Capital Budgeting

INTERNAL RATE OF RETURN (IRR) 2

 Internal Rate of Return (IRR) = The discount rate that equates

the present value of the future net cash flows from an investment
project with the project’s initial cash outflow.
 INTERNAL RATE OF RETURN (IRR) 3

 Internal Rate of Return (IRR) is the discount rate at which Net

Present Value (NPV) is zero
Consider the cash flows of a project being considered by Techtron
Limited. Calculate the IRR of the project
Year Cash flow
0 (100,000)
1 30,000
2 30,000
3 40,000
4 45,000

Internal Rate of Return (IRR) = ?

Internal Rate of Return (IRR) is the discount rate at which Net Present Value (NPV) is
zero
 Year Cash flow
0 (100,000)
1 30,000
2 30,000
3 40,000
4 45,000

Internal Rate of Return (IRR) = ?

Internal Rate of Return (IRR) is the discount rate at which Net Present Value (NPV) is
zero
Discount Rate = ?
Net Present Value (NPV) = Sum of Present Values of Inflows - Sum of Present Values of Outflows
At this stage, we will choose “trial-and-error approach”
6
method. Under this method, we assume different “Discount
Rates” and check at which discount rate we can get Net
Present Value (NPV) = 0

Suppose Discount Rate is 15%

 Present Value
Year Cash flow
of Cash Flows
0 (100,000)
1 30,000
2 30,000
3 40,000
4 45,000

New Column Added of “Present

Value of Net Cash Flows”
 Present Value
Year Cash flow
of Cash Flows
0 (100,000) -
1 30,000
2 30,000
3 40,000
4 45,000

Year 0 Present Value = FV/[(1 + i)n]

Present Value at Year 0 = At year 0, we will not calculate any

present value because at this point
there in not any “Cash Inflow”
 Present Value
Year Cash flow
of Cash Flows
0 (100,000) -
1 30,000 26090
2 30,000
3 40,000
4 45,000

Year 1 Present Value (PV) = FV/[(1 + i)n]

PV = ?; FV = 30,000; i = 15% or 0.15; n=1
PV = FV/[(1 + i)n]
PV = 30,000/[(1 + 0.15)1]
PV = 30,000 /1.15
PV = 26090
 Present Value
Year Cash flow
of Cash Flows
0 (100,000) -
1 30,000 26090
2 30,000 𝟐𝟐𝟔𝟖𝟒
3 40,000
4 45,000

Year 2 Present Value (PV) = FV/[(1 + i)n]

PV = ?; FV = 30,000; i = 15% or 0.15; n=2
PV = FV/[(1 + i)n]
PV = 30,000/[(1 + 0.15)2]
PV = 30,000/(1.15)2
PV = 30,000/1.3225
PV = 𝟐𝟐𝟔𝟖𝟒
 Present Value
Year Cash flow
of Cash Flows
0 (100,000) -
1 30,000 26090
2 30,000 𝟐𝟐𝟔𝟖𝟒
3 40,000 26301
4 45,000

Year 3 Present Value (PV) = FV/[(1 + i)n]

PV = ?; FV = 40,000; i = 15% or 0.15; n=3
PV = FV/[(1 + i)n]
PV = 40,000/[(1 + 0.15)3]
PV = 40,000/(1.15)3
PV = 40,000/1.5208
PV = 26301
 Present Value
Year Cash flow
of Cash Flows
0 (100,000) -
1 30,000 26090
2 30,000 𝟐𝟐𝟔𝟖𝟒
3 40,000 26301
4 45,000

Year 4 Present Value (PV) = FV/[(1 + i)n]

PV = ?; FV = 45,000; i = 15% or 0.15; n=4
PV = FV/[(1 + i)n]
PV = 45,000/[(1 + 0.15)4]
PV = 45,000/(1.15)4
PV = 45,000/1.7490
PV =
 Year Cash flow Present Value of Cash Flows
0 (100,000) -
1 30,000 30,000/[(1 + 0.15)1] = 26090
2 30,000 30,000/[(1 + 0.15)2] = 𝟐𝟐𝟔𝟖𝟒
3 40,000 40,000/[(1 + 0.15)3] = 26301
4 45,000 45,000/[(1 + 0.15)4] =
Sum of All Present Value of Cash Flows = 1,00,804

Net Present Value (NPV) = Sum of Present Values of Inflows - Sum of Present Values of
Outflows
Net Present Value (NPV) = 1,00,804 - 100,000
Net Present Value (NPV) = 804
 14

Suppose Discount Rate is 30%

 Present Value
Year Cash flow
of Cash Flows
0 (100,000)
1 30,000
2 30,000
3 40,000
4 45,000
 Present Value
Year Cash flow
of Cash Flows
0 (100,000) -
1 30,000
2 30,000
3 40,000
4 45,000

Year 0 Present Value = FV/[(1 + i)n]

