of the
respective cash flows over the proposed lifetime of the project – taking into account the terminal
values, including salvage/remediation costs – are calculated.

𝑃𝑉𝐵
Benefit-cost ratio: BCR= 𝐼

𝑃𝑉𝐵 −𝐼
Net Benefit-cost ratio: NBCR= =BCR-1
𝐼

Where PVB is the present value of benefits, and I is the initial investment.

Key features of BCR

1. Costs and benefits are, as far as possible, expressed in monetary terms and hence are
directly comparable with one another.
2. BCR provides a basis for comparing investments or decisions, comparing the total
expected costs of each option with its total expected benefits.
3. Costs and benefits are evaluated in terms of the claims they fulfilled, and the gains they
provided, namely the triple bottom line as a whole. The perspective is 'global' or society-
wide, rather than that of any particular individual, organization or group.

Advantages and disadvantages of using benefit-cost analysis

BCR is a valuable tool for decision making. It is most useful because it provides a starting point
from which to begin evaluation of a project. BCR forces project advocates and opponents to
provide quantitative data to back up qualitative arguments. With BCR actual data must be used
to support the analysis. Typically, some subjective reasoning or value judgments come into play
when deciding on projects or investments. While BCR may not be able to include all the criteria
which is deemed important in evaluation, it does allow interested parties to clearly define the
issues involved.

BCA is also useful because it allows comparisons to be made between investments or projects.
This comparison is made easier because all investments are evaluated using the same method. It
then becomes easier to exclude the bad projects from consideration.

Limitations of BCR
The primary limitation of the BCR is that it reduces a project to a simple number when the
success or failure of an investment relies on many factors and can be undermined by unforeseen
events. Simply following a rule that above 1.0 means success and below 1.0 spells failure is
misleading and can provide a false sense of comfort with a project. The BCR must be used as a
tool in conjunction with other types of analysis to make a well-informed decision.
 17

(c) Internal Rate of Return:

Meaning: The internal rate of return is a measure of an investment‟s rate of return. The term
internal refers to the fact that the calculation excludes external factors such as risk free rate,
inflation, deflation, the cost of capital, or various financial risks.

Definition: The internal rate of return on an investment or project is the „annualized effective
compounded return rate‟ or rate of return that sets the net present value of all cash flows (both
positive and negative) from the investment equal to zero. Similarly it is the discount rate at
which the net present value of the future cash flows is equal to the initial investment, and it is
also the discount rate at which the total present value of costs (negative cash flow) equals the
total present value of benefits. It is the value of r in the following equation:

𝑛 𝐶𝑡
Investment= 𝑡=1 (1+𝑟)𝑡

Where 𝐶𝑡 is the cash flow at the end of year t, r is the internal rate of return (IRR), and n is the
life of the project.

Advantages:

Finds the Time Value of Money

Internal rate of return is measured by calculating the interest rate at which the present value of
future cash flows equals the required capital investment. The advantage is that the timing of cash
flows in all future years are considered and, therefore, each cash flow is given equal weight by
using the time value of money.

Simple to Use and Understand

The IRR is an easy measure to calculate and provides a simple means by which to compare the
worth of various projects under consideration. The IRR provides any small business owner with
a quick snapshot of what capital projects would provide the greatest potential cash flow. It can
also be used for budgeting purposes such as to provide a quick snapshot of the potential value or
savings of purchasing new equipment as opposed to repairing old equipment.

No requirement of cost of capital

In capital budgeting analysis, the hurdle rate, or cost of capital, is the required rate of return at
which investors agree to fund a project. It can be a subjective figure and typically ends up as a
rough estimate. The IRR method does not require the hurdle rate, mitigating the risk of
 18

determining a wrong rate. Once the IRR is calculated, projects can be accepted where the IRR
exceeds the estimated cost of capital.

Disadvantages:

1. It ignores future costs: The IRR method merely concerns itself with the projected cash
flows generated by a capital injection and ignores the potential future costs that may affect
profit. If we are considering an investment in trucks, for example, future fuel and
maintenance costs might affect profit with the fluctuation of fuel prices and maintenance
requirements might change. A dependent project may be the necessity to purchase vacant
land on which to park a fleet of trucks, and such cost would not factor in the IRR calculation
of the cash flows generated by the operation of the fleet.

2. Ignores Size of Project: A disadvantage of using the IRR method is that it does not
account for the project size when comparing multiple projects. Cash flows are simply
compared to the amount of capital outlay generating those cash flows. This can be
troublesome when two projects require a significantly different amount of capital outlay, but
the smaller project returns a higher IRR.

For example, a project with a $200,000 capital outlay and projected cash flows of $50,000 in
the next five years has an IRR of 15.88 percent, whereas a project with a $20,000 capital
outlay and projected cash flows of $6,000 in the next five years has an IRR of 30.4 percent.
Using the IRR method alone makes the smaller project more attractive, and ignores the fact
that the larger project can generate significantly higher cash flows and probably larger
profits.

3. Avoids reinvestment rates: Although the IRR allows us to calculate the value of future
cash flows, it makes an implicit assumption that those cash flows can be reinvested at the
same rate as the IRR. That assumption is not practical as the IRR is sometimes a very high
number and opportunities that yield such a return are generally not available or significantly
very limited.

Exceptions in IRR: There is significant problem in Internal Rate of Return which takes
place when at least one future cash inflow of a project is followed by cash outflow. Alternatively
it can be said that, after a positive value there is minimum one negative value. If this happens, we
call this project having non-normal cash flows. On the contrary, normal cash flows have one or
more consecutive cash outflows followed by cash inflows.
 19

Initial
Expenditure,
Cash flows at the end of relevant year, CFt
CF0

0 1 2 3 4 5
Normal cash
-$20,000 $8,000 $12,000 $16,000 $14,000 $8,000
flows
Normal cash
-$20,000 -$10,000 $14,000 $16,000 $22,000 $18,000
flows
Non-normal
-$20,000 $4,000 $10,000 $16,000 $14,000 -$12,000
cash flows
Non-normal
-$20,000 $10,000 $8,000 -$4,000 $22,000 -$8,000
cash flows
If any project has non-normal cash flows, it can have more than one IRR.

