Chapter Six: Capital Budgeting/Investment Decision

4.1 Introduction
An efficient allocation of capital is the most important finance function in the modern time; it
involves decisions to commit the firm’s funds to the long-term assets. Such decisions are of
considerable importance to the firm since they tend to determine its value, size by influencing its
growth, profitability and risk.

4.2. Nature of Investment Decisions

The investment decisions of a firm are generally known as the capital budgeting or capital
expenditure decisions. As capital budgeting decision may be defined as the firm’s decision to
invest its current funds most efficiently in the long-term assets in anticipation of an expected
flow of benefits over a series of years. The long-term assets are those which affect the firm’s
operation beyond a one-year period.
The following are the features of investment decisions:
 The exchange of current funds for future benefits.
 The funds are invested in long-term assets.
 The future benefits will occur to the firm over a series of year.
It is significant to emphasize that expenditure and benefits of an investment should be measured
in cash. In the investment analysis, it is cash flow which is important, not the accounting profit .
It may also be pointed out that investment decisions affect the firm’s value. The firm’s value will
increase if investments are profitable and add to the shareholders’ wealth. Thus, investments
should be evaluated on the basis of a criterion which is compatible with the objective of the
shareholders’ wealth maximization. An investment will add to the benefits as per the
opportunities cost of capital. In this section we assume that the investment project’s opportunity
cost of capital is known. We also assume that the expenditures and benefits of the investment are
known with certainty.
4.3 Importance of Investment Decisions.
Investment decisions require special attention because of the following reasons:
 They influence the firm’s growth in the long run.
 They involve commitment of large amount of funds.
 They are irreversible, or reversible at substantial loss.
 They are among the most difficult decisions to make.
Growth: The effects of investment decisions extend in to the future and have to be endured for a
longer period than the consequences of the current operating expenditure. A firm’s decisions to
invest in long-term assets have a decisive influence on the rate and direction of its growth.
Wrong decisions can prove disastrous for the continued survival of the firm; unwanted or
unprofitable expansion of assets will result in heavy operating costs of the firm. On the other
hand, inadequate investment in assets would make it difficult for the firm to compete
successfully and maintain its market share.
Funding: Investment decisions generally involve large amount of funds which make it
imperative for the firm to plan its investment programmers very carefully and make an advance
arrangement for procuring finances internally or externally.

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 Irreversibility: most investment decisions are irreversible. It is difficult to find a market for
such capital items once they have been acquire. The firm will incur heavy losses if such assets
are scrapped.
Complexity: investment decisions are among the firm’s most difficult decisions. They are an
assessment of future events which are difficult to predicate. It is really a complex problem to
correctly estimate the future cash flow of an investment. The uncertainty in cash flow is caused
by economic, political, social and technological forces.
4.4 Types of investment Decisions
There are many ways to classify investments. One classification is as follows:
 Expansion of existing business
 Expansion of new business
 Replacement and modernization
1. Expansion and Diversification: A company may add capacity to its existing product lines to
expand existing operations. Expansion of a new business requires investment in new products
and a new kind of production activity within the firm. If a package manufacturing company
invests in a new plan and machinery to produce a product which the firm has not manufactured
before this represents expansion of new business or diversification. Sometimes a company
acquires exiting firms to expand its business. In either case, the firm makes investment in the
expectation of additional revenue. Investments in existing or new products may also be called
as Revenue-expansion investments.
2. Replacement and Modernization: the main objective of modernization and replacement is
to improve operating efficiency and reduce costs. Costs savings will reflect in the increased
profits. The firm must decide to replace those assets with new assets that operate more
economically. If a cement company changes from semiautomatic drying equipment to fully
automatic drying equipment, it is an example of modernization and replacement. Replacement
decisions help to introduce more efficient and economical assets and therefore, as also called
cost-reduction investments. However, replacement decision which involves substantial
modernization and technological improvement expand revenue as well as reduce costs.
Yet another useful way to classify investments is as follows:
 Mutually exclusive investment
 Independent investments
 Contingent investments
Mutually Exclusive Investment: mutually exclusive investments serve the same purpose and
compete with each other. If one investment is undertaken, others will have to be excluded. A
company may for example; either use a more labor-intensive, semi automatic machine or employ
a more capital intensive highly automatic machine for production. Choosing the semi automatic
machine precludes the acceptance of the highly automatic machine.
Independent Investments: independent investments serve different purpose and do not compete
with each other. For example, a heavy engineering company may be considering expansion of its
plant capacity to manufacture additional excavators and addition of few production facilities to
manufacture new product- light commercial vehicles. Depending on their profitability and
availability of funds, the company can undertake both investments.
Contingent Investments: contingent investments are dependent projects; the choice of one
investment necessitates undertaking one or more other investment. For example, if a company
decides to build a factory in a remote, backward area, it may have to invest in house, roads,
hospitals, schools etc. for employees. The total expenditures will be treated as one single
investment.

