Analyzing Capital Budgeting Techniques

This assignment delves into capital budgeting techniques, emphasizing the Internal Rate of Return (IRR) method and Net Present Value (NPV). It presents detailed calculations for Project A and Project B, illustrating how these methods help businesses evaluate investment opportunities. The analysis includes start-up costs, annual cash flows, residual values, and overall project worth, culminating in a comparison of both projects' NPVs and IRRs to determine the most favorable option. The assignment concludes by emphasizing the significance of capital budgeting decisions and the role of IRR in investment selection.

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Internal rate of Return

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Introduction
When any decision regarding the capital expenditure has been made in the organization,
the management wants to know that what the whole project will cost and what return that project
will give if it has been selected. Management always wants to select such investment proposals
that provide maximum profits and returns with minimal risks from the available list of mutually
exclusive investment projects. In order to determine the best capital expenditure proposal, project
and portfolio of the desired investments, there are several capital finance evaluation methods
available that can be used by the management to choose the best project from the available
project list. Management can rely on such capital investment evaluation methods in order to
decide the acceptance and rejection of the project. Some of the commonly used capital
investment evaluations methods are pay back method, accounting rate of return, net present
value and internal rate of return. Among all these methods internal rate of return is the most
common and also important methods that is used by the potential investors to decide whether to
take up the investment in particular or not.
Capital investment decisions are regarded as the most important decisions that are taken
by the management to earn the maximum return with minimum risk. The main goal of the capital
investment decisions is to increase the value of firm as the substantial cash outlays are involved
and these decisions if once implemented that it cannot be reversed.
In this essay there will be discussion regarding the importance of the internal rate of
return method and how the IRR is the useful indicator of the potential project performance even
if there is no capital rationing. Numerical examples are used to evaluate this statement and to
support the findings.

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Internal rate of return
The internal rate of return (IRR) has been defined as the interest rate or percentage of the
discount rate where the project will be going to break even. So it can said that IRR of any project
refers to such rate of return that equal the cash flows form the project to zero. In other words it
can be said that it provides that interest rate if used as the discount rate or cost of capital in
calculating the net present value will give answer as zero. It can be said that internal rate of
return provides the information about the return that project will provide if that project is
implemented. In financial term it can be understand as the financial metric of cash flow that is
primarily used for the project appraisal, project evaluation, project proposal analysis and capital
acquisition decisions (Bromwich and Bhimani, 2005). The internal rate of return can be simply
understood from this equation: NPV = ∑ [CFt / (1 + IRR) t] =0, where, CFt represents the cash
flow at time t. Here, NPV is given the value zero because if the calculated IRR rate used for
discount cash flows than certainly it will be zero as at this value the project is providing the
returns to the company. So, it can be said that by sampling calculating the internal rate of return
one can judge whether the project is useful for the investment point of view of not. If the IRR is
lower than the cost of capital to the company than it is costlier for the management, but if the
IRR is gather than the cost of the capital than such project can be accepted as it is increasing the
shareholders value (Brealey, Myers and Marcus, 2007).
Importance of the internal rate of return and why it is different from other methods
All capital budgeting methods are used to evaluate the performance of the potential
investment projects but IRR is most successful indicator for evaluating the investment appraisal.
There are numerous advantages that made it important and different from others. Firstly it must

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be note that internal rate of return method is based on the time value of money so all the cash
flows are discounted that desired interest rates so that IRR can be computed. Discounting the
cash flows to the present values helps to give equal weight to all the future cash flows. IRR is
easy to measure and it provides useful means to evaluate the projects that are under
consideration. Using the IRR method to decide which project has to be selected from the
available projects, it proves to very useful as it make it very easy to compare. The most
important advantage that makes it different from others while making the calculation for the
internal rate of return there is that there is no requirement of cost of capital or discount rate
whereas in rest of methods there is requirement of cost of capital in order to make calculation
(Damodaran, 2011). The cost of capital is discount rate that is fixed by the management for the
capital rationing purpose. So it can be said that IRR can be used without the decisions of capital
rationing for evaluating the potential projects. Internal rate of return does not give emphasis to
the capital rationing decisions made by the company as this method is truly based on the
assumptions that every project provides some return and through using that rate of return projects
can be compared with one another. IRR is vey useful as compared to NPV method as NPV
considered various factors such as taxation rate, depreciation expenses, and cost that arises in
future while IRR clearly ignores all such factors aim of the IRR is to calculate the rate of return
where the NPV is zero. Using IRR as the method of evaluation one can compare all the projects
that are under consideration without even using the capital rate decided by the management for
evaluation purpose (Davies and Crawford, 2011).
The IRR is a useful indicator of potential project performance even if there is no capital
rationing