Illustration: To exemplify the multiple IRR findings problem, let‟s assume that Project X has
non-normal cash flows given in the table below:

Initial
Cash flows at the end of relevant year, CFt
Cost, CF0
0 1 2
Project X -$160,000 $1,000,000 -$1,000,000
Find out the IRR problem in this project:

Solution: We know, IRR is the rate at which NPV is 0

So, NPV=𝑃𝑉0 +𝑃𝑉1 +𝑃𝑉2

1 𝐹𝑉
2 𝐹𝑉
Or, 0= -160000+ (1+𝑟) 1 +(1+𝑟)2

1000000 1000000
Or, 0= -160000+ + (1+𝑟)2
(1+𝑟)1

1000000 1000000
Or, 160000= -
(1+𝑟)1 (1+𝑟)2

1 1
Or, 160000= 1000000 − (1+𝑟)2
1+𝑟

160000 1+𝑟 −1
Or, 1000000 = (1+𝑟)2

4 𝑟
Or, 25 = (1+𝑟)2

Or, 4(1 + 𝑟)2 =25r

 20

Or, 4(12 + 2𝑟 + 𝑟 2 )=25r

Or, 4 + 8r +4𝑟 2 =25r

Or, 4𝑟 2 - 17r +4=0

−𝑏 ± 𝑏 2 −4𝑎𝑐
So, a=4, b=-17, c=4 As we know, (a𝑥 2 +bx+c=0); therefore, x= 2𝑎

−(−17)± (−17)2 −4∗4∗4

Or, r = 2∗4

17±15
Or, r = 8

2 32
Or, r = 8; 8

Or, r= 0.25; 4

Therefore, the two IRR rates are: r= 25% or 400%

Illustration 2: let‟s assume that Project X has non-normal cash flows given in the table below:

Initial
Cash flows at the end of relevant year, CFt
Cost, CF0
0 1 2 3 4 5 6
Project -500000 281250 281250 281250 281250 281250 -937500
Y
Find out the IRR problem in this project.

After calculating the IRR in excel sheet with formula, we find the following values. There are
two IRR rates, first one is 3% and second one is 28% at different assuming discount rates. And
again we find the NPV rates at different discount rates in this project.
 21

To get rid of this problem there are two basic ways to solve the multiple IRR problems:

i. The NPV method should be used for projects with non-normal cash flows. In such cases,
there is no dilemma about which IRR is better.
ii. An alternative way is to use the modified internal rate of return (MIRR) as a screening
criterion. It was just developed to eliminate the multiple internal rates of return problem.

(d) Discounted Payback Period: Generally payback period is a non-discounted

investment criterion. So this conventional payback period does not take into account the time
value of money. Therefore, to overcome this limitation, the discounted payback period emerged.

Firstly, cash flows are converted into their present values by calculating with discounting factors.
Secondly those values are added to find the period of time required to recover the initial
investment on the project.

Below we get an example of discounted payback period:

Year Cash flow Present value @10% Cumulative net cash

discount rate flow after
cash flow/(1 + discounting
0.10)^n
1 -150000 -150000 -150000
2 45000 40909.09 -109090.91
3 45000 37190.08 -71900.83
 22

4 60000 45078.89 -26821.94

5 60000 40980.81 14158.87
6 75000 46569.1
7 30000 16934.22
8 45000 23092.12
We can see the above table shows the net cash flows using the discounted payback period.

Again from the above project we identify the following advantages of payback period:

1. The discounted payback period shows the break even point. It serves as a useful shortcut
in the process of information generation and evaluation.
2. Moreover, the discounted payback period conveys the information about the uncertainty
of the return on investment is resolved.
3. Again we find that, the longer the payback period, the slower the uncertainty and the
shorter the payback period, the faster the uncertainty associated with the project.

Modified NPV: The standard net present value method is based on the assumption that the
immediate cash flows are re-invested at a rate of return equal to the cost of capital. When the
assumption is not valid, the re-investment rates applicable to the intermediate cash flows need to
be defined for calculating the modified NPV.

Procedure for calculating modified NPV:

Step 1: Calculate the terminal value of the project‟s cash inflows using the explicitly defined
reinvestment rate or rates which are supposed to reflect the profitability of investment
opportunities ahead for the firm. The formula to calculate TV is given below:
𝑛
TV= 𝑡=1 𝐶𝐹𝑡 (1 + 𝑟)𝑛−𝑡

Here TV is the terminal value of the project‟s cash inflows, 𝐶𝐹𝑡 is the cash inflow at the end of
year t, and r is the reinvestment rate applicable to the cash inflows of the project.

Step 2: Determine the modified net present value:

𝑇𝑉
Modified NPV= (1+𝑟)𝑛 -I

Where NPV is the modified net present value, TV is the terminal value, r is the cost of capital,
and I is the investment outlay.

An illustration of calculating modified NPV, consider two projects Y and Z:

 23

Project Y Project Z
Investment outlay cash $220000 220000
inflows
Year 1 62000 142000
Year 2 80000 80000
Year 3 100000 80000
Year 4 140000 40000
The NPV for Y and Z may be calculated for two re-investment rates, 14% and 20% assuming a
cost of capital of 10%

Solution: The terminal values for cash inflows of the projects Y and Z for the two re-investment
rates are:

𝑇𝑉(𝑌)14% = 62000(1.14)3 +80000(1.14)2 +100000(1.14)1 +140000

=91856+103968+114000+140000

=449824

𝑇𝑉(𝑌)20% =62000(1.20)3 +80000(1.20)2 +100000(1.20)1 +140000

=107136+115200+120000+140000

=482336

𝑇𝑉(𝑍)14% =142000(1.14)3 +80000(1.14)2 +80000(1.14)1 +40000

=210379+103968+91200+40000

=445547

𝑇𝑉(𝑍)20% =142000(1.20)3 +80000(1.20)2 +80000(1.20)1 +40000

=245376+115200+96000+40000

=496576

Step 2: The NPV of projects Y and Z for two re-investment rates are:

𝑇𝑉(𝑌)14%
𝑁𝑃𝑉(𝑌)14% = - 220000 =87236
(1.10)4

𝑇𝑉(𝑌)20%
𝑁𝑃𝑉(𝑌)20% = – 220000 = 109442
(1.10)4
 24

𝑇𝑉(𝑍)14%
𝑁𝑃𝑉(𝑍)14% = – 220000=84315
(1.10)4

𝑇𝑉(𝑍)20%
𝑁𝑃𝑉(𝑍)20% = – 220000 = 119168
(1.10)4

Limitations of modified NPV: Though modified NPV has advantages and a direct linkage to
the objective of value maximization, the NPV rule has its opponents who point towards some
limitations:

a. The NPV is revealed in absolute terms rather than relative terms and hence does not
factor in the scale of investment. Thus project A may have an NPV of 5000 while project
B has an NPV of 2500 but project A may require an investment of 50000 whereas project
B may require an investment of just 10000. Masters of NPV argue that what matters is
the surplus value, over and above the hurdle rate, irrespective of what the investment is.
b. The NPV rule does not consider the life of the project. Hence when the mutually
exclusive projects with different lives are being considered, the NPV rule is biased in
favor of longer term project.