Chapter Four -Capital Budgeting Notes Page 2

4.5. Phases of Capital Budgeting
The capital budgeting process consists of five distinct but interrelated steps.
1. Proposal generation: Proposals are made at all levels within a business organization and are
reviewed by finance personnel. Proposals that require large outlays are more carefully
scrutinized than less costly ones.
2. Review and analysis: Formal review and analysis is performed to assess the appropriateness
of proposals and evaluate their economic viability. Once the analysis is complete, a summary
report is submitted to decision makers.
3. Decision making: Firms typically delegate capital expenditure decision making on the basis
of dollar limits. Generally, the board of directors must authorize expenditures beyond a certain
amount. Often plant managers are given authority to make decisions necessary to keep the
production line moving.
4. Implementation: Following approval, expenditures are made and projects implemented.
Expenditures for a large project often occur in phases.
5. Follow-up: Results are monitored and actual costs and benefits are compared with those that
were expected. Action may be required if actual outcomes differ from projected ones.
Each step in the process is important. Review and analysis and decision making consume the
majority of time and effort. Because of their fundamental importance, this chapter gives primary
consideration to review and analysis and to decision making
4.6 Capital Budgeting under Certainty.
Evaluation Techniques
The methods of apprising capital expenditure proposals can be classified into two broad
categorized.
A. Traditional techniques(Non discounting factors)
1. Accounting Rate of Return(ARR)
2. Payback period (PBP)
B. Time adjusted Techniques ( Discounting factor)
3. Net present value(NPV) method
4. Profitability Index(PI) method
5. Internal rate of Return(IRR) method
A. Traditional techniques (Non - discounting factors)
1. Accounting rate of return(ARR)
The method is based upon accounting information rather than cash flows. It is a measure of a
project’s profitability from a conventional accounting stand point.
ARR = Average annual profit x100
Initial investment
Average annual profit = total expected after tax profit of the project
Life of the project
 In the case annuity (equal annual cash inflow), the average after tax profits is equal to
any year’s profit.
A). with equal annual net profit (net income)
Example: ACL Corporation is considering an investment in project “A” based on the following
information.
Net investment……………………………………………Br.12, 000
Annual net income (estimated)………………….. 2,000
Estimated life…………………………………………..… 5 years
Target ARR………………………………………………. 15%

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Required: Compute ARR and interpret your result.
Average annual net income = 5 yrs x Br.2000 = Br.2, 000
5 yrs
ARR = Average Annual net income = 2,000 x100 = 16.67%
Initial net investment 12,000
Accept-project rules: accept the project if the computed ARR is greater than the minimum
target ARR set by the firm. Otherwise the project is rejected. In ranking projects having the same
target ARR, the project with the highest ARR should be selected because it is more profitable.
 Interpretation: ACL Corporation should accept the investment in project A because
the actual ARR (16.67%) is greater than the target ARR of 15%.
B) With unequal annual net profit (net income)
Example 2: Determine ARR from the following data of two machines A and B and interpret your
result assuming the target ARR is 10%.
Machine A Machine B
Cost (Initial Investment) Br.60,000 Br.60,000
Profit before depreciation and taxes:
1st year…………………………. Br.20, 000 Br.29, 000
2nd year ……………………….. 22,000 27,000
rd
3 year………………………… 25,000 25,000
4th year………………………. 27,000 22,000
5th year………………………. 29,000 20,000
Total ………………………… 123,000 123,000
Estimated life in year…….. 5 5
Estimated salvage value…. Br.5, 000 Br.5,000
Average Income tax rate. 55% 55%
Additional information: depreciation is to be computed on straight line basis.
Solution:
Machine A machine B
Net income After Tax:
1st year………..……………… Br.4050 Br.8100
nd
2 year ……………………….. 4950 7200
3rd year………………………… 6300 6,300
th
4 year………………………. 7200 4950
5th year………………………. 8100 4050
Total net income……….. 30,600 30,600

