Management Information CLASS (L-01 & L-02) : Prepared By: A.K.M Mesbahul Karim FCA

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MANAGEMENT INFORMATION

CLASS (L-01 & L-02)

Prepared By: A.K.M Mesbahul


Karim FCA
Chapter – 11 : Investment appraisal techniques
The investment decision-making process

A typical model for investment decision making has a number of distinct stages.

Origination of proposals. It has been suggested that good ideas for investment are likely to occur in
environments in which staff feel free to present and develop ideas. Some alternatives will be rejected early
on. Others will be more thoroughly evaluated.

Project screening. Before a detailed financial analysis is undertaken a qualitative evaluation of the project
will be made. For example, questions will be asked such as whether the project 'fits' with the organization's
long-term objectives and whether all possible alternatives have been considered. Only if the project passes
this initial screening will more detailed financial analysis begin.

Analysis and acceptance. This will include a financial analysis, using the organization's preferred investment
appraisal techniques. Qualitative issues will also be considered before a decision is made whether to
proceed and the project is implemented.

Monitoring and review. During the project's progress it will be necessary to ensure that capital spending
does not exceed the amount authorized, that the implementation of the project is not delayed and that the
anticipated benefits are eventually obtained.
Continue…
The payback method:
 The payback period is the time it takes for a project's net cash inflows to equal the initial cash
investment.
 The payback period is often used as an initial screening process.
 If a project's payback period is shorter than a defined maximum period then the project
should be evaluated further using a more sophisticated project appraisal technique.
 A major disadvantage is that the timing of cash flows within the payback period are ignored
and therefore no account is taken of the time value of money.

Worked example: Payback period

An asset costing Tk.120,000 is to be depreciated over 10 years to a nil residual value. Profits
after depreciation for the first five years are as follows.
Year Tk.
1 12,000
2 17,000
3 28,000
4 37,000
5 8,000

Requirement
Calculate the payback period to the nearest month.
Continue…
Solution
Cash flows, ie profits before depreciation should be used.
Year Profit after depreciation Tk.'000 Depreciation Tk.'000 Cash flow Tk. '000 Cumulative cash flow Tk. '000
1 12 12 24 24
2 17 12 29 53
3 28 12 40 93
4 37 12 49 142
5 8 12 20 162
Payback period = 3 years + [ ( 120 - 93)/ 49 X 12 months]
= 3 years 7 months = 36 + 7 = 43 months

Disadvantages of the payback method


There are a number of serious drawbacks to the payback method.
 It ignores the timing of cash flows within the payback period.
 It also ignores the cash flows after the end of the payback period and therefore the total project return.
 It ignores the time value of money

There are also other disadvantages.


 The method is unable to distinguish between projects with the same payback period.
 The choice of any cut-off payback period by an organization is arbitrary.
 It may lead to excessive investment in short-term projects.
 It takes account of the risk of the timing of cash flows but does not take account of the variability of those cash flows.
Continue…
Advantages of the payback method
The use of the payback method does have advantages, especially as an initial screening device.
 A long payback means capital is tied up
 Focus on early payback can enhance liquidity
 Shorter-term forecasts are likely to be more reliable
 The calculation is quick and simple
 Payback is an easily understood concept

The accounting rate of return method


 The Accounting Rate of Return (ARR) expresses the average accounting profit as a percentage
of the capital outlay.
 The capital outlay (the denominator in the ARR calculation) may be expressed as the initial
investment or as the average investment in the project.
 The decision rule is that projects with an ARR above a defined minimum are acceptable; the
greater the ARR, the more desirable the project.