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There are various capital budgeting methods used by the business enterprises for
evaluating the potential worth of an investment. The management of a business company has to
take decisions regarding the selection of the most profitable business project through examining
the risk level. The various techniques for examining the potential worth of an investment used by
a business are NPV (Net Present Value), IRR (Internal Rate of Return), payback period, ARR
(Accounting Rate of Return) and many others. The IRR is regarded to be most used technique
for evaluating the performance of a project. The method helps in determining a rate at which a
project is able to attain its break-even point that is the situation of no profit or loss by a business
entity. This is the rate of return at which the present value of cash inflows is equal to the value of
outflows of cash (Brigham and Ehrhardt, 2007).
The project manager accepts a project on the basis when the IRR is greater than the
capital cost and vice-versa. The business managers largely adopt the use of IRR for taking
decisions related to capital budgeting as it is an objective method in comparison to other
methods. The method is also relatively easy to understand and implement even by the people
having little knowledge of finance. This is because the method only uses a single discount rate
for analyzing the potential worth of an investment. On the other hand, the other methods of
capital budgeting such as NPV are highly complex to understand and apply by a project
manager. The method can be used by business organizations for examining a project
performance and taking decision regarding the amount of capital to be invested in a project even
if there is no capital rationing (Petty et al., 2015).
The capital rationing refers to imposing restrictions on the amount of new investments
undertaken by a company due to budget constraints. This can be done by the businesses by
placing higher cost of capital when the expected returns attained from a project are less than that

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expected. The business organizations incorporates the use of capital budgeting techniques such
as NPV and IRR to allocate the funds available to different project options that are expected to
provide maximum profitability. Therefore, the method of capital budgeting are extremely
important for businesses in gaining a selection of a project that will provide the best results in the
condition of capital constraints (Megginson, 2008).
However, the method of IRR can be used by a project manager to examine the potential
performance of a project even if there is no capital rationing. This is due to the simplicity of the
method that enables the business managers to use at any time without any constraints. The net
cash flows realized by a project selected through the use of IRR technique are re-invested at the
same or higher IRR to generate larger returns in the future. The results obtained from the method
can be easily interpreted by the business mangers and thus evaluating the potential worth of an
investment (Megginson, 2008). For example, if the IRR calculated for a project is 15% and the
hurdle rate is 10%, it clearly indicates that investors can gain 5% returns on the capital invested.
As such, the higher IRR of a project indicates its more desirability to be undertaken by a business
manager. Thus, if a business manager has different project options each requiring similar
investments then the project with highest IRR should be accepted even if there is no capital
rationing. Also, the method takes into account the concept of time value of money and therefore
can be regarded to be highly reliable in predicting the future worth of an investment (Drury,
2004).
The method is highly intuitive and therefore will improve one’s ability to analyze the
potential investments. As such, the business managers are recommended to incorporate the use
of the technique of IRR for taking capital budgeting decisions to increase their skills related to
taking decisions for selecting a viable project option. However, there are some drawbacks of the

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method that limits its application in the capital budgeting decision to some extent. The major
issue of concern related with the use of method is that it is not highly useful in comparing the
internal rate of return to the cost of capital as there is not an accurate calculation of IRR. There
may be computation of different IRR’s and as such comparison of IRR with the cost of capital is
difficult. Also, the method is not reliable if there is not an accurate prediction regarding the cost
of capital and it changes over a period of time. The feasibility of project having different cash-
flows at varied discount rates cannot be calculated accurately through the use of IRR method.
Therefore, there are some limitations of the method in relation to evaluating a project
performance (Chary, 2009).
Despite of these limitations, the method is most commonly used for evaluating the
potential worth of an investment due to is simple nature. The method provides a simple
evaluation of a project worth that supports the decision-making process of management of
capita; investment. Also, the use of the modified internal rate of return (MIRR) has helped the
business managers to overcome from the problems faced during the use of IRR method. The
financial method of MIRR can be used in the capital budgeting decisions for analyzing the
potential performance of projects having multiple cash-flows. The method has also helped in
overcoming the assumption of the IRR method that cash flows realized should be re-invested at
the same rate of return which is often unrealistic. The MIRR method uses the basis of the
weighted average cost of capital for considering the decision related to re-investment of the cash
flows realized from a proposed project investment. In addition to this, the problem associated
with the use of IRR of computing multiple IRR’s for projects having positive and negative cash
flows is effectively overcome by the method of MIRR. The method of MIRR computes only one