Modified IRR: In spite of NPV‟s conceptual superiority, managers seem to prefer IRR over
NPV because IRR is intuitively more appealing as it is a percentage measure. There is a
percentage measure that overcomes the shortcomings of the regular IRR and it is referred t as
modified IRR.

Steps involved in modified IRR are as follows:

Step 1: Calculate the present value of the costs associated with the project, using the cost of
capital r as discount rate:

𝑛 𝐶𝑎𝑠𝑕 𝑜𝑢𝑡𝑓𝑙𝑜𝑤 𝑡
PVC= 𝑡=0 (1+𝑟)𝑡

Step 2: Calculate the terminal value (TV) of the cash inflows expected from the project:
𝑛
TV= 𝑡=0 𝑐𝑎𝑠𝑕 𝑖𝑛𝑓𝑙𝑜𝑤𝑠𝑡 (1 + 𝑟)𝑛 −𝑡

Step 3: Obtain modified IRR by solving the following equation:

𝑇𝑉
PVC= (1+𝑀𝐼𝑅𝑅 )𝑛

Now let us consider an example to calculate MIRR. Sharoj Limited is evaluating a project that has the
following cash flow stream associated with it:

Year 0 1 2 3 4 5 6
Cash flow -240 -160 40 120 160 200 240

(in million)
 25

The cost of capital for Sharoj is 15%. The present value of costs is:

160
240+(1.15)=379.1

The terminal value of cash inflows is:

=40(1.15)4 + 120(1.15)3 + 160(1.15)2 + 200(1.15)1 + 240

=70+182.5+211.6+230+240

=934.1
934
Therefore, the MIRR: 379.1=(1+𝑀𝐼𝑅𝑅 )6

Or, (1 + 𝑀𝐼𝑅𝑅)6 =2.464

Or, 1+MIRR= 2.4641/6 =1.162

Or, MIRR=1.162-1=0.162 or 16.2%

Evaluation of Modified IRR: Modified IRR is more advantageous than regular IRR for mainly
two reasons. Firstly, in MIRR project cash flows are re-invested at the cost of capital, whereas
the in regular IRR project cash flows are re-invested at the project‟s own IRR. Re-investment at
the cost of capital is considered as more realistic and so MIRR brings truer profitability than the
regular IRR. Secondly, the problem of multiple rates does not exist in modified IRR.

Conclusion
To recapitulate, we can say that Discounted Cash Flows lead to an infinite variety of
modification with their tools, techniques and methods. A deep understanding in Discounted Cash
Flows is adequate to implement many real investment decisions in business. We have talked
about six capital planning choice techniques, contrasting the strategies and each other, and
featuring their relative qualities and shortcomings. All the while, we presumably made the
feeling that "refined" firms should utilize just a single technique in the choice procedure, NPV.
Beside NPV, other techniques are modified NPV (MNPV) IRR, modified IRR (MIRR),
Discounted Payback Period and BCR. In making the acknowledge/dismiss choice, generally
enormous, modern firms figure and think about the entirety of the measures, on the grounds that
every one gives chiefs to some degree distinctive bit of significant data. NPV is significant in
light of the fact that it gives an immediate proportion of the dollar advantage of the task to
investors. In this way, we see NPV as the best single proportion of gainfulness. IRR likewise
measures gainfulness. Further, IRR contains data concerning a venture's "security edge."
However, implementation of these implications in capital budgeting will be favorable for
business growth.
 26

Case 1:

Accenture Incorporation

Since he headed toward his boss‟s cabin, Daniel Defoe, chief finance manager for the Accenture
Corporation – one of the largest technology companies that specialized in airborne support –
wished he could remember more of his training in financial theory that he had been exposed to in
university. Daniel had just completed summarizing the financial aspects of four capital
investment projects that were open to Accenture during the coming year, and he was faced with
the task of recommending which should be accepted. What concerned him was the knowledge
that his boss, Scott Wagner, a “street smart” chief executive, with no background in financial
theory, would immediately favor the project that promised the highest return in reported net
income. Daniel knows that selecting projects purely on that basis would be incorrect; but he was
not sure of his ability to convince Scott, who tended to assume financiers thought up fancy
methods just to show how smart they were.

As he prepared to enter Scott‟s cabin, Daniel pulled his summary sheets from his briefcase and
quickly reviewed the details of the four projects, all of which he considered to be equally risky.

c. A proposal to add a jet to the company‟s fleet. The plane was only seven years old and
was considered a good buy at $330,000. In return, the plane would bring over $660,000
in additional revenue during the next five years with only about $61,600 in operating
costs. (See Table 1 for details)

Table 1: Financial Analysis project A: Add a twin-jet to the company‟s fleet

Particulars Initial Year 1 Year 2 Year 3 Year 4 Year 5
Expenditures
Net cost of new $330,000
plane
Additional 47300 84480 123530 247500 185625
revenue
Additional 12375 12375 12375 12375 12375
operating costs
Depreciation 49500 72600 69300 69300 69300
Net increase in -14575 -495 41855 165825 103950
income
Less: Tax at 33% 0 0 13813 54723 34304
Increase in after tax -14575 -495 28043 111103 69646
income
Add back 49500 72600 69300 69300 69300
depreciation
Net change in cash ($330,000) 34925 72105 97343 180403 138946
flow
 27

B. A proposal to diversify into copy machines. The franchise was to cost $770,000, which would
be amortized over a 40-year period. The new business was expected to generate over 1.5 million
in sales over the next five years and over $800,000 in after tax earnings (See Table 2 for details)

Table 2: Financial Analysis project B: Add a twin-jet to the company‟s fleet

Particulars Initial Year 1 Year 2 Year 3 Year 4 Year 5
Expenditures
Net cost of new $770,000
franchise
Additional 96250 192500 288750 433125 577500
revenue
Additional 28875 28875 28875 28875 28875
operating costs
Amortization 19250 19250 19250 19250 19250
Net increase in 48125 144375 240625 385000 529375
income
Less: Tax at 33% 15881.8 47644.3 79406.8 127050 174694.3
Increase in after tax 32244.3 96731.8 161219.3 257950 354681.8
income
Add back 19250 19250 19250 19250 19250
depreciation
Net change in cash ($770,000) 51494.3 115981.8 180469.3 277200 373931.8
flow