Calculating the accounting rate of return


The accounting rate of return (ARR) method of appraising a project involves estimating the
accounting rate of return that a project should yield. If it exceeds a target rate of return then the
project is acceptable.
Continue…
There are two different ways of calculating the ARR.
ARR Average annual accounting profit/Initial investment X 100%

ARR Average annual accounting profit/ Average investment X 100%


The average investment is calculated as ½ (initial investment + final or scrap value).
Worked example: The accounting rate of return
A project involves the immediate purchase of plant at a cost of Tk. 110,000. It would generate annual profits before
depreciation of Tk. 24,000 for five years. Scrap value will be Tk. 10,000 at the end of the fifth year.
Requirement
Calculate the ARR using the initial and average investment.
Solution
(a) Using initial investment
Average profit (Profits before depreciation – depreciation)/5
[(Tk. 24,000x5) - (Tk.110,000 – Tk.10,000)]/5
= Tk. 4,000 p.a.

ARR Tk. 4,000/ Tk.110,000 X 100%


= 3.60%

(b) Using average investment Tk. 4,000/ Tk.(110,000 + 10,000) / 2 X 100%


= 6.70%
Continue…

Disadvantages of the ARR method:

 It does not take account of the timing of the profits from a project. Whenever capital is invested in a project,
money is tied up until the project begins to earn profits which pay back the investment.
 Money tied up in one project cannot be invested anywhere else until the profits come in.
 Management should be aware of the benefits of early repayments from an investment, which will provide the
money for other investments.

There are a number of other disadvantages.


 It is based on accounting profits rather than cash flows, which are subject to a number of different accounting
policies
 It is a relative measure rather than an absolute measure and hence takes no account of the size of the
investment
 It takes no account of the length of the project
 Like the payback method, it ignores the time value of money

Advantages of the the ARR method:

 It is quick and simple to calculate


 It involves a familiar concept of a percentage return
 Accounting profits can be easily calculated from financial statements
 It looks at the entire project life
 Managers and investors are accustomed to thinking in terms of profit, and so an appraisal method which
employs profit may be more easily understood
 It allows more than one project to be compared
Continue…

The net present value method:

 The terminal value of an investment is its value at some point in the future, including an
allowance for interest.
 Discounting converts a sum of money receivable or payable in the future to its present value,
which is the cash equivalent now of the future value.
 Discounted cash flow (DCF) techniques discount all the forecast cash flows of an investment
proposal to determine their present value.
 The net present value (NPV) of a project is the difference between its projected discounted
cash inflows and discounted cash outflows.
 The decision rule is to accept a project with a positive NPV.
 An annuity is a constant cash flow for a number of years.
 The net terminal value (NTV) is the cash surplus remaining at the end of a project after
taking account of interest and capital payments.
Compounding: calculating the terminal value
Suppose that a company has Tk.10,000 to invest, and wants to earn a return of 10% (compound
interest*) on its investments. This means that if the Tk. 10,000 could be invested at 10%, the
value of the investment with interest would build up as follows.
(a) After 1 year Tk.10,000 X (1.10)1 = Tk 11,000
(b) After 2 years Tk 10,000 X (1.10)2 = Tk 12,100
(c) After 3 years Tk 10,000 X (1.10)3 = Tk 13,310 and so on.
Continue…
* This means that interest is earned each year on the previous years' interest.

This is compounding. The formula for the future value or terminal value of an investment plus accumulated
interest after n time periods is V = X(1 + r)n

Where,
V is the future value or terminal value of the investment with interest
X is the initial or 'present' value of the investment
r is the compound rate of return per time period, expressed as a decimal (so 10% = 0.10, 5% = 0.05
and so on)
n is the number of time periods.
Usually r is an annual rate of return and n is the number of years.
Worked example: Terminal value
What is the terminal value of Tk. 200 invested today at an interest rate of 7% per annum in 10 years' time?
Solution:
Terminal value = Tk.200 X (1 +.07)10 = Tk. 393

Terminal values can cause difficulties when trying to compare or choose between projects because:
 the projects may not end on the same future date (or may not end at all)
 decision makers are more likely to be interested in the effect of the project on shareholder wealth now,
rather than in the future.
 It is therefore more common to look at present values. The present value of a future sum shows what
that future sum is worth today. This is in effect the reverse of compounding.
Continue…

Discounting:

Discounting starts with the future value (a sum of money receivable or payable at a future
date), and converts the future value to a present value, which is the cash equivalent now of the
future value.
For example, if a company expects to earn a (compound) rate of return of 10% on its
investments, how much would it need to invest now to have the following investments?
(a) Tk 11,000 after 1 year
(b) Tk 12,100 after 2 years
(c) Tk 13,310 after 3 years
The answer is Tk 10,000 in each case, and we can calculate it by discounting.