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value of internal rate of return thus providing an accurate rate of return to be compared with cost
of capital during investment decisions (Baker and English, 2011).
The method of IRR is regarded to be a popular method used for taking investment
decisions as it is simple to be used and is also not time-consuming. Thus, the practitioners,
finance officers, managers can analyze the potential worth of their investments through the use
of method even if there is no capital rationing. The method of NPV is mainly sued by businesses
in the situation of capital rationing when there is need of selecting the bets project option for
capital investment due to presence of capital constraints. As such, of there is no capital rationing
it is highly advised to businesses to incorporate the use of IRR method for project evaluation so
that accurate decisions can be taken for ensuring the business growth in future context (Petty et
al., 2015).
Numerical Example that examples that explains the calculation of the IRR
These are two projects that are under consideration by the management of the company.
Both these projects will be evaluated using the NPV and IRR methods and differences are noted
in order to explain why IRR does not consider the capital rationing decisions.
Years Particulars Project A Project B
Machine 1 Machine 2
1-Jan-17 Initial Investment $ (160,000.00) $ (170,000.00)
31-Dec-17 Cash Inflow $ 61,000.00 $ 21,000.00
31-Dec-18 Cash Inflow $ 61,000.00 $ 31,000.00
31-Dec-19 Cash Inflow $ 61,000.00 $ 41,000.00

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31-Dec-20 Cash Inflow $ 51,000.00 $ 71,000.00
31-Dec-21 Cash Inflow $ 51,000.00 $ 81,000.00
31-Dec-22 Cash Inflow $ 41,000.00 $ 61,000.00
31-Dec-22 Residual Value $ - $ 20,000.00
Net present value method
Here as the capital rationing decision, cost of capital is taken as 20%
Particulars
PVF @
20%
PV of Project A @
20%
PV of Project B @
20%
31-Dec-17 0.833 £50,833.33 £17,500.00
31-Dec-18 0.694 £42,361.11 £21,527.78
31-Dec-19 0.579 £35,300.93 £23,726.85
31-Dec-20 0.482 £24,594.91 £34,239.97
31-Dec-21 0.402 £20,495.76 £32,552.08
31-Dec-22 0.335 £13,730.82 £20,428.78
Residual
Value 0.335 £0.00 £6,697.96
Present Value of Cash
Inflows £187,316.85 £156,673.42
Decision
Particulars Project A Project B

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Present value of cash Inflows £187,316.85 £156,673.42
Present value of cash outflows £160,000.00 £170,000.00
NPV £27,316.85 £13,326.58
Internal Rate of Return
Particulars
PVF @
15 %
PV of Project A @
15%
PVF @
35 %
PV of Project A @
35%
31-Dec-17 0.870
$
53,043.48 0.741
$
45,185.19
31-Dec-18 0.756
$
46,124.76 0.549
$
33,470.51
31-Dec-19 0.658
$
40,108.49 0.406
$
24,792.97
31-Dec-20 0.572
$
29,159.42 0.301
$
15,354.48
31-Dec-21 0.497
$
25,356.01 0.223
$
11,373.69
31-Dec-22 0.432
$
17,725.43 0.165
$
6,773.00
Residual
Value 0.432
$
- 0.165
$
-
Total $ $

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211,517.59 136,949.83
NPV
$
51,517.59
$
(23,050.17)
IRR of
Project A 28.82%
Particulars
PVF @
15 %
PV of Project B @
15%
PVF @
35 %
PV of Project B @
35%
31-Dec-17 0.870
$
18,260.87 0.741
$
15,555.56
31-Dec-18 0.756
$
23,440.45 0.549
$
17,009.60
31-Dec-19 0.658
$
26,958.17 0.406
$
16,664.13
31-Dec-20 0.572
$
40,594.48 0.301
$
21,375.84
31-Dec-21 0.497
$
40,271.32 0.223
$
18,064.09
31-Dec-22 0.432
$
26,371.98 0.165
$
10,076.91
Residual
Value 0.432
$
8,646.55 0.165
$
3,303.90
Total $ $

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184,543.82 102,050.03
NPV
$
14,543.82
$
(67,949.97)
IRR of
Project B 18.53%
In IRR it can be seen that there is no use of cost of capital while making the calculations
Conclusion
Thus, it can be stated from the overall discussion held in the report that capital budgeting
decisions are very important in business context for ensuring its sustained growth and
development. There are various capital budgeting techniques that are used by business mangers
for evaluating the potential worth of an investment. The IRR method is most used for investment
decisions due to is intuitive and simple nature. The method can be easily applied and also leads
to improving the ability of business managers in selecting feasible project options. Thus, the
method is largely used by the business people and practitioners for analyzing the potential worth
of different investment options even if there is no capital rationing. The use of various numerical
examples in the report has also helped in developing a better understanding of the method of
IRR.