Average Annual 30,600 = 6120 30,600 =6120

Net income = 5 5
ARR of machine A &B = 6120 x 100=10.2% 6120 x 100 = 10.2%
60,000 60, 000
Interpretation: Project A&B are equally desirable thus both of them should be accepted, because
computed ARR is greater than Target ARR (10.2% > 10%)
Advantages of ARR
1. It is easy to calculate 3. It considers profitability
2. It is understandable

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Disadvantages of ARR.
1. It uses accounting income rather than cash flow. Accounting profits are based on arbitrary
assumptions and choices and also include non-cash items.
2. It ignores the time value of money for it values benefits in the earlier years and later years at
par (as being the same).
3. It assumes that net investment is written off at a constant rate (i.e., straight line method).
2. THE PAY BACK PERIOD(PBP)
1. PBP is the length of time required for a project’s cumulative net cash inflows (cash inflows
after taxes) to equal its net investment.
2. Thus, the payback period measures the time period needed for a project to break-even on its
net investment.
a. Payback period with equal annual cash inflows
Here, the expected annual net cash inflows are equal (i.e., annuity form)
PB = NI where: NI = Net investment
NCF NCF = Annual net cash inflows ignoring interest payments.
Accept-reject Rule: Accept the project if the actual or computed PB period is less than the
maximum payback set by the firm. Otherwise, the project is rejected. In ranking two projects
having the same maximum allowable payback, the project with shorter payback period should be
chosen because it pays for itself more quickly.
Example 1: The information proved below pertains to project A of XYZ Corporation. The
maximum payback period set by the firm’s management is 4 years.
Net Investment………………………………Br.12, 000
Annual net cash inflows…………………… 4,000
Estimated life………………………………. 5 years
Required: Compute the payback period and interpret the result.
PBP = NI 12,000 = 3 years
NCF 4,000
Interpretation: XYZ Corporation should accept project A because the computed PBP
(3years) is less than the maximum allowable payback period (4 years). Project A will
recover its initial investment in 3 years which is one year before the target payback period set by
management.
b. Payback period with unequal annual cash inflows: If the expected cash inflows are
unequal, the payback period is calculated by determining the length of time required for
cumulative cash inflows to equal the net investment. Thus, the following formula can be used:
PBP = Year before full recovery + unrecovered cost
Cash flow during full recovery year
Or
PBP = year before full recovery + Initial cost (investment) – Recovered cost
Cash flow during full recovery year
Example 2: Compute the PBP for the following cash flows, assuming a net investment of
Birr 25, 000.
Year net investment year cash inflows
0 Br. 25,000 0
1 10,000
2 7,000
3 6,000
4 2,000
5 2,000

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 Assume target PBP is 3 years.
Solution:
Year Net cash inflows Cumulative Net cash flow
1 10,000 10,000
2 7,000 17,000
3 6,000 23,000
4 2,000 25,000
5 2,000 27,000
Payback is 4 years because the cumulative cash inflow equals the initial investment at the end of
4th year.
Interpretation; Reject the project as the computed payback period of 4 years is greater
than the target payback period of 3 years.
Example 3: ABC Company is evaluating two projects with the following cash inflows:

Cash Inflows
Year project X project Y
0 (Br. 56,000) (Br. 56,000)
1 14,000 22,000
2 16,000 20,000
3 18,000 20,000
4 20,000 14,000
5 25,000 17,000
Required: compute the PBP for each project and show which one is preferred or more desirable.
Solution:
Cumulative Net Cash Inflows
Year project X project Y
1 14,000 22,000
2 30,000 42,000
3 48,000 62,000
4 68,000 76,000
5 93,000 93,000
PBP for project X = 3 years + 56,000 – 48,000 PBP for project Y = 2 years + 56,000 – 42,000
20,000 20,000
= 3 years + 0.4 = 2 years + 0.7
= 3.4years = 2.7 years
Interpretation: Project X: The initial investment of Birr 56,000 on project X will be recovered
between year 3 and 4. The payback period would be a fraction more than 3 years. The sum of
48,000 birr is recovered by the end of third year. The balance, birr 8,000 is needed to recovered
in the fourth year. In the fourth year cash flow after tax is 20,000. The pay back fraction is,
therefore, birr 8,000/birr 20,000 = 0.4. Thus the payback period for project X is 3.4 years.
Project Y: the pay back would be 2 years and a fraction of a year. A birr 42,000 is recovered by
the end of second year. The balance of birr 14,000 needs to be recovered in the third year. In the
third year cash flow after tax is birr 20,000. The pay back fraction is 0.7 (Birr 14,000/Birr
20,000). Thus the payback period for project y is 2.7 years.
Decision: Assume the projects are mutually exclusive projects and target PBP is 4 years, ABC
Company should prefer project Y over project X because it has a shorter payback period of
2.7years.