The discounting formula to calculate the present value (X) of a future sum of money (V) at the
end of n time periods is X = V/(1+r)n
(a) After 1 year, Tk 11,000/(1.10)1 = Tk 10,000
(b) After 2 years, Tk 12,100/(1.10)2 = Tk 10,000
(c) After 3 years, Tk 13,310/(1.10)3 = Tk 10,000
Continue…
Net present value (NPV)

Discounted cash flow (DCF) techniques are used in calculating the net present value of a series
of cash flows. This measures the change in shareholder wealth now as a result of accepting a
project.

NPV = present value of cash inflows less present value of cash outflows

 If the NPV is positive, it means that the cash inflows from a project will yield a return in
excess of the cost of capital, and so the project should be undertaken if the cost of capital is
the organisation's target rate of return.

 If the NPV is negative, it means that the cash inflows from a project will yield a return below
the cost of capital, and so the project should not be undertaken if the cost of capital is the
organisation's target rate of return.
 If the NPV is exactly zero, the cash inflows from a project will yield a return which is exactly
the same as the cost of capital, and so if the cost of capital is the organisation's target rate of
return, the project will have a neutral impact on shareholder wealth and therefore would
not be worth undertaking because of the inherent risks in any project.
Continue…
Worked example: NPV
Rahim has a cost of capital of 15% and is considering a capital investment project, where the
estimated cash flows are as follows.
Year Cash flow
0 (100,000)
1 60,000
2 80,000
3 40,000
4 30,000
Requirement
Calculate the NPV of the project, and assess whether it should be undertaken.
Solution
Year Cash flow Discount factor Present value
15%
0 (100,000) 1.00 -100,000
1 60,000 (1/1.15)1 = 0.870 52,200
2 80,000 (1/1.15)2 = 0.756 60,480
3 40,000 (1/1.15)3 = 0.658 26,320
4 30,000 (1/1.15)4 = 0.572 17,160
NPV 56,160
Continue…
Timing of cash flows: conventions used in DCF

Discounting reduces the value of future cash flows to a present value equivalent and so is clearly concerned
with the timing of the cash flows. As a general rule, the following guidelines may be applied.
 A cash outlay to be incurred at the beginning of an investment project ('now') occurs in time 0. The
present value of Tk 1 now, in time 0, is Tk 1 regardless of the value of the discount rate r.
 A cash flow which occurs during the course of a time period is assumed to occur all at once at the end of
the time period (at the end of the year). Receipts of Tk 10,000 during time period 1 are therefore taken
to occur at the end of time period 1.
 A cash flow which occurs at the beginning of a time period is taken to occur at the end of the previous
time period. Therefore a cash outlay of Tk 5,000 at the beginning of time period 2 is taken to occur at the
end of time period 1.

Worked example: Calculating the present value of an annuity


In the example of the college training course, the present value of the fees, assuming a 20% cost
of capital, could be calculated as follows.