C. A proposal to buy a helicopter. The machine was expensive and, counting additional training
and licensing requirements, would cost $43,200 a year to operate. However, the versatility that
the helicopter was expected to provide would generate over $1.5 million in additional revenue,
and it would give the company access to a wider market as well. (See Table 3 for details)
Table 3: Financial Analysis project B: Add a twin-jet to the company‟s fleet
Particulars Initial Year 1 Year 2 Year 3 Year 4 Year 5
Expenditures
Net cost of new $864,000
helicopter
Additional
108000 216000 324000 486000 648000
revenue
Additional
43200 43200 43200 43200 43200
operating costs
Depreciation 129600 190080 181440 181440 181440
Net increase in
-64800 -17280 99360 261360 423360
income
Less: Tax at 33% 0 0 32789 86249 139709
Increase in after tax
-64800 -17280 66571 175111 283651
income
Add back
129600 190080 181440 181440 181440
depreciation
Net change in cash ($864,000)
64800 172800 248011 356551 465091
flow
 28

D. A proposal to begin operating a fleet of truck. Ten would be bought for only $56,100 each,
and the additional business would bring in almost $700,000 in new sales in the first two years
alone.
(See Table 4 for details)Table 3: Financial Analysis project B: Add a twin-jet to the
company‟s fleet
Particulars Initial Year 1 Year 2 Year 3 Year 4 Year 5
Expenditures
Net cost of new $561,000
trucks
Additional
420750 357637.5 98175 84150 56100
revenue
Additional
21037.5 21037.5 28050 35062.5 42075
operating costs
Depreciation 84150 123420 117810 117810 117810
Net increase in
315562.5 213180 -47685 -68722.5 -103785
income
Less: Tax at 33% 104135.9 70349.4 0 0 0
Increase in after tax
211426.6 142830.6 -47685 -68722.5 -103785
income
Add back
84150 123420 117810 117810 117810
depreciation
Net change in cash ($561,000)
315376.6 266250.6 70125 49087.5 14025
flow

In his mind, Daniel quickly went over the evaluation methods he had used in the past: internal
rate of return, benefit cost ratio and net present value. Daniel knew that Scott would add a fourth,
size of reported earnings, but he hoped he could talk Scott out of using it this time. Daniel
himself favored the net present value method, but he had always had a tough time getting Scott
to understand it.

One additional constraint that Daniel had to deal with was Scott‟s insistence that no outside
financing be used this year. Scott was worried that the company was growing too fast and had
piled up enough debt for the time being. He was also against a stock issue for fear of diluting
earnings and his control over the firm. As a result of Scott‟s prohibition of outside financing, the
size of the capital budget this year was limited to $800,000, which means that only one of the
four projects under consideration could be chosen. Daniel was not too happy about that, either,
but he had decided to accept it for now, and concentrate on selecting the best of the four.

As he closed his briefcase and walked toward Scott‟s door. Daniel reminded himself to have
patience; Scott might not trust financial analysis, but he would listen to sensible arguments.
Daniel only hoped his financial analysis sounded comprehensible!
 29

Requirements:

1. Refer to Tables 1 through 4. Add up the total increase in after tax income for each
project. Given what you know about Scott Wagner, to which project do you think he will
be attracted?
2. Compute net present value (NPV), internal rate of return (IRR) and benefit cost ratio
(BCR) of all four alternatives based on cash flow. Use 11% for the discount rate in your
calculations. Create a table of the findings of NPV, IRR and BCR for each alternative.
3. a. According to NPV, which project should be selected?
b. What are the disadvantages of this method?
4. According to BCR, which project should be selected? Why is this method considered as
most useful tool for decision making?
5. a. According to the IRR method, which project should be chosen?
b. What are the major disadvantages of the IRR method?
c. If Scott had not put a limit on the size of the capital budget, would the IRR method
allow acceptance of all four alternatives? If not, which one(s) would be rejected and
why?
6. a. If Kay had not put a limit on the size of the capital budget, under the NPV method
which projects would be accepted? Do the NPV and IRR both reject the same project(s)?
Why?
b. Given all the facts of the case, are you more likely to select Project A or C?

Solution:
1. Total reported earnings increase for each project:

No Project A Project B Project C Project D

1 -14575 32244.3 -64800 211426.6
2 -495 96731.8 -17280 142830.6
3 28043 161219.3 66571 -47685
4 111103 257950 175111 -68722.5
5 69646 354681.8 283651 -103785
193722 902827.2 443253 134064.7
Total

With what we know about Scott Wagner, Scott is sensitive Accenture‟s level of earnings.
Project B with 902827.2 in reported earnings increase is twice as much as other projects,
will most likely attract Scott. Project D may be interesting to Scott at the first year
providing $211426.6 but the later losses will lead to its rejection rather quickly.

Projects A and C produce earnings decrease for years one and two. We can infer that if
Daniel thinks that either project would be selected, he will need a convincing
explanation.
 30

2. Net present value (NPV) and Internal rate of return (IRR) calculation:
Project A:

We know,
𝑁𝑒𝑡 𝑐𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑎𝑠 𝑕 𝑓𝑙𝑜𝑤
NPV= ─ Net change in expenditure
(1+𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 )𝑛

34925 72105 97343 180403 138946

= + + + + – 330000
(1+0.11)1 (1+0.11)2 (1+0.11)3 (1+0.11)4 (1+0.11)5

= 31464 + 58522 + 71176 + 118837 + 82458 – 330,000

=362457 – 330,000
=32,457
So, NPV= 32,457

Let NPV @ 16%

34925 72105 97343 180403 138946

= + + + + – 330000
(1+0.16)1 (1+0.16)2 (1+0.16)3 (1+0.16)4 (1+0.16)5

= 30108 + 53586 + 62364 + 99635 + 66154 – 330000

= 311847 – 330000
= –18153

𝑁𝑃𝑉@𝐿𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒
So, IRR= Lower rate + 𝑁𝑃𝑉@𝐿𝑜𝑤𝑒𝑟 * Higher rate – Lower rate
𝑟𝑎𝑡𝑒 −𝑁𝑃𝑉@𝐻𝑖𝑔 𝑕𝑒𝑟 𝑟𝑎𝑡𝑒