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 Advantage of PBP
1. It easy to understand, calculates, and interprets.
2. It measures the time require for a project to recover the initial investment and, therefore, it
provides a measure of liquidity. This is so because the PBP is based on cash flows analysis
rather than on accounting income.
3. It provides crude measures of risk because it considers project with shorter PBP as less risky.
4. PBP is superior to ARR because the former uses cash flows rather than accounting profits.
Disadvantage of PBP
1. It doesn’t measure the profitability of investment because it ignores cash inflows beyond of
PBP, this can be very misleading in capital budgeting evaluations.
Example:
Year project X project Y
Cost of project (Br. 15,000) (Br. 15,000)
1 5,000 4,000
2 6,000 5,000
3 4,000 6,000
4 0 6,000
5 0 3,000 ignored
6 0 3,000
PBP period of project X = 3 years
Project Y = 3 years
Under the payback method both projects will be given equal weights or ranking which is
apparently incorrect. However from profitability point of view, project Y is more attractive
than project X because it provides birr 12,000 cash inflow after PBP but project X provides 0.
2. It ignores that time value of money: It fails to consider the magnitude and timing of cash
inflows. It doesn’t discount future cash inflows to their present values. Thus, the PBP cannot
be specified in light of the wealth maximization goal because it not based on discounted cash
flows. Instead it considers only the recovery period as a whole. It treats one birr received in
the second year or third year as valued as the first years.
project X project Y
Cost of project (Br. 15,000) (Br. 15,000)
Cash inflows:
Year 1. 10,000 1,000
2. 4,000 4,000
3. 1000 10,000

Total cash inflows 15,000 15,000

PBP: project X = 3years
Project Y = 3 years
 Both projects have same cost of Birr 15,000
 Both projects have same total cash inflows of Birr.15,000
 Both projects have same PB period of 3 years
Although PB method ranks the two projects as being equally desirable, project A would be more
acceptable because of the time values of money.
1. It biases capital budgeting decisions in favor of short-term projects and against long-term
project.

Chapter Four -Capital Budgeting Notes Page 7

 2. Provides no objective criterion for decision making that will maximize shareholders
wealth.
To conclude the discussion of the traditional methods of appraising capital investment decisions,
there are two major drawbacks of these techniques. They do not consider the total benefits in
terms of (1) the magnitude and (2) the timing of cash flows. For these reasons the traditional
methods are unsatisfactory as capital budgeting decision criteria. The two essential ingredients of
theoretically sound appraisal methods, therefore, are that
(1) It should be based on a consideration of the total cash stream, and
(2) It should consider the time value of money as reflected in both the magnitude and the timing
of expected cash flows in each period of a project’s life. The time-adjusted (also known as
discounted cash flow) technique satisfy these requirements and , to that extent, provide a more
objective basis for selecting and evaluating investment projects.
Discounted payback period: This is similar to the regular PB except that the expected cash
flows are discounted by the project’s cost of capital. The discounted payable period is defined as
the number of years required to recover the initial investment from discounted net cash flows.
Example: ABC Company is evaluating two projects with the following cash inflows:
Cash Inflows
Year project X project Y
0 (Br. 56,000) (Br. 56,000)
1 14,000 22,000
2 16,000 20,000
3 18,000 20,000
4 20,000 14,000
5 25,000 17,000
Required:
1. Compute the discounted cash inflows (PV of cash inflows), using a 10% cost of capital
for project X and Project Y.
2. Determine discounted payback period and comment on acceptability of the projects.
Solution:
a) Determining PV of cash inflows
Project X project Y
Year cash inflows PVIF (10%) PV Cash inflows PVIF (10%) PV
1 14,000 0.909 12726 22,000 0.909 19998
2 16,000 0.826 13216 20,000 0.826 16520
3 18,000 0.751 13518 18,000 0.751 13518
4 20,000 0.683 13660 16,000 0.683 10928
5 25000 0.621 15525 17,000 0.621 10557
68,645 71,521
Determination of cumulative present values
Project X project Y
Year PV Cumulative PV PV Cumulative PV
1 12726 12,726 19998 19.998
2 13216 25942 16520 35518
3 13518 39450 13518 50036
4 13660 53120 10928 60964
5 15525 68645 10557 71521