Year Cash flow Present value factor Present value of cash values
Tk. 20%
1 30,000 0.833 24,990
2 30,000 0.694 20,820
3 30,000 0.579 17,370
63,180
Continue…
Where there is a constant cash flow from year to year (in this case Tk 30,000 per annum for years 1– 3) it is
quicker to calculate the present value by adding together the discount factors for the individual years. These
total factors could be described as 'same cash flow per annum' factors, 'cumulative present value' factors or
'annuity' factors.
Annuity PV factor = 1 – (1 + r)-n / r , Where r = rate per period, n = Number of periods
The calculation could then be performed in one step:
Tk 30,000 x 2.106 = Tk 63,180

Net terminal value


Net terminal value (NTV) is the cash surplus remaining at the end of a project after taking account of
interest and capital repayments.
The NTV discounted at the cost of capital will give the NPV of the project.
Worked example: The net terminal value
A project has the following cash flows.
Year Tk.
0 -5,000
1 3,000
2 2,600
3 6,200

Requirement
Calculate the net terminal value of the project.
Continue…
Solution
The net terminal value can be determined directly from the NPV, or by calculating the cash surplus at the end
of the project.
Assume that the Tk 5,000 for the project is borrowed at an annual interest rate of 10% and that cash flows
from the project are used to repay the loan.
Tk.
Loan balance outstanding at beginning of project 5,000
Interest in year 1 at 10% 500
Repaid at end of year 1 -3,000
Balance outstanding at end of year 1 2,500
Interest year 2 250
Repaid year 2 -2,600
Balance outstanding year 2 150
Interest year 3 15
Repaid year 3 -6,200
Cash surplus at end of project 6,035

So, The net terminal value is Tk 6,035.


Continue…
Advantages of NPV
The advantages of NPV are as follows.
 It is directly linked to the assumed objective of maximizing shareholder wealth as it measures, in
absolute (Tk) terms, the effect of taking on the project now, ie year 0
 It considers the time value of money, ie the further away the cash flow the less it is worth in present
terms
 It considers all relevant cash flows, so that it is unaffected by the accounting policies which cloud profit-
based investment appraisal techniques such as ARR
 Risk can be incorporated into decision making by adjusting the company’s discount rate
 It provides clear, unambiguous decisions, ie if the NPV is positive, accept; if it is negative, reject.

The time value of money


DCF is a project appraisal technique that is based on the concept of the time value of money, that Tk 1 earned
or spent sooner is worth more than Tk 1 earned or spent later. Various reasons could be suggested
as to why a present Tk 1 is worth more than a future Tk 1.
Uncertainty. The business world is full of risk and uncertainty, and although there might be the promise of
money to come in the future, it can never be certain that the money will be received until it has actually been
paid. This is an important argument, and risk and uncertainty must always be considered in investment
appraisal. But this argument does not explain why the discounted cash flow technique should be used to
reflect the time value of money.
Inflation. Because of inflation it is common sense that Tk 1 now is worth more than Tk 1 in the future. It is
important, however, that the problem of inflation should not confuse the meaning of DCF, and the following
points should be noted.
Continue…
– If there were no inflation at all, discounted cash flow techniques would still be used for investment
appraisal.
– Inflation, for the moment, has been completely ignored.
– It is obviously necessary to allow for inflation.

An individual attaches more weight to current pleasures than to future ones, and would rather have Tk
1 to spend now than Tk 1 in a year's time. Individuals have the choice of consuming or investing their
wealth and so the return from projects must be sufficient to persuade individuals to prefer to invest now.
Discounting is a measure of this time preference.

Money is invested now to make profits (more money or wealth) in the future. Discounted cash flow
techniques can therefore be used to measure either of two things.
– What alternative uses of the money would earn (NPV method) (assuming that money can be invested
elsewhere at the cost of capital)
– What the money is expected to earn

Advantages of DCF methods of appraisal


Taking account of the time value of money (by discounting) is one of the principal advantages of the DCF
appraisal method. Other advantages include the following.
 The method uses all cash flows relating to the project
 It allows for the timing of the cash flows
 There are universally accepted methods of calculating the NPV and IRR
Continue…
A comparison of the ROI and NPV methods
 That managers are often judged on the return on investment (ROI) of their division or responsibility centre which is very
similar in principle to the ARR.
 Managers will only want to invest in projects that increase divisional ROI but on occasion such a strategy may not
correspond with the decision that would be arrived at if NPV were used to appraise the investment.

