Question

 

1. Describe and explain the significance of each of the following: payback period, internal rate of return (IRR), modified internal rate of return (MIRR), net present value (NPV), and profitability index (PI). Explain. Provide examples for better clarity.
2. Discuss the notions of conventional and nonconventional cash flows in capital budgeting. Which investment evaluation criteria would you use for unconventional cash flows and why? Provide a fictitious unconventional cash flow example and apply the payback period, NPV, IRR, MIRR, and PI methods to your example. Interpret the results.

Answer 1

The payback method of investment appraisal simply asks the question ‘how long before I get my money back?’ In other words how quickly will the cash flows arising from the project exactly equal the amount of the investment.

The net present value approach involves discounting all cash outflows and inflows of a capital investment project at a chosen target rate of return or cost of capital.

The IRR method calculates the exact rate of return which the project is expected to achieve based on the projected cash flows. The IRR is the discount factor which will have the effect of producing a NPV of 0.

The MIRR is improved method of project valuation as it is comprehensive method the IRRs of the project with uneven cash flows (mix of positive and negative cash flows).

The Profitability index is calculated by dividing Present value of cash flow by Investment amount.

Significance of NPV -

• It takes into account the time value of money.
• Profit and the difficulties of profit measurement are excluded.
• Using cash flows emphasises the importance of liquidity.
• It is easy to compare the NPV of different projects.

Significance of IRR

• Time Value of Money is considered.
• It makes the interpretation simple
• No requirement for rate of return

Significance of Payback

• It is simple to understand and apply.
• It promotes a policy of caution in investment.
• It involves less cost and time as compared to other methods.
• It gives importance to speedy recovery of investment.

Significance of Profitability index

• It provides you with information about how an investment changes the value of a firm.
• It will take into consideration all cash flows from a project.It involves using all of the cash flows that are generated from the business, even the one which are not classified on the books as outgoing or incoming cash flows, to determine what your NPV will be.
• It will give you information about ranking projects while still rationing capital.The profitability index does more than calculate an equity investment for individuals. Companies can also use this tool to determine if certain projects are worth an investment in the future.

Significance of MIRR

• MIRR overcomes 2 major drawbacks of IRR including the elimination of multiple IRRs in case of investments with unusual timing of cash flows and secondly the re-investment problem discussed earlier.
• Helps in the measurement of sensitivity of an investment towards variation in the cost of capital.
• It considers all the possible reinvestment rates and hence it is improved method of project valuation.

Examples -

if an investment of Rs. 100000 in a machine is expected to generate cash inflow of Rs. 20,000 p.a. for 10 years. Its PBP will be calculated using following formula:

PBP = Initial investment/Annual cash flow = 100000/20000 = 5 years.

Calculate NPV for a Project X initially costing Rs. 250000. It has 10% cost of capital. It generates following cash flows:

Year Cash flows PV @ 10% PV

Year	CF	PV@10%	PV
1	90000	0.909	81810
2	80000	0.826	66080
3	70000	0.751	52570
4	60000	0.683	40980
5	50000	0.621	31050

Less: ΣPV 272490

NCO 250000

NPV( Rs.) 22490

As the project has positive NPV, i.e. present value of cash inflows is greater than the cash outlays, it should be accepted.

IRR

Let’s say Company X has a year-long project that is going to cost $1,000 and has a discount rate of 8%. At the end of the year, the company will receive $1,300. Calculating the NPV for this project looks like this:

NPV=-1,000 + 1,3001.08=203.70

In general, if the NPV is greater than 0, a project is worth pursuing.

The IRR calculation for this same project puts the NPV at 0. When the NPV is 0, it acts as the break-even point. If that’s the case, it will look like this:

0=-1,000 + 1,300(1+IRR)

Notice how the discount rate of 8% is replaced with IRR, but the formula remains the same.

Solving for IRR, you will get 0.30 or 30%.

MIRR

Let’s consider the following example. Company A wants to assess the investment viability of its upcoming project of building a new plant. The company must spend $200 million on the plant’s construction. At the same time, it expects that the new plant will generate revenues of $50 million in the first year, $100 million in the second year, and $150 million in the third year. Note that the cost of capital of Company A is 10%.

Using the information above, we may calculate the modified internal rate of return of the project. First, we need to calculate the future value of positive cash flows at the reinvestment rate. We may assume that the reinvestment rate equals the cost of capital

The present value of negative cash flows discounted at the financing rate is simply $200 million because there is only one cash outflow occurring before the project. Therefore, we can use the variables to calculate the modified internal rate of return (MIRR):

The modified internal rate of return for the project is 17.02%

. Conventional Cash Flows - A conventional investment has cash flows the pattern of an initial cash outlay followed by cash inflows. Conventional projects have only one change in the sign of cash flows. For ex -the initial outflow followed by inflows i.e - + + +.

A non - conventional investment on the other hand, has cash outflows mingled with cash inflows throughout the life of the project. Non-conventional investments have more than one change in the signs of cash flows, for example - + + + - + + - +.

Investment decisions evaluation criteria -

A company with a conventional cash flow profile will normally show just a single IRR, but a company with an unconventional cash flow will demonstrate multiple IRRs.

If the cash flow pattern is non conventional i.e. cash inflow followed by a series of cash outflows (as in the case of a loan), NPV greater than zero indicates that IRR is less than the discount rate used to calculate the NPV.

NPV leads to the appropriate decision in unconventional cash flow pattern.

Example -

IRR - 14.6%