Chapter Four -Capital Budgeting Notes Page 8

 PBP = 4 years + 2880 PBP = 3 years + 5964
15525 10928
= 4 years + 0.1855 = 3 years + 0.5457
= 4.19 years = 3.55years

A. Sophisticated techniques of capital budgeting (Time - adjustment technique)

These techniques are also called time adjusted or discounted cash flow techniques and include
net Present Value, profitability index and internal rate of return which will be discussed in the
following sections.

1. Net present value method

The net present value method is the classic economic method of evaluating the investment
proposals. It is one of the discounted cash flow (DCF) techniques explicitly recognizing the
time value of money. The following steps are involved in the calculation of NPV.
 Cash flows of the investment project should be forecasted based on realistic
assumptions.
 Appropriate discount rate should be identified to discount the forecasted cash flows.
This rate is the firm’s cost of capital which is equal to the required rate of return
expected by investors on investment of equivalent risk.
 Present value of cash flows should be calculated using the cost of capital as the
discount rate.
 NPV should be found by subtracting present value of cash outflows from present
value of cash inflows.
The formula for the NPV can be written as follows
NPV = C1 + C2 +…… Cn - Co
(1+k) (1+k)2 (1+K)n
NPV = PVB – PVC
Where C1, C2 = net cash inflows in years 1, 2
K = the opportunity cost of capital (cost of capital)
PVB = present value of benefits (inflows)
PVC = present value of costs
Co = the initial cost of investment
n = expected life of the investment.
It should be noted that the cost of capital K, is assumed to be know (given) and is constant.
Using PV table NPV can be calculated as follows
A) For annuity form of cash inflows
NPV = PMT (PVIFAk, n) – Co
Where: PMT = constant periodic payment of inflows)
PVIFA k, n = PV interest factor of an annuity at K discount rate for n periods.
Acceptance Rule: it should be noted that the acceptance rule of NPV method is to accept the
investment project if its NPV is positive (NPV>0) and to reject it if the net present value is
negative (NPV<0). Positive NPVs contributed to the net wealth of the shareholders which
should result in the increased price of the firm’s share. The positive NPV will result only if the
project generates cash inflows at a rate higher than the opportunity cost of capital. A project may
be accepted if NPV =0. A zero NPV implies that projects generate cash flows at a rate just equal
to the cost of capital. Thus, the NPV acceptance rues are:
 Accept if NPV > 0
 Reject if NPV < 0

Chapter Four -Capital Budgeting Notes Page 9

  May accept if NPV =0
The NPV method can be used to select between mutually exclusive projects: the one with the
highest NPV should be selected using NPV method. Projects would be ranked in order of NPV’s,
that is, first rank will be given to the project with highest positive NPV and so on.
Example: 1. Project A has a net investment of Birr 12,000 and an annual net cash inflow of Birr
4,000 for five years. Management wants to calculate project A’s NPV using a 16% discount rate
and make the proper decisions.
Using Formula
Given: NI = Br.12, 000 PVOA = PMT (1 - (1+k)-n
NCF = Br.4, 000 each year k
N = 5 years
K = 16% = 4,000(1 - (1.16)-5
0. 16

PVOA = 4000(3.2743) = 13,098

Present value of cash inflows (4000x3.2743) = Br.13, 098

Less: net investment……………………………………............12,000
Equal: Net present value……………………………………………1,098
Various project proposals would be ranked in order of their NPV and the project with the highest
NPV would be assigned the first rank followed by other in descending orders.
Interpretation: project A should be accepted because its NPV is positive.