32457
= 0.11 + 32457 −(−18153 ) * 0.16 – 0.11

= 0.11+0.64*0.05
=0.142 or 14.2%

Therefore, IRR= 14.2%

Project B:

We know,
𝑁𝑒𝑡 𝑐𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑎𝑠 𝑕 𝑓𝑙𝑜𝑤
NPV= ─ Net change in expenditure
(1+𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 )𝑛

51494 115982 180469 277200 373932

= + + + + – 770000
(1+0.11)1 (1+0.11)2 (1+0.11)3 (1+0.11)4 (1+0.11)5
 31

=46391+94134+131957+ 182600+221910 – 770000

= ─ 93008
So, NPV= ─ 93008

Let NPV @ 6%

51494 115982 180469 277200 373932

= + + + + – 770000
(1+0.06)1 (1+0.06)2 (1+0.06)3 (1+0.06)4 (1+0.06)5

= 48579+103224+151525+219568+279424 – 770000
= 82320 – 770000
= 32320

𝑁𝑃𝑉@𝐿𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒
So, IRR= Lower rate + 𝑁𝑃𝑉@𝐿𝑜𝑤𝑒𝑟 * Higher rate – Lower rate
𝑟𝑎𝑡𝑒 −𝑁𝑃𝑉@𝐻𝑖𝑔 𝑕𝑒𝑟 𝑟𝑎𝑡𝑒

32320
= 0.06 + 32320 −(−93008 ) * 0.11 – 0.06

=0.06+0.26*0.05
=0.73 or 7.3%

Therefore, IRR= 7.3%

Project C:

We know,
𝑁𝑒𝑡 𝑐𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑎𝑠 𝑕 𝑓𝑙𝑜𝑤
NPV= ─ Net change in expenditure
(1+𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 )𝑛

64800 172800 248011 356551 465091

= + + + + – 864000
(1+0.11)1 (1+0.11)2 (1+0.11)3 (1+0.11)4 (1+0.11)5

=58378+140248+181344+ 234871+276009 – 864000

= 26850
So, NPV= 26850

Let NPV @ 16%

64800 172800 248011 356551 465091

= + + + + – 864000
(1+0.16)1 (1+0.16)2 (1+0.16)3 (1+0.16)4 (1+0.16)5

= 55862 + 128419 + 158890 + 196920 + 221436 – 864000

= 761527 – 864000
= – 102473
 32

𝑁𝑃𝑉@𝐿𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒
So, IRR= Lower rate + 𝑁𝑃𝑉@𝐿𝑜𝑤𝑒𝑟 * Higher rate – Lower rate
𝑟𝑎𝑡𝑒 −𝑁𝑃𝑉@𝐻𝑖𝑔 𝑕𝑒𝑟 𝑟𝑎𝑡𝑒

26850
= 0.11 + * 0.16 – 0.11
26850 −(−102473 )

=0.11+0.208*0.05
=0.1204 or 12.04%

Therefore, IRR= 12.04%

Project D:
We know,
𝑁𝑒𝑡 𝑐𝑕𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑎𝑠 𝑕 𝑓𝑙𝑜𝑤
NPV= ─ Net change in expenditure
(1+𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 )𝑛

315376 .6 266250 .6 70125 49087 .5 14025

= + + + + – 561000
(1+0.11)1 (1+0.11)2 (1+0.11)3 (1+0.11)4 (1+0.11)5

=284123+216095+51275+ 32335+8323 – 561000

= 31151
So, NPV= 31151

Let NPV @ 16%

315376 .6 266250 .6 70125 49087 .5 14025

= + + + + – 561000
(1+0.16)1 (1+0.16)2 (1+0.16)3 (1+0.16)4 (1+0.16)5

= 271876 + 197868 + 44926 + 27111 + 6677 – 561000

= 548458 – 561000
= –12542

𝑁𝑃𝑉@𝐿𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒
So, IRR= Lower rate + 𝑁𝑃𝑉@𝐿𝑜𝑤𝑒𝑟 * Higher rate – Lower rate
𝑟𝑎𝑡𝑒 −𝑁𝑃𝑉@𝐻𝑖𝑔 𝑕𝑒𝑟 𝑟𝑎𝑡𝑒

31151
= 0.11 + 31151 −(−12542 ) * 0.16 – 0.11

=0.11+0.713*0.05
=0.11+0.036
=0.146 or 14.6%

Therefore, IRR= 14.6%

 33

Benefit Cost Ratio Calculation:

Project A:

Cash flows (PV of PV factor PV of expected benefit ( Cash

Year
cost of Project) (1/((1+r)^n)) flows*PV factor
1 34925 0.900900901 31463.96396
2 72105 0.811622433 58522.03555
3 97343 0.731191381 71176.36263
4 180403 0.658730974 118837.0439
5 138946 0.593451328 82457.68823
362457.0943
Total

𝟑𝟔𝟐𝟒𝟓𝟕
Therefore Benefit cost ratio=
𝟑𝟑𝟎𝟎𝟎𝟎

=1.1

Project B:

Cash flows (PV of PV factor PV of expected benefit ( Cash

Year
cost of Project) (1/((1+r)^n)) flows*PV factor
51494.3 46391.26
1 0.900900901
115981.8 94133.43
2 0.811622433
180469.3 131957.6
3 0.731191381
277200 182600.2
4 0.658730974
373931.8 221910.3
5 0.593451328
676992.8
Total

𝟔𝟕𝟔𝟗𝟗𝟐.𝟖
Therefore Benefit cost ratio=
𝟕𝟕𝟎𝟎𝟎𝟎
=0.88
 34

Project C:

Cash flows (PV of PV factor PV of expected benefit ( Cash

Year
cost of Project) (1/((1+r)^n)) flows*PV factor
64800 58378.38
1 0.900900901
172800 140248.4
2 0.811622433
248011 181343.5
3 0.731191381
356551 234871.2
4 0.658730974
465091 276008.9
5 0.593451328
890850.3
Total
𝟖𝟗𝟎𝟖𝟓𝟎.𝟑
Therefore Benefit cost ratio=
𝟖𝟔𝟒𝟎𝟎𝟎
=1.03

Project D:

Cash flows (PV of PV factor PV of expected benefit ( Cash

Year
cost of Project) (1/((1+r)^n)) flows*PV factor
315376.6 284123.1
1 0.900900901
266250.6 216095
2 0.811622433
70125 51274.8
3 0.731191381
49087.5 32335.46
4 0.658730974
14025 8323.155
5 0.593451328
592151.4
Total

𝟓𝟗𝟐𝟏𝟓𝟏.𝟒
Therefore Benefit cost ratio=
𝟓𝟔𝟏𝟎𝟎𝟎
=1.06

Findings of NPV, IRR and Benefit Cost Ratio:

Project A Project B Project C Project D
NPV 32457 (93008) 26850 31151
IRR 14.2% 7.3% 12.04% 14.6%
BCR 1.1 0.88 1.03 1.06
 35

3. a. According to NPV project A should be selected since it brings the highest gain of
return.
b. 1. This method requires estimation of cash flows which is very difficult due to uncertainties
existing in business world due to so many uncontrollable environmental, political or external
factors.

