Chapter 10 –

Capital Budgeting II:

Additional Aspects

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 Learning Objectives
• Use present value profiles to compare and evaluate NPV, IRR and PI techniques in
context of conflicting rankings
• Describe project selection under capital rationing
• Explain the procedure to incorporate impact of inflation on capital budgeting
decisions

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 Introduction
• A firm generally faces complex investment situations and has to choose among
alternatives.
• The evaluation techniques discussed in previous chapter can be extended to
handle such decisions.

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 NPV, IRR, Profitability Index Methods —
A Comparison
NPV Vs. IRR Methods
• The comparison of these methods, involves a discussion of
the similarities between them, and
 their differences, as also the factors which are likely to cause such
differences.

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 NPV and IRR: Similarities

• The situations in which the two methods will give a concurrent accept-reject
decision will be in respect of
 conventional and
 independent projects.
• Conventional investment projects are projects which cash outflows are confined
to the initial period.
• Independent projects are all profitable projects that can be accepted.

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 NPV and IRR Methods: Differences
• In certain situations NPV and IRR will give contradictory results such that
 if the NPV method finds one proposal acceptable,
 IRR favours another.
• This is so in the case of mutually exclusive investment projects.
• If there are alternative courses of action, only one can be accepted.
• Such alternatives are mutually exclusive.
• The mutual exclusiveness of the investment projects may be of two types:
 technical, and
 financial.
• The term technical exclusiveness refers to alternatives having different
profitabilities and the selection of that alternative which is the most profitable.

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• The exclusiveness due to limited funds is popularly known as capital rationing.
• The different ranking given by the NPV and IRR methods can be illustrated under
the following heads:
 Size-disparity problem;
 Time-disparity problem; and
 Unequal expected lives.
• Conflicting ranking is conflict in the ranking of a given project by NPV or IRR
resulting from differences in magnitude or timing of cashflows.

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 Size-disparity Problem
• Size-disparity arises when the initial investment in mutually exclusive projects is
different.
• The cash outlay of some projects is larger than that of others.
• In such a situation, the NPV and IRR will give a different ranking.

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 Incremental Approach
• The conflict between the NPV and IRR in the above situation can be resolved by
modifying the IRR so that it is based on incremental analysis.
• Incremental analysis involves computation of IRR of the incremental outlay of the
project requiring bigger initial investment.

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 Time-disparity Problem
• Time-disparity arises when the cash flow pattern of mutually exclusive projects is
different.
• The time-disparity problem may be defined as the conflict in ranking of proposals
by the NPV and IRR methods which have different patterns of cash inflows.

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 Projects with Unequal Lives
• When the mutually exclusive projects have different expected lives the IRR and
NPV methods would give a conflicting ranking.
• The conflict in the ranking may be resolved by following two approaches
 common time horizon approach and
 equivalent annual value/cost approach.

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 Common time horizon approach
• Common time horizon approach makes a comparison between projects that
extends over multiples of the lives of each.
• It encounters operational difficulty in terms of assumptions of the same
technology, price of the capital asset, and operating costs and revenues.

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 Equivalent annual value/cost approach

• Equal annual net present value (EANPV) approach evaluates unequal-lived projects
that converts the net present value of unequal-lived mutually exclusive projects into
an equivalent (in NPV terms) annual amount.
• Equal annual cost (EAC) converts the present value of costs of unequal-lived mutually
exclusive projects into an equivalent annual amount/cost.

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 Reinvestment Rate Assumption
• The conflict between NPV and IRR is mainly due to different assumptions with
regard to the reinvestment rate on funds released from the proposal.
• IRR criterion implicitly assumes that the cash flow generated by the projects will
be reinvested at the internal rate of return.
• NPV assumes that the funds released can be reinvested at a rate equal to the cost
of capital.
• Theoretically, the assumption of the NPV method is considered to be superior.
• Implicit investment rate is the rate at which interim cash flows can be invested.
• Intermediate cash flows are cash inflows received prior to the termination of the
project.

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 Modified IRR Method
• The IRR can be modified (to overcome the deficiency of the reinvestment rate
assumption) assuming the cost of capital to be the reinvestment rate.
• The MIRR can be computed by:

• The MIRR method, prima-facie, appears to be better than the standard IRR.
• But its superiority is open to question.
• First, is not a rate of return on the project’s annual cash flows.
• Second, it cannot be reckoned as a true ‘internal’ rate of return,
• Finally, the value of a project does not depend on what the firm does with the cash flows

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 Computational Problems

• The IRR method also suffers from computational problem.

• These may be discussed with reference to two aspects.
Computation in Conventional Cash Flows
Computation in Non-conventional Flows

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 Multiple Rates of IRR

• Another serious computational deficiency of IRR method is that it can yield

multiple internal rates of return.

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 Net Present Value Vs. Profitability Index
• In most situations, the NPV and PI, as investment criteria, provide the same
accept and reject decision, because both the methods are closely related to each
other.
• However, while evaluating mutually exclusive investment proposals, these
methods may give different rankings

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 Project Selection Capital Rationing
• Capital rationing implies the choice of investment proposals under financial
constraints of capital expenditure budget.
• The project selection under capital rationing involves two stages:
 identification of the acceptable projects.
 selection of the combination of projects.

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 Types of Capital rationing
• Capital rationing can be of two types, namely,
 soft rationing and
 hard rationing.
• Hard rationing refers to the situation when a business firm cannot raise required
finances to execute all potential available profitable investment project.
• In Soft rationing different divisions/units of a firm are allocated a fixed amount of
capital budget each year.
• The method of selecting investment projects under capital rationing situation will
depend upon whether the projects are indivisible or divisible.
• Indivisible project is a project which can be accepted/rejected in its entirety.
• Divisible project is a project which can be accepted in parts.

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 Fallout of Capital Rationing
• Capital rationing limits the amount to be spent on capital expenditure decisions.
• It usually results in an investment policy that is less than optimal.
• It may lead to the acceptance of several small investment projects rather than a
few large investment projects.
• It does not reckon intermediate cash inflows expected to be provided by an
investment project.

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 Inflation and Capital Rationing

• Cash flows of the project should be adjusted for the inflation factor so that
they reflect the real purchasing power.
• Real cash flows are cash flows discounted/deflated to reflect effect of
inflation on nominal cash flows.
• Real cost of capital is cost of capital adjusted for inflation effect.

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