Example 2: Cash outlay of machine A and B is Birr 56,125 each. Both machines are estimated
to have a salvage value of Br.3000 and useful life of 5 years. The net cash flows for the two
projects are estimated below:
Net Cash Flows
Year Machine A Machine B
1. Br.14,000 22,000
2. 16,000 20,000
3. 18,000 18,000
4. 20,000 16,000
5. 25,000 17,000
Total 90.000 90,000
Required:
1. Compute NPV of the two machines assuming k = 10%
2. Which machine should be accepted if the two machines are
a. Mutually exclusive
b. Independent and the firm have sufficient cash.
Solution:
Machine A Machine B
Net cash PV Present Net cash PV Present value
Year inflows factor value inflows factor
1. Br.14,000 0.9091 12727 22,000 0.9091 20000
2. 16,000 0.8264 13222 20,000 0.8264 16528

Chapter Four -Capital Budgeting Notes Page 10

 3. 18,000 0.7513 13523 18,000 0.7513 13523
4. 20,000 0.6830 13660 16,000 0.6830 10928
5. 25,000 0.6208 15523 17,000 0.6208 10555
Total PV of inflows Br.68655 Br. 71534
Cost outlay (project cost)……… 56,125 …………………………. ………56,125
Net present value (NPV)…………… 12530 15409
A) If project A and B are mutually exclusive, machine B would be preferred because it has
higher NPV and we must select only one in case of such projects (mutually exclusive).
B) If projects A and B are independent, we should accept both machines because the firm has
no shortage of fund. This is because both have positive NPV.
Note:
1. If NPV is positive, project’s actual rate of return exceeds the minimum rate of return.
2. If NPV is negative, the project’s actual rate of return is less than the minimum required
rate of return.
3. If NPV is zero, the projects rate or return equals to the minimum required rate of return.
Advantages of NPV
1. It considers the time value of money because it takes into account the magnitude and timing
of cash flows.
2. It provides an objective criterion for decision-making which maximizes shareholders wealth.
3. It is most conceptually correct capital budgeting approach for selection of mutually exclusive
projects.
4. It considers the total cash flows arising from the proposed project over its life time.
Disadvantages of NPV
1. It is most difficult to compute than the unsophisticated methods
2. Its meaning is difficult to interpret because NPV does not provide a measure of project’s
actual rate of return.
3. THE PROFITABILITY INDEX (PI) Also called benefit/cost ratio (BCR)
The PI is the ratio of the sum of the present values of a project’s net cash inflows to the
project’s present values of cash outflows. The PI indicates the increase in the value of the firm
created by each birr invested in the project. The PI gives the same results regarding investment
proposals as that of the NPV.
Example 1: Refer to example 1 under the topic NPV for Project A

Present value of cash inflows…………………13,097

Net Investment in period 0(NI) …………….....12000

PI = PV of inflows = 13,097/ 12,000= 1.09

Investment (cost)
Interpretation: project “A” returns Birr 1.09 in PV for each birr invested.
Accept – Reject Rues:
A) Accept the project if it’s PI>1, increase the value of the firm.
B) Reject the project if it’s PI<1, decreases the value of the firm.
Note: A project whose PI is equal to or greater than one will maintain or increase the wealth of
owner (as reflected by the share price of the firm’s ordinary share)
Decision: Accept project A as its PI greater than 1.
Advantages of PI:

Chapter Four -Capital Budgeting Notes Page 11

1. It has all advantages of NPV
2. It is a relative measure of rerun per birr of net investment and therefore, it is better than the
NPV method when projects have the same NPV but different PV of cash outflows.
Disadvantages
*PI may conflict with the NPV method when dealing with mutually exclusive investments.
Example2: Refer to example 2 under the topic NPV for machines A and B and compute the PI
PI = PV of cash inflows
PV of cash outflows

PI (machine A) = 68,655 = 1.22

56,125

PI (machine B) = 71,534 = 1.27

56,125
 If Machines A and B are mutually exclusive, machine B would be preferred.
 If Machine A and B are independent, we would accept both machines.
3. INTERNAL RATE OF RETURN(IRR)
The internal rate of return (IRR), although considerable more difficult to calculate by hand than
NPV, is probably the most used sophisticated capital budgeting techniques for evaluation
investment alternatives.
The internal rate of return (IRR) is defined as the discount rate that equates the present value
of cash inflows with the cost of investment project. The (IRR), in other words, is the discount
rate that equates the NPV of an investment with zero.
NPV = present value of cash inflows - cost of initial investment.

( )
n
CFt
NPV = ∑ t−Co
t =1 (1+k )
Where: Co = initial investment
CFt = cash inflows at time t.
K = firm’s discount rate
Now the above NPV formula can be solved for the value of K that causes NPV equal 0.