For example, suppose that Division M is considering an investment of Tk 200,000 which will provide a net cash inflow
(before depreciation) of Tk 78,000 each year for the four years of its life. It is group policy that investments must show a
minimum return of 15%.

As the working below shows, using net book value (NBV) at the start of each year and depreciating on a straight line basis to
a nil residual value, in year 1 the ROI would be below the target rate of return of 15%. If management were to take a short-
term view of the situation, the investment would be rejected if the ROI measure were to be used, despite the fact that the
investment's NPV is positive and that in years 2 to 4 the ROI is greater than the target rate of return.

Years
1 2 3 4
Particulars Tk. Tk. Tk. Tk.
NBV of investment at start of year 200,000 150,000 100,000 50,000
Cash flow (before depreciation) 78,000 78,000 78,000 78,000
Less depreciation -50,000 -50,000 -50,000 -50,000
Net profit 28,000 28,000 28,000 28,000
ROI 0.14 0.1867 0.28 0.56

Net present value = – Tk. 200,000 + (Tk 78,000 X 2.855) = Tk 22,690.


Continue…
Discounted payback
The payback method can be combined with DCF to calculate a discounted payback period.
The discounted payback period (DPP) is the time it will take before a project's cumulative NPV turns from
being negative to being positive.

Worked example: Discounted payback


If we have a cost of capital of 10% and a project with the cash flows shown below, we can calculate a
discounted payback period.

Year Cash flow Discount factor 10% Present value Cumulative NPV

0 -100,000 1.ooo (100,000) (100,000)


1 30,000 0.909 27,270 (72,730)
2 50,000 0.826 41,300 (31,430)
3 40,000 0.751 30,040 (1,390)
4 30,000 0.683 20,490 19,100
5 20,000 0.621 12,420 31,520
NPV 31,520
Continue…

Advantages and disadvantages of discounted payback period

The approach has all the perceived advantages of the payback period method of investment appraisal: it is
easy to understand and calculate, and it provides a focus on liquidity where this is relevant. In addition,
however, it also takes into account the time value of money. It therefore bridges the gap between the
theoretically superior NPV method and the regular payback period method.

Because the DPP approach takes the time value of money into consideration, it produces a longer payback
period than the non-discounted payback approach, and takes into account more of the project's cash flows.
Another advantage it has over traditional payback is that it has a clear accept-or-reject criterion. Using
payback, acceptance of a project depends on an arbitrarily determined cut-off time. Using DPP, a project is
acceptable if it pays back within its lifetime (because it has a positive NPV).

DPP still shares one disadvantage with the payback period method: cash flows which occur after the
payback period are ignored (although as the DPP is longer than the payback period, fewer of these are
ignored).
Continue…
Worked example: Annuities in advance and delayed annuities
What is the present value of Tk. 1,000 received annually for five years if the first receipt is:
(a) In one year’s time?
(b) Now?
(c) In three years’ time?
Use a discount rate of 15%.

Solution
(a) Present value = Tk.1,000 X annuity factor for five years at 15%
Tk. 1,000 X 3.352 = Tk. 3,352
(b) Only the cash flows at the end of years 1 to 4 need discounting.
Present value = Tk.1,000 received now + (Tk. 1,000 X annuity factor for four years at 15%)
Tk. 1,000 + (Tk. 1,000 X 2.855)
Tk. 3,855
(c) This can be solved in two possible ways.
(i) Present value Tk. 1,000 X (annuity factor for seven years – annuity factor for two years)
Tk. 1,000 X (4.160 – 1.626)
Tk. 2,534

(ii) Present value of annuity at end of year five = Tk. 1,000 X 3.352
= Tk. 3,352
Now this must be discounted again to bring it back to the present value at year 0 (now).
Present value = Tk.3,352 X PV factor for year 2 at 15%
Tk. 3,352 X 0.756
Tk. 2,534
Continue…

Annual cash flows in perpetuity


A perpetuity is an equal annual cash flow forever, ie an annuity that lasts forever. The present
value of a perpetuity of Tk.a per annum forever is calculated as Tk.a/r , where r is the annual
discount rate. This formula finds the present value of the perpetuity stream one year before the
first cash flow.