2. It requires the calculation of the required rate of return to discount the cash flows. The
discount rate is the most important element used in the calculation of the present values as
different discount rates will give different present values. The relative desired amount of the
proposal will change with the changes in the different discount rates.

3. When projects under consideration are mutually exclusive, it may not give dependable results
if the projects are having unequal lives, different cash flow pattern, and different cash outlay and
so on.

4. It does not explicitly deal with uncertainty when valuing the project and the extent of
management‟s flexibility and decision to respond to uncertainty over the life of the project.

5. It avoids the value of creating options. Sometimes, an investment that appears uneconomical
when viewed in isolation may, in fact, create options that enable the firm to undertake other
investments in the future should have market conditions.

6. Not having proper accounting for the options that investments in emerging technology may
yield, naive NPV analysis can lead firms to invest too little.

7. NPV is excessive in use capital budgeting practice being a true profitability measure.

4. In accordance to the BCR method, project A should be chosen due to its ratio higher than
1 and highest among the other three projects.
5. a. According to IRR method, project D should be chosen, though it returns only 0.4%
more than the closest competing project.

d. A project‟s cash flows must be reinvested at the IRR rate in order to achieve IRR during
the project‟s life. If a high IRR is involved it may be very difficult and improbable to
achieve.
Again, the IRR method merely concerns itself with the projected cash flows generated
by a capital injection and ignores the potential future costs that may affect profit.
Moreover, it does not account for the project size when comparing multiple projects.
Cash flows are simply compared to the amount of capital outlay generating those cash flows.
This can be troublesome when two projects require a significantly different amount of capital
outlay, but the smaller project returns a higher IRR.
c. Considering the size of Accenture‟s capital budgeting were not limited, the IRR
method would accept project A, C and D. Project B should be rejected because it has an IRR
of only 7.3, nearly 4% less than the cost of capital.
 36

6. a. Assuming the size of Accenture‟s capital budget were not limited, the NPV method
would accept projects A, C and. Project B, with an NPV of -93008 would be rejected. Both the
NPV and IRR methods certainly reject project B since its return is less than the cost of capital
and its BCR is less than 1.

b. According to my opinion project A should be selected because of its high net present
value and greatest benefit cost ratio, though its IRR is slightly lower than the project D.

Features of the Case 1:

1. The project of Accenture Incorporation is an illustrative case study. The aim of this
case is to give the readers an in-depth common idea about the topic and sub-topics of
this research.
2. The project of Accenture Incorporation deals with time value of money.
3. All the projects in this case are almost equally risky
4. It is both qualitative and quantitative cast study.
5. Through this case we can obtain an enlightened record of a company‟s capital
budgeting techniques and its inner strivings, tensions and motivations to take actual
decisions.
Limitations of the case 1:
1. This case is not authentic material, because the subjectivity of the researcher enters
into the collection of information in the case.
2. Again the case is based on several assumptions which may not be very realistic at
different times.
3. The opportunity to consume more time in developing the case would provide a better
generalization in it.
 37

Case 2:

VOLKSWAGEN INTERNATIONAL

CASE DESCRIPTION: Since capital budgeting is an integral part in finance for decision
making, Volkswagen International (VI) is considering whether to invest in a new model of car
using capital budgeting techniques. To determine the profitability in the project, VI must first
determine the weighted average cost of capital to finance the project, secondly the simple
payback period, next the discounted payback period, net present value (NPV), benefit cost ratio
(BCR), internal rate of return (IRR) and finally modified internal rate of return (MIRR)
techniques. MIRR is a relatively new capital budgeting technique, which assumes that the
reinvestment rate of the project‟s intermediary cash flows is the firm‟s cost of capital.

KEYWORDS: Capital budgeting, weighted average cost of capital, cash flow, payback period,
net present value, benefit cost ratio, internal rate of return, modified internal rate of return and so
on.

CASE INFORMATION
Volkswagen International (VI) is planning to invest in a special manufacturing system to
produce a new car. The invoice price of the system is $560,000. It would require $10,000 in
shipping expenses and $30,000 in installation costs. The system falls in MACRS 3-year class
with depreciation rates of 33% for the first year, 45% for the second year and 15% for the third
year. VEC plans to use the system for four years and it is expected to have a salvage value of
$80,000 after four years of use. VI expects the new system to generate sales of 3,000 units per
year. The company estimates that the new car will be sold for $500 per unit in the first year with
a cost of $300 per unit, excluding depreciation. Both the selling price and the cost per unit will
increase by 6% per year due to inflation. VI‟s net operating working capital would have to
increase by 20% of sales revenues to produce the new product. The company‟s marginal tax rate
is 40%.

VI‟s WACC
John Donne, a recent MBA graduate of Northumbria University, is conducting the capital
budgeting analysis for the project. The company hired him only a few days ago as the finance
manager. To evaluate the feasibility of the investment in the new system, John Donne‟s first task
is to estimate VI‟s WACC using the data from Table: 1. When VI started evaluating the project,
the following conversation took place between John Donne and Thomas Hardy, the CEO of the
company, who is a Princeton graduate with a major in financial economics and he has high
administrative experiences.

Donne: It might be hard to estimate the cost of borrowing in the present recessionary
environment.

Thomas: We can determine the yield to maturity (YTM) on our outstanding bonds by using their
current market prices. We can assume that we will be able to issue additional bonds with
this YTM as the cost of borrowing. We should be able to place the new bonds without
any flotation costs. We can rethink the acceptability of the project later before raising
 38

funds by using sensitivity analysis to assess the impact of possible changes in interest
rates on the net present value of the project.

Donne: Do you think the company‟s present market value capital structure is ideal? Can we use
the current percentages of the capital components as weights in the calculation of the
company‟s WACC?