( )
n
CFt
0 = ∑ (1+k )
t−Co
t =1
The decision Criterion
The decision criterion when IRR is used to make accept-project decision is as follows:
 If IRR greater than the cost of capital (WACC), accept the project.
 If IRR is less than the cost of capital (WACC), reject the project.
 This criterion guarantees that the firm earns at least its required return (cost of capital)

Calculating the IRR

The IRR can be found by using trial-and-error technique or with the aid of a sophisticated
financial calculator. Here we demonstrate the trial-and-error approach. The steps involved in
calculating IRR are given below.
A. Steps for calculating IRR of Annuity cash streams
Step 1: Calculate the payback period for the project, PBP = investment /annual inflows.

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 Step 2: Use a table (the factor for a $1 annuity, PVIFA) for life of the project, to find the
factor closest to the pay back value. The discount rate associated with that factor is the IRR.

B. Steps for calculating IRR of Mixed cash stream

Step 1: Calculate the average annual cash inflow.
Step 2: Divide the average annual cash inflow into the initial investment to get an average
payback period.
Step 3: Use a table (the factor for a $1 annuity, PVIFA) for life of the project, to find the
factor closest to the Average pay back value. The result will be very rough approximation of the
IRR based on the assumption that the mixed stream of cash inflows is an annuity.
Step 4: Adjust subjectively the IRR obtained in step 3 comparing the pattern of average annual
cash inflows (calculated in step 1) to the actual mixed stream of cash inflows. If the actual
cash flow steam seems to have higher inflows in the earlier years than the average stream,
adjust the IRR up. If the actual cash inflows in the earlier years are below the average,
adjust the IRR down. If the average cash inflows seem fairly close the actual pattern,
make no adjustment.
Step 5: using the IRR from step 4, calculate the net present value of the mixed stream cash
flow for the project.
Step 6: if the resting NPV is greater than zero, subjectively raise the discount rate; if the resting
NPV is less than zero, subjectively reduce the discount rate
Step 7: Repeat step 5 until we got negative NPV(NPV< zero).
Example: ABC Company is contemplating two projects - project A and project B. relevant
information is given below. Note that we assume that:
1. All project cash inflows have the same level of risk.
2. The projects have equals useable life.
3. The firm has unlimited fund.
Machine A Machine B
Initial investment Br. 42,000 Br.45,000
Year Operating Cash Flows

1. Br.14,000 28,000
2. 14,000 12,000
3. 14,000 10,000
4. 14,000 10,000
5. 14,000 10,000
Total 70,000 70,000
 Average 14,000 14,000
 Firm cost of capital is 10%.
IRR for project A: for annuity cash stream
Step 1: Payback period = 42,000/14,000 = 3.00
Step 2: According to Present value of annuity factor table, a factor closest to 3.00 for 5 years are
3.058 (for 19%) and 2.991 (for 20%). The value closest to 3.00 is 2.991, therefore the IRR for
project A is 20%.
Interpretation: project A is quite acceptable because IRR (20%) > cost of capital (10%).
IRR of project B: Mixed cash stream
Step 1: Average cash inflows = 70,000/5 = 14,000
Step 2: Average payback period = 45,000/14,000 = 3.214

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Step 3: In Present value of annuity factor table, the factor closest to 3.214 for 5 years is 3.199;
the discount rate at this factor (3.199) is 17%. The staring estimate of IRR is therefore 17%.

Step 4: Because the actual early year cash inflows are greater than average annual cash inflows
of Br.14, 000, subjectively increase of 2% is made in the discount rate. This makes in the
estimated IRR 19%.
Step5: the NPV of the mixed streams cash inflow at 19% is calculated as follows;
Let’s try at 19%.
Year Cash inflow PVIF(19%) PV of Cash inflow at 19%
t (A) (B) (A) x (B) =
1 28,000 0.840 Br.12, 520
2 12,000 0.706 8,472
3 10,000 0.593 5,930
4 10,000 0.499 4,990
5 10,000 0.419 4,190
PV of cash inflows ……………………………………… 47,102
Initial investment………………………………………… 45,000
NPV……………………………………………………… 2,102
Step 6 &7: Because the NPV of Br.2, 102 calculated in step 5, is greater than zero. The discount
rate should be subjectively increased. So, let’s try at 21%.
Year Cash inflow PVIF at 21% PV of cash inflow at 21%
t A B (A) x (B)
1 28,000 0.826 Br. 23,128
2 12,000 0.683 8,196
3 10,000 0.564 5,640
4 10,000 0.467 4,670
5 10,000 0.386 3,860
PV of cash inflows ……………………………………… 45,494
Initial investment…………………………………………… 45,000
NPV………………………………………………………… 494
This calculation indicates that the NPV of Br. 494 for an IRR of 21% is reasonable close to, but
sill greater than zero. Thus a higher discount rate should be tried and let’s try at 22%
Year Cash inflow PVIF (22%) PV of cash inflow at 22%
t A B (A) x (B)
1 28,000 0.082 Br. 22,960
2 12,000 0.674 8,064
3 10,000 0.551 5,510
4 10,000 0.151 4,510
5 10,000 0.370 3,700
PV of cash inflows ……………………………………… 44,744
Initial investment………………………………………… 45,000
NPV………………………………………………………… Br. -256
Interpretation:
Because 21% and 22% are consecutive discount rates that give positive and negative NPV,
the trial and error problems can be terminated.