Worked example: Perpetuities


(a) What is the present value of Tk. 3,000 received in one year's time and forever if the annual
interest rate is 10%?
(b) What would be the present value if the first receipt is in four years’ time?

Solution
(a) Present value = Tk.3,000/0.10
= Tk. 30,000
(b) Present value one year before the first cash flow = at end of year 3
= Tk. 3,000/0.10
= Tk. 30,000
Present value at year 0 = Tk. 3,000 X year 3 10% discount
factor
= Tk. 30,000 X 0.751
= Tk. 22,530
Continue…
Changing discount rates
If the discount rate changes over time the net present value is calculated as follows
Year 0 Year 1 Year 2
NPV = outflow + inflow/(1+r1) + inflow/(1+r1)(1+r2) etc

Where r1 = interest rate for year 1


r2 = interest rate for year 2

Worked example: Changing discount rates


A project's estimated cash flows are as follows.
Year 0 Year 1 Year 2
Tk.m Tk.m Tk.m
Cash flow (10) 6 8

Calculate the NPV if the cost of capital is 10% for the first year and 20% for the second year.

Solution
NPV = (Tk. 10m) + Tk. 6/1.10 + Tk. 8 / (1.10 x1.20)
= Tk. 1.52 m
Continue…
The internal rate of return method

 The internal rate of return (IRR) is the DCF rate of return that a project is expected to achieve.
It is the discount rate at which the NPV is zero.
 If the IRR exceeds a target rate of return, the project would be worth undertaking.
 The IRR can be estimated from a graph of the project's NPV profile. The IRR can be read from
the graph at the point on the horizontal axis where the NPV is zero.
 The IRR interpolation formula is IRR = A + [ P/ P+N X (B - A)] %
where A is the (lower) rate of return with a positive NPV
B is the (higher) rate of return with a negative NPV
P is the value of the positive NPV
N is the absolute value of the negative NPV
Worked example: The IRR method and interpolation
A company is trying to decide whether to buy a machine for Tk. 80,000 which will save costs of
Tk. 20,000 per annum for five years and which will have a resale value of Tk. 10,000 at the end
of year 5.

Requirement
If it is the company's policy to undertake projects only if they are expected to yield a DCF return
of 10% or more, ascertain using the IRR method whether this project should be undertaken.
Continue…
Solution
 The first step is to calculate two net present values, both as close as possible to zero, using rates for the
cost of capital which are whole numbers. One NPV should be positive and the other negative .
 Choosing rates for the cost of capital which will give an NPV close to zero (that is, rates which are close
to the actual rate of return) is a hit-and-miss exercise, and several attempts may be needed to find
satisfactory rates. As a rough guide, try starting at a return figure which is about two thirds or three
quarters of the ARR.
 Annual depreciation would be Tk. (80,000 – 10,000)/5 = Tk. 14,000.
 The ARR would be (Tk. 20,000 - depreciation of Tk. 14,000)/(½ of Tk.(80,000 + 10,000)) =
Tk.6,000/Tk.45,000 = 13.3%.
 Two thirds of this is 8.9% and so we can start by trying 9%. The discounted tables do not provide discount
factors for an interest rate of 9% therefore we need to calculate our own factors.
Using the formula provided at the top of the final column in the tables
PV of an annuity = 1/r [1-1/(1+r)n]
PV factor for 5 years at 9% = 1/ .09 [1- 1/ (1+.09)5] = 3.89
PV factor at 9% for year 5 = 1/ (1.09)5 = 0.65
We can use these factors to discount the cash flows.
Try 9% Year Cash flow PV factor PV of cash flow
Tk. 9% Tk.
0 (80,000) 1.00 (80,000)
1 – 5 20,000 3.89 77,800
5 10,000 0.65 6,500
NPV 4,300
Continue…
 This is fairly close to zero. It is also positive, which means that the internal rate of return is more than 9%.
 We can use 9% as one of our two NPVs close to zero, although for greater accuracy, we should try 10% or
even 11% to find an NPV even closer to zero if we can.
 As a guess, it might be worth trying 12% next, to see what the NPV is. Again we will need to calculate our
own discount factors.
PV factor for 5 years at 12% = 1/ .12 [1- 1/ (1+.12)5] = 3.605
PV factor at 12% for year 5 = 1/ (1.12)5 = 0.567
We can use these factors to discount the cash flows.
Try 12% Year Cash flow PV factor PV of cash flow
Tk. 12% Tk.
0 (80,000) 1.00 (80,000)
1 – 5 20,000 3.605 72,100
5 10,000 0.567 5,670
NPV (2,230)
 This is fairly close to zero and negative.
 The internal rate of return is therefore greater than 9% (positive NPV of Tk. 4,300) but less than 12%
(negative NPV of Tk. 2,230).
 Note. If the first NPV is positive, choose a higher rate for the next calculation to get a negative NPV. If the
first NPV is negative, choose a lower rate for the next calculation.