Thomas: Yes, I believe that the company‟s current market value capital structure of 30% debt,
10% preferred stock and 60% equity is optimal. We have about $80,000 in retained
earnings this year, which is also available in cash. We should be able to use this year‟s
retained earnings to finance part of the equity financing required for the project.
However, we will have to issue some new common shares for the remainder of the
necessary equity financing. We can assume a flotation cost of about 10% for the new
common shares.

Donne: There are three basic methods of calculating a firm‟s cost of equity when retained
earnings are used as equity capital: 1) the discounted cash flow (DCF) approach, 2) the
capital asset pricing method (CAPM) and 3) the bond-yield-plus-risk-premium method.
Which one should we follow?

Thomas: Though each of these methods has its advantages, I believe that the most appropriate
approach for our company would be to find an average cost with the three methods.

Thomas Hardy gave only one week to Joan Hamilton for his calculation of VI‟s WACC. With
the instructions he received from the CEO and with the help of the financial data in Exhibit 1,
John Donne began the task of calculating the company‟s WACC immediately. Thomas Hardy
knew that estimating the company‟s cost of capital was the first critical step in the capital
budgeting process. Without this analysis, it would be difficult to determine if the new system
would be a profitable investment for VI. Thomas Hardy was very pleased when he received
John Donne‟s calculation of WACC. He thought that he had made a good decision in hiring John
Donne.

Exhibit 1: Data for estimating VI‟s WACC

VEC’s current market value optimal capital structure:

Weight
Bonds $30,000,000 30%
Preferred Stock 10,000,000 10%
Common Equity 60,000,000 60%

Data to be used in the calculation of the cost of borrowing with bonds:

Par value = $990, non-callable
Market value = $1,075
Coupon interest = 8.5%, semiannual payment
Remaining maturity = 14 years
New bonds can be privately placed without any flotation costs
 39

Data to be used in the calculation of the cost of preferred stock:

Par value = $100
Annual dividend = 9% of par
Market value = $103
Flotation cost = 5%

Data to be used in the calculation of the cost of common equity:

CAPM data: VI‟s beta = 1.2
The yield on T-bonds = 5%
Market risk premium = 5%
DCF data: Stock price = $19
Last year‟s dividend (D0) = $1.00
Expected dividend growth rate = 5%
Bond-yield-plus-risk-premium: Risk premium = 3.5%
Amount of retained earnings available = $80,000
Amount of new common stock to be issued = ($300,000) (0.6) - $80,000 = $100,000

Analysis of the Profitability of the Project

Thomas Hardy and John Donne had the following conversation regarding how they should evaluate the
potential profitability of the project.

Donne: From the sales and cost calculations I have obtained from the marketing and accounting
departments in Exhibit 2, we are now able to estimate the project‟s cash flows for the four-year
sky-line.

Thomas: Great! How are we going to evaluate the project‟s profitability to determine if it is acceptable?

Donne: The Net Present Value (NPV), Benefit Cost ratio (BCR) and Internal Rate of Return (IRR)
methods are generally used in the evaluation of projects. However, these three methods have
different assumptions regarding the reinvestment rate of the intermediary cash flows. The NPV
method assumes that the intermediary cash flows can be reinvested at the firm‟s cost of capital.
However, the IRR method assumes that the reinvestment rate is the project‟s IRR. BCR assumes
that the relationship between the relative costs and benefits of a proposed project should be the
decision indicator. Generally the NPV method is accepted as the NPV of a project shows its
contribution to the market value of the firm.

Thomas: Right! But we should consider all methods. Again, there is a new improved capital budgeting
technique that measures the profitability of a project as a percentage similar to the IRR method
and it assumes that the project‟s intermediary cash flows can be reinvested at the firm‟s cost of
capital as in the NPV method. I believe the technique is called the Modified Internal Rate of
Return (MIRR) method.

Donne: It is fine, we will consider all of the methods.

With the instructions she received from Thomas Hardy, John Donne immediately started to work on the
cash flow calculations using the data in Exhibit 2 to analyze the profitability of the project with the NPV,
BCR, IRR, MIRR and discounted payback period methods.

Exhibit 2: The data Joan Hamilton plans to use in the calculation of the cash flows for the project and in
the evaluation of its profitability.
 40

The Machinery‟s Invoice Price $560,000

Shipping Charges 10,000
Installation Cost 30,000
Depreciable Basis $600,000

MACRS Depreciation Rates: Year 1: 33%

Year 2: 45%
Year 3: 15%
Year 4: 7%
Salvage Value: $40,000

Annual revenue and cost estimates (assume 3% inflation rate):

Year 1 Year 2 Year 3 Year 4
Units 3000 3000 3000 3000
Unit Price 500 -- -- --
Unit Cost 300 -- -- --
Sales 750000 -- -- --
Costs 450000 -- -- --

Net Operating Working Capital (NOWC) Requirement:

Year 0 Year 1 Year 2 Year 3 Year 4
Sales 750000 -- -- --
NOWC (20% 150000 -- -- -- --
of sales)
CF due to (150000) -- -- -- --
NOWC

Questions:

Assume that you are John Donne. Answer the following questions:

1. Calculate VI‟s WACC using the data in Exhibit 1.

2. Calculate the project‟s cash flows using the data in Exhibit 2. Why is it important to take
into account the effect of inflation in forecasting the cash flows? Briefly comment.
3. Evaluate the profitability of the project with the NPV, BCR, IRR, MIRR and discounted
payback period methods. Is the project acceptable? Briefly explain. Why is the NPV
method superior to the other methods of capital budgeting? Briefly explain.
 41

Solution 1:

1. To calculate WACC we first have to calculate the following issue:

𝐹𝑉 −𝑀𝑉
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 +
𝑛
Step 1: Cost of debt: 𝑟𝑑 = 𝐹𝑉 −𝑀𝑉
2

990 −1075
85+
14
= 990 +1075
2
78.93
=1032 .5

=0.0764

After tax cost of debt = 𝑟𝑑 (𝐵𝑇)(1-T)

=0.0764(1-.40)

=0.0458
Dps
Step 2: Cost of preferred Stock, rps = Pps (1 – F)

9
= ($103 )(1 − 0.05)

= $9 / $97.85 = 9.2%

Step 3: Cost of Common Equity:

CAPM: 𝑟𝑠 = 𝑟𝑅𝐹 + (𝑅𝑃𝑀 )b

= 0.05 + (0.05) (1.2)

