Page 171 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 9: Capital Budgeting

Again, NPV = 0, when the discount rate is equal to cost of capital and PI = I and by definition IRR Notes
is the interest rate that discounts an investments’, future cash flows to the present so that present
value of inflows equals to the present value of cash outflows i.e., NPV is equal to zero. Hence,
under IRR, if interest rate is equal to cost of capital, NPV is zero and also PI = I.
The steps for determining IRR for an annuity (equal annual cash flows).

1. Payback period, which will give the cumulative present value factor.
2. From cumulative PV (discount) factor tables see the corresponding interest rate nearest to
that figure corresponding to the life of the project (No. of years).

From the above discussion we can conclude the following:
1. Payback period = Cumulative Present value of Discount, based.
(equal annual cash flows) on cost of capital.
2. At IRR rate of interest NPV = 0 i.e., Cost of the project = Cash outflows
= Present value of cash inflows

= Annual cash inflows × Cumulative discount factor
(In case of equal annual cash inflows)

Example: Following are the data on a capital project being evaluated by the management
of X Ltd.

Project M
Annual cost saving 40,000
Useful life 4 years
IRR 15%

Profitability Index (PI) 1.064
NPV ?
Cost of capital ?
Cost of project ?

Payback ?
Salvage value 0
Find the missing values. (Given cumulative PV 1-4 years @ 15% = 2.855)
Solution:

At 15% IRR, the sum total of cash inflows = Initial cash outlay i.e. cost of the project
Cumulative present value @ 15% for 4 years = 2.855 and Annual Cost saving 40,000
Hence, Total of Cash inflows = 40,000 × 2.855 = 1,14,200
Therefore, Initial Cost Outlay

i.e., Cost of the project = 1,14,200
Cost of the project 1,14,200
Payback period = = = 2.855
Annual cost saving 40,000

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