So IRR = 9 + [ 4300/4300+2230 X (12-9)]%


= 10.98 % say 11%.
Continue…
Advantages of IRR method
 The main advantage is that the information it provides is more easily understood by managers, especially non-
financial managers. 'The project will be expected to have an initial capital outlay of Tk. 100,000, and to earn a
yield of 25%. This is in excess of the target yield of 15% for investments' is easier to understand than 'The
project will cost Tk.100,000 and have an NPV of Tk. 30,000 when discounted at the minimum required rate of
15%'.
 A discount rate does not have to be specified before the IRR can be calculated. A hurdle discount rate is simply
required which is then compared with the IRR.
Disadvantages of IRR method
 If managers were given information about both ARR and IRR, it might be easy to get their relative meaning and
significance mixed up.
 It ignores the relative size of investments. Both projects below have an IRR of 18%.
Project A Project B
Tk. Tk.
Cost, year 0 350,000 35,000
Annual savings, years 1–6 100,000 10,000

Clearly, project A is bigger (ten times as big) and so more 'profitable' but if the only information on which the
projects were judged were to be their IRR of 18%, project B would be made to seem just as beneficial as project A,
which is not the case.

 When discount rates are expected to differ over the life of the project, such variations can be incorporated
easily into NPV calculations, but not into IRR calculations.
 There are problems with using the IRR when the project has non-conventional cash flows or when deciding
between mutually exclusive projects.
Continue…
Mutually exclusive projects
The IRR and NPV methods can give conflicting rankings when assessing which project should be given
priority. Let us suppose that a company with a cost of capital of 16% is considering two mutually exclusive
options, option A and option B. The cash flows for each are as follows.
Year Option A Option B
Tk. Tk.
0 Capital outlay (10,200) (35,250)
1 Net cash inflow 6,000 18,000
2 Net cash inflow 5,000 15,000
3 Net cash inflow 3,000 15,000
The NPV of each project is calculated below. Use the formula 1/(1+ r)n to calculate the discount factors.
Option A Option B
Year Discount factor Cash flow Present value Cash flow Present value
16% Tk. Tk. Tk. Tk.
0 1.000 (10,200) (10,200) (35,250) (35,250)
1 0.862 6,000 5,172 18,000 15,516
2 0.743 5,000 3,715 15,000 11,145
3 0.641 3,000 1,923 15,000 9,615
NPV = + 610 NPV = + 1,026
 The IRR of option A is 20%, while the IRR of option B is only 18% (workings not shown).
 On a comparison of NPVs, option B would be preferred, but on a comparison of IRRs, option A would be
preferred. The preference should go to option B because with the higher NPV it creates more wealth
than option A.

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