Page 140 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 6: Capital Budgeting

Hence, Cumulative Present Value at 19% Notes

= =

If we refer to Cumulative Present Value @19% Cumulative Present Value of 5.07 is computed
at 19 years. Therefore, useful life =19 years.
3. PI = 1.14 at cost of capital rate of interest; at IRR rate of discount
PI index = 1. Hence Cumulative Present Value at cost of capital rate of interest = 5.07 × 1.14
= 5.778. By referring to Cumulative Present Value table up to 19 years. We find at 17%
Cumulative Present Value 5,585 and at 16% = 5.877. Since 5,778 Cumulative Present value
is lying between 5.877 and 5,585 by interpolation we get,
16 + = 16 + = 34 + 16 = 16.34%
4. NPV at IRR rate of discount = 0 when PI = I

Since PI = 1.14
Therefore, NPV = 0.14 × Cost of the project = 0.14 × 1,01,400 = 1, 41,196

6.4.3 Concept of Project IRR

In spite of the theoretical superiority of NPV, financial managers prefer to use IRR. The preference
for IRR is due to the general preference of business people towards rates of return rather than
actual rupee returns. Because interest rates, profitability and so on are most often expressed as
annual rates of return, the use of IRR makes sense to financial decision makers. They tend to find
NPV less intuitive because it does not measure benefits relative to amount invested. The concept
of project IRR finds favour material financial undertakings and other providers of capital. It
gives an idea of how much discounting towards amount of capital, the project can sustain during
its life span. This can be explained through an example.

Example: XYZ Ltd. an infrastructural company is evaluating a proposal to build, operate
and transfer a section of 35 km of road at a project cost of 200 crores to be financed as:
Equity share capital 50 crores
Loans at the rate of interest of 15% from financial institutions 150 crores

The project after completion must be opened to the traffic and must be affected for a period of
15 years and after 15 years, it must be handed over to the highway authorities at zero value. It is
estimated that the total revenue must be 50 crore per annum and annual collection expenses
including maintenance of roads will amount to 5% of the project cost. The company considers to
write off the total cost of the project in 15 years in a straight line basis for corporate income tax,
the company is allowed to take depreciation @ 10% on NDV basis. The financial institutions are
agreeable to the repayment of the loan in 15 equal annual installments - consisting of principal
and interest.

Calculate Project IRR and Equity IRR. Ignore corporate taxation. Explain the difference in project
IRR and equity IRR.

Solution:
The project cash inflows and cash outflows can be summarized as follows:

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