Page 181 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 9: Capital Budgeting

Hence from the present value of annuity 1—15 years closest factors to 7 are 7.191, (at 11% rate of Notes
discount) and 6.811 (at 12% rate of discount). Hence IRR would be somewhere between 11% and
12%.
Using interpolation IRR would be:
7.191 – 7 0.191
11% + = 11% + = 11.5%
7.191 – 6.811 0.380
We know that reciprocal of payback period is a good approximation of the IRR provided the life
of the project is large or at least twice the payback period and the project generates equal annual
cash inflows. Since both the conditions are satisfied. IRR would be reciprocal of the payback
period i.e., 1/7 = 14.28%.
The two IRR’s are different. The second method is an approximation present value whereas the
first gives the correct IRR, since at that discount rate cash inflows equals the cost of the project or
the net present value is zero.
Illustration 2:

Valuable Products are considering purchase of a machine for its production line. Two types of
options are available deluxe model with 30,000 initial cost and economy model with 20,000
initial cost. Each model has 5 years life and no salvage value. The net cash flows after taxes
associated with each investment proposal are:
Deluxe Model Economy Model

Net cash flows after taxes 1—5 years 9,000 6,000
Solution:
1. Net Present Value Method:
Cash inflow after taxes Total Present Value
Year’s Deluxe Model Economy Model PV Factor Deluxe Model Economic
( ) ( ) 10% ( ) Model ( )
1 – 5 9,000 6,000 3.7907 34,116 22,744
Deduct initial cost 30,000 20,000
Net Present Value 4,116 2,744
Hence, the model that gives higher NPV should be chosen i.e. Deluxe Model.
Remark: Since capital outlay was higher for Deluxe Model it has given higher NPV.
2. Present Value Index:

Deluxe Model Economy Model
34,116 22,744
= =
30,000 20,000
= 1.1372 = 1.1372
Since both give same PI Index, we are indifferent as to both the models.

3. IRR:
Deluxe Model Economy Model
30,000 20,000
= =
9,000 6,000
= 3.33 years = 3.33 years

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