Present Value at Year 0 = At year 0, we will not calculate any

present value because at this point
there in not any “Cash Inflow”
 Present Value
Year Cash flow
of Cash Flows
0 (100,000) -
1 30,000 23077
2 30,000
3 40,000
4 45,000

Year 1 Present Value (PV) = FV/[(1 + i)n]

PV = ?; FV = 30,000; i = 30% or 0.30; n=1
PV = FV/[(1 + i)n]
PV = 30,000/[(1 + 0.30)1]
PV = 30,000 /1.30
PV = 23077
 Present Value
Year Cash flow
of Cash Flows
0 (100,000) -
1 30,000 23077
2 30,000 17751
3 40,000
4 45,000

Year 2 Present Value (PV) = FV/[(1 + i)n]

PV = ?; FV = 30,000; i = 30% or 0.30; n=2
PV = FV/[(1 + i)n]
PV = 30,000/[(1 + 0.30)2]
PV = 30,000/(1.30)2
PV = 30,000/1.69
PV = 17751
 Present Value
Year Cash flow
of Cash Flows
0 (100,000) -
1 30,000 23077
2 30,000 17751
3 40,000 18207
4 45,000

Year 3 Present Value (PV) = FV/[(1 + i)n]

PV = ?; FV = 40,000; i = 20% or 0.30; n=3
PV = FV/[(1 + i)n]
PV = 40,000/[(1 + 0.30)3]
PV = 40,000/(1.30)3
PV = 40,000/2.197
PV = 18207
 Present Value
Year Cash flow
of Cash Flows
0 (100,000) -
1 30,000 23077
2 30,000 17751
3 40,000 18207
4 45,000

Year 4 Present Value (PV) = FV/[(1 + i)n]

PV = ?; FV = 45,000; i = 30% or 0.30; n=4
PV = FV/[(1 + i)n]
PV = 45,000/[(1 + 0.30)4]
PV = 45,000/(1.30)4
PV = 45,000/2.8561
PV =
Year Cash flow Present Value of Cash Flows
0 (100,000) -
1 30,000 30,000/[(1 + 0.30)1] = 23077
2 30,000 30,000/[(1 + 0.30)2] = 17751
3 40,000 40,000/[(1 + 0.30)3] = 18207
4 45,000 45,000/[(1 + 0.30)4] =
Sum of All Present Value of Cash Flows = 74791
Net Present Value (NPV) = Sum of Present Values of Inflows - Sum of Present Values of
Outflows
Net Present Value (NPV) = 74791 - 100,000
Net Present Value (NPV) = -25209
Internal Rate NPV at
of Return Lower Rate Higher Rate
Lower Rate

Lower Rate NPV at NPV at

Lower Rate Higher Rate
 IRR = L + [{NPVL / (NPVL – NPVH)} x (H - L)]
L = 0.15
NPVL = 804
H = 0.30
NPVH = -25209

IRR = L + [{NPVL / (NPVL – NPVH)} x (H - L)]

IRR = 0.15 + [{804 / (804 – -25209)} x (0.30 - 0.15)]
IRR = 0.15 + [{804 / (804 + 25209)} x (0.30 - 0.15)]
IRR = 0.15 + [{804 / (26013)} x (0.15)]
IRR = 0.15 + [{0.0309} x (0.15)]
IRR = 0.15 + 0.0046
IRR = 0.1546
 INTERNAL RATE OF RETURN (IRR) 24

Acceptance Criteria. High value of IRR of the project is considered

good. IRR value should be greater than 0
Consider the cash flows of a project being considered by Techtron
Limited. Calculate the IRR of the project. Is this project acceptable if
the cost of capital is 14%

Year Cash flow

0 (100,000)
1 30,000
2 30,000
3 40,000
4 45,000

Internal Rate of Return (IRR) = ?

Internal Rate of Return (IRR) is the discount rate at which Net Present Value (NPV) is
zero
Consider the cash flows of a project being considered by Techtron
Limited. Calculate the IRR of the project. Is this project acceptable it
the cost of capital is 14%

Year Cash flow

0 (100,000)
1 30,000
2 30,000
3 40,000
4 45,000

Internal Rate of Return (IRR) = 15.45%

Interpretation: Since the Internal Rate of Return (IRR)
(15.45%), project is acceptable
 Decision Regarding IRR In Case of 2 Projects

 In Case of Independent Projects

 Select such project which provide highest IRR
IRR Hint
 IRR Hint
Scenario 1
 Take a start from 30 %
 If NPV is in Positive, increase the interest rate to 45%.
 Still if you get positive NPV, make the interest rate 50%.
Scenario 2
 Take a start from 30 %
 If NPV is negative, make the interest rate 15%.
 If still NPV is negative, make the interest rate 0%.
Capital Rationing
 Capital Rationing
 A situation where a constraint (or budget ceiling) is placed on the total size of
capital expenditures during a particular period.
 Example: Allocating limited resources (Investment) across several projects
may actually threaten the success of the projects, if, for example, the projected
budget for one or more projects turns out to have significantly underestimated
costs. Wise capital rationing can help a company avoid such problems