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The IRR that we are seeking is the discount rate for which the NPV is closest to zero. For this
project, 22% causes the NPV to be closer to zero than 21%, 22 % is the IRR that we should use.
 Project B is acceptable because its IRR of approximately 22% is greater than 10%,
cost of capital of ABC Company.

If the projects (A and B) are mutually exclusive and/or the firm has cash difficulty, project B
should be accepted first because its 22% IRR is greater than 20% of project A.
N.B Both NPV method and IRR method should reach the some accept/reject conclusion.
 If NPV accepts a project, IRR will also accept it
 If a project is rejected by using NPV will also be rejected under IRR method.

Interpolation (Approximation of IRR): To find an exact IRR we use the following formula.
IRR = LTR + NPV at LTR * HTR- LTR
NPV at LTR - NPV at HTR
Where: LTR = Lower trial discount rate
HTR = Higher trial discount rate
 Computation of the exact IRR for Project A and project B is shown below.
Project A
IRR = 19% + 812 * 20%-19%
812-(-126)

= 0.19 +0.008656716= 0.1986 = 19.86%

Work Note:
PV of inflow at 20% = 2.991 x 14,000 = 41874. Thus, NPV at 20%= PV of cash
inflow – Project cost = 41874- 42,000= -126
PV of inflow at 19% = 3.058 x 14,000 = 42812. Thus, NPV at 19%= PV of cash
inflow – Project cost = 42, 812- 42,000= 812
Project B
IRR = 21% + 494 * 22%-21%
494-(-256)

= 0.21 + 0. 0065866667 = 0.216586667= 21.66%

Exercises: 1.A chemical Company is considering investing in a project that cost $4,000,000.
The estimated salvage value is zero, tax rate is 55%, and cost of capital (k) is 15%. The company
uses straight line depreciation and the proposed project has cash flow before tax (CFBT) as
follows.
Year CFBT (Cash Flow Before Tax)
1. Br.1 million
2. 1 million
3. 1.5 millions
4. 1.5 millions
5. 2,5 millions
Required: Determine the following:
i) Discounted pay back
ii) NPV
iii) IRR
iv) PI( profitability index)

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2. A company is considering a new project for which the investment data are as follows;
Capital outlay………………………………Br. 1 million
Depreciation……………………………… 20% per Annam on the initial outlay.

Forecasted annual income before charging depreciation, but after all other charges is as
follows:
Year Forecasted annual income
1. ……………………….Br. 1 million
2. …………………….. 1 million
3. …………………….. 80,000
4. ……………………. 80,000
5. ……………………. 40,000
Br. 4 millions
On the basis of available data, set out, calculate, illustrating and comparing the following
methods of evaluating the capital projects.
1. Discounted payback period
2. NPV
3. IRR
4. Profitability index (PI)
3. Machine A requires an initial investment of Br.56, 125 and has estimated salvage value
of BR.3, 000 and estimated life of 5 years. Average income tax rate is 55% and
depreciation has been charged on straight-line basis. Annual estimated net income for
the machine for the five years of its estimated useful life is given below:
Year 1 2 3 4 5
Net Income 3375 5375 7375 9375 11375
Required: for Machine A
1. Compute the ARR and interpret your result if the form’s target ARR is 27%
2. Compute the payback period and interpret your result if the film’s maximum payback period
set by management is 3 years.
3. Compute the NPV assuming the firm’s cost of capital is 15% and interpret your result.
4. Compute the profitability index and interpret your result (considered your result of
requirement 3.)
5. Compute the IRR and interpret it assuming the firm’s cost of capital is 19%
6. Compute the discounted payback period.

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