= 11%

DCF: 𝑟𝑠 = [𝐷0 (1 + g) / 𝑃0 ] + g

= [$1(1 + 0.05) / $19] + 0.05 = 10%

Own-Bond Yield-Plus-Risk Premium: 𝑟𝑠 = 𝑟𝑑 (𝐵𝑇) + Bond RP

= 0.0764 + 0.035

= 11.14%

Cost of retained earnings (average rs) = (11% + 10% + 11.14%) / 3 = 10.71%

 42

Cost of new common stock = 10.71% / (1 - 0.1) = 11.9%

WACC = 𝑤𝑑 𝑟𝑑 + 𝑤𝑝𝑠 𝑟𝑝𝑠 + 𝑤𝑟𝑒 𝑟𝑠 + 𝑤𝑛𝑐𝑠 𝑟𝑒

= (0.3)(0.0458) + (0.1)(0.092) + (0.6)(80,000/180,000)(0.11) +

(0.6)(100,000/180,000)(0.119)

= 0.093 or 9.3%

Solution 2: Annual revenue and cost estimates (assume 3% inflation rate):

Year 1 Year 2 Year 3 Year 4

Units 3000 3000 3000 3000
Unit Price 500 515 530.45 546.36
Unit Cost 300 309 318.27 327.82
Sales 750000 772500 795675 819545.25
Costs 450000 463500 477405 491727.15

Depreciation:

Year 1: 33% x $600,000 = $198,000

Year 2: 45% x $600,000 = 270,000

Year 3: 15% x $600,000 = 90,000

Year 4: 7% x $600,000 = 42,000

Operating cash flows:

Particulars Year 1 Year 2 Year 3 Year 4

Sales 750000 772500 795675 819545.25
Costs 450000 463500 477405 491727.15
Depreciation 198,000 270,000 90,000 42,000
EBIT 102000 39000 228270 285818.1
Tax (40%) 40800 15600 91308 114327.24
Net operating
61200 23400 136962 171490.86
profit after tax
Add:
198,000 270,000 90,000 42,000
Depreciation
Net Operating
259200 293400 226962 213490.9
Cash Flow
 43

Net operating working capital (NOWC) requirement:

Year 0
Particulars Year 1 Year 2 Year 3 Year 4
Sales 750000 772500 795675 819545.25
NOWC (20% 150000 154500 159135 163909.05
of sales)
CF due to (150000) (4500) (4635) (4774.05) 163909.05
NOWC
Salvage value: ($80,000)(1 – 0.4) = $48,000

Project net cash flows:

Particulars Year 0 Year 1 Year 2 Year 3 Year 4

Initial
(600000)
Investment
Operating Cash
259200 293400 226962 213490.9
Flows
CF due to
(150000) (4500) (4635) (4774.05) 163909.05
NOWC
Salvage Cash
48000
Flow
Net Cash
Flows
(750000) 254700 288765 222187.95 425400

The discount rate generally includes an inflation premium. If the cash flows are not adjusted for
inflation, the project‟s NPV would be understated.

Solution 3:
254700 288765 222187 .95 425400
Project‟s NPV= 1+0.093 1 +1+0.093 2 + 1+0.093 3 +1+0.093 4 - 750000

=942973.73 – 750000

=192,973.73

Project‟s IRR:

First let‟s assume NPV @20%

254700 288765 222187 .95 425400
= + + + - 750000
1+0.20 1 1+0.20 2 1+0.20 3 1+0.20 4

=$746,512.70 – 750000

= -3487.3

𝑁𝑃𝑉@𝐿𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒
So, IRR= Lower rate + * Higher rate – Lower rate
𝑁𝑃𝑉@𝐿𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒 −𝑁𝑃𝑉@𝐻𝑖𝑔 𝑕𝑒𝑟 𝑟𝑎𝑡𝑒
 44

192973 .73
= 0.093 + 192973 .73−(−3487 .3) * 0.20 - 0.093

=0.093+0.98*0.107
=0.093+0.105
=0.198 or 19.8%

Project‟s BCR=

Cash flows (PV of PV factor PV of expected benefit ( Cash

Year
cost of Project) (1/((1+r)^n)) flows*PV factor
1 254700 0.91491 233027.577
2 288765 0.83707 241716.52
3 222187.95 0.76584 170160.42
4 425400 0.70068 298069.272
942973.8
Total

𝟗𝟒𝟐𝟗𝟕𝟑.𝟖
Therefore Benefit cost ratio=
𝟕𝟓𝟎𝟎𝟎𝟎

=1.26

MIRR=16% (using spread sheet)

Year Cash flow Present value @9.3% Cumulative net cash

discount rate flow after
cash flow/(1 + discounting
0.093)^n
0 -750000 -750000 -750000
1 254700 233028.36 -516971.64
2 288765 241715.35 -275256.3
3 222187.95 170161 -105095.31
4 425400 298069.02 192973.71
Therefore, Discounted Payback Period = 3.6 years

The NPV technique is superior to the other techniques of capital budgeting. The goal of financial
management is to maximize the market value of the firm. The NPV of a project shows the
contribution of the project to the market value of the firm. The NPV method‟s reinvestment rate
assumption is also more realistic compared with the IRR method.
 45

Features of the Case 2:

1. The second case of Volkswagen International is also an illustrative case study, but the
elements of exploratory research are also present in this case. Because research questions
and methods of study are shown there.
2. Again the project of Volkswagen International also deals with time value of money.
3. The case depends on our perception and gives into life directory.
4. This case is not highly risky like the previous case.
5. It is both qualitative and quantitative cast study due to opinion and countable amounts in
cash.

Limitations of the case 2:

1. We first have to count the WACC in this case which is very time consuming to calculate
the capital budgeting techniques.
2. Moreover this case is not authentic material, because the subjectivity of the researcher
enters into the collection of information in the case.
3. Again the case is based on several assumptions which may not be very realistic at
different times.
4. The methods used in this case are formula based and difficult to remember and so general
people cannot conduct this case easily.
 46

Bibliography
1. Projects by Prasanna Chandra
2. Article of Aerocomp Incorporation
3. Case of Dashen Bank Share Company: Capital Budgeting Decision
4. file:///C:/Users/User/Downloads/RBFCS-V1N1-2010-2.pdf
5. https://poseidon01.ssrn.com/delivery.php?ID=589112090009121106119006090127065064031
03802807900500112610508000508801006802607903110004809703902602803310510607209
10290911170170010020760920090801011211200811170800540480040210201190030060660
94126089025011115071023003086007092092093001070090002124125&EXT=pdf
6. https://www.coursehero.com/tutors-problems/Finance/531131-Rollins-Corporation-has-a-
target-capital-structure-consisting-of-20-d/