IRR and NPV Analysis for Capital Budgeting Decision Making

The assignment content discusses capital budgeting concepts such as net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), and mutually exclusive projects. The NPV is calculated by discounting cash inflows and outflows, and the IRR is used to determine whether a project is acceptable or not. MIRR is another method to evaluate a project's profitability. Mutually exclusive projects are those with different lifespans, and the replacement chain method can be used to analyze them. The assignment also includes examples of applying these concepts to real-world scenarios, such as evaluating two investment projects with different lifespans and costs.

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Overview
Capital budgeting process as value addition budget, helps in evaluation and ranking in projects
investment. Intention behind every investment budgeting strategy is to facilitate higher return.
Allocation of capital to several projects involves in planning and funding of cash. The proper
decision making process helps an organization worth to investment to pursue business and
capital expenditures in real assets means in new assets with the expectation, growth of
organization more than one year. To understand every stage origanization need to go through
them whether its of decision making knowledge, position establishment by using option pricing
analysis and also discounted cash flow analysis. Usually different approaches compared the
projects performance and one of the non discount methods are accounting rate of return and
payback analysis.
Decision making
Uncertainty is the main reason in modern world decision making strategy. Proposed capital
projects with management can take overall decisions and count the possible outcomes of existing
market circulation. Decision tree implementation ensure that using different software’s like
expert choice and decision pro to gain knowledge regarding decision. Decision tree provided
trade included private trade building to help. Different opinions and ideas, group and team
execution are much better due to decision tree.
Option pricing

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Uncertainty is an important factor while considering option pricing also. First stage provide
knowledge through decision tree whereas second stage ascertain the option offered by customers
where producing company have options to change according to suitable option for the project to
go through. Options can be taken in various ways: postponement, alteration, changes etc. How to
recognize the project with the options values organization need to manage capital projects.
Financial management in accounting studies the present values of assets. Inflation is main cause
to reduce the cost of asset over the useful life. Future perspective involves uncertainty and sunk
cost of money recognized the respective time value of money.
Discounted rate of return consists of net present value, IRR and profitability index. The key
element decision making usually examine these method. The entire company go through the
purpose only to generate profitability. Operating expenses involves in every sales and to increase
the performance in order to profit throughout the whole system obligated to pay this operating
expenses. The primary component of capital budgeting is making proposal in order to maximize
the growth for through put to operate favorably. Cost reduction is less important. (Andor, G., et
al 2015)Spreadsheet is a way where expected cash flows information laid. Payback analysis
decisions determined time period and revenue generation.
Cash flows determination after tax consider in capital budgeting. Some risk involvement are in
its adjustment. After considering decision tree knowledge for decision making and also options
building for company’s projects. Different factors comprised its scope are as:
1) Compensate the risk engagement in projects
2) Acknowledge the risk for foreign projects.

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3) Adjustment in capital budgeting for expected results.
Economic life of planning projects can evaluate through stages of capital budgeting whereas
calculation is the another level to examine capital projects.
Depreciation
Assets including capital assets are associated with depreciation, estimated life of an asset helps to
calculate the depreciable value of asset. Depreciation is a non-cash item in cash flow statement.
Application of depreciation deducted to measure taxes on project revenues payment and also
added depreciation to bring cash flow.
Working Capital
Investment basic requirement is to increase working capital. New production consumes more
working capital which often need stock and salaries to pay. Change in working capital means
mainly leads to company’s project. End in project evaluation brought reverse mechanism in
projects.
Overhead:
Moreover planned projects involved in allocated overheads to increase proportion often. There is
no difference happens with nature of allocation. For relevancy of cost there is need to access the
overhead implemented in respective project associated with more capital investment.
Financing Costs:

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To funding a capital project financing is needed. To cover additional cash flows need to plan the
capital project in its best way double cost effect possibility eliminates due to financing cost
deduction from it. Discount rates included in financing cost from our capital project.
Capital budgeting decisions influenced by the different factors:
 Funding for the business project
 Capital criteria
 Investment and replacement
 Government intervention
 Economic life criteria
 Engagement of risk
 Location of an organization
 Predictions of market performance
 Performance level of an organization
 Generation of favorable returns
Total money involved in projects show the profit of firm. Once investment made in long capital
project cannot be reversed, capital budgeting help and provide advice to decrease sunk cost and
ignore the investment in non planned investment. Since companies should make decision
properly. Profit earning capacity based always on investment decision the right decision impact
on whole organization. Continuation of project needs large funding whereas retained earning can
help in project investment. (Lane, K.,2015)

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In capital budgeting capital rationing is a one of the where the funds require in larger proportion
than the available resources for the investment. At this situation NPV is preferable because for
wealth maximization selection of investment plan of NPV provide highest present value to
shareholders value to increase.
Introduction
Capital budgeting emphasize the planning of major project for the company’s long term
investment strategy included machinery replacement, new product, new capital assets, projects
regarding research and development. Capital budgeting also called as investment appraisal where
capital expenditure plays an important role. Considering individual examples from every
methods helps to access the conclusion. Some of the key terms used in capital budgeting are
ATP stands for arbitrage pricing theory which is a usual theory carry asset pricing in financial
management. Financial assets in various economic factors to conclude market practices in a
linear function. MIRR stands for Modified Internal return measure investment in a attractive
manner to solve the problem facing situation and used ranking in its process for different
alternatives. Modified version of internal rate of return follow MIRR for rates variation. Major
methods we already use such methods to overview capital budgeting and in detail in examples
with proper defining definition of each methods. They are the integral techniques we often used
to comes to conclusion whether to find present value of money or whether to execute planning in
considering various rate of return with capital generation. Mutually exclusive projects comes to
vary its existence using IRR and NPV. Mutually exclusive projects when seems having different
life span, we can consider capital budgeting decision based on NPV Analysis or replacement

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chain method. With the help of highest NPV or IRR can represent the analysis having same life
span.
Ranking projects is also the task execute through capital budgeting where large amount of
investment proposal takes in consideration. The purpose is to serve the budgeting to ensure
capital expenditures and revenues. A framework of this particular model analyze the
performance of business and plans according to forecasting measure. Actual operation to hold
by managers capital budgeting consider the following conditions arise in an event. Co-ordination
and planning of activities helps managers and also to examine their performance in between their
own running operation that of others. (Roncalli, T. 2016)
Scope of capital budgeting
Mechanization project:
Replacement of manual process in production takes place through mechanization of this
process. The main aspect is to ensure that this changes helps to decrease cost. Lower cost
operation resulted in savings for the investment on future cash inflows.
Project expansion:
Increased production and sales in business can expand its operation. In concise company can
allocate new assets such as machinery, building, acquisition and take over of another businesses
where huge funding require for future earning.
Machinery replacement:

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Replacement also takes place in old machinery to new machinery with advanced technology
resulted in less operating expenses and more over productivity. Savings done due to application
of new machinery, the volume of production also increased in additional amount.
Lease or buy:
Capital assets can be purchased or acquired through lease. Higher amount of funding required for
initial purpose or investment. Same asset can be acquired on lease, used on basis of lease and
future benefits can be made from mutually exclusive alternatives.
Choice of equipment:
Two machines performed similar work and each machine cost differently. Advantages and
disadvantages of every machinery in product line are analysed and best option selected in
between. Capital budgeting helps during such selection.
Product innovation:
Innovation takes place in new product. Research and development staff find out innovative new
products. Every process require higher amount of funding for implementation and this process
also do so. Net cash inflow and cash outflow are too useful for the comparative analysis of
projects.
Housekeeping :
An indirect production impact these products for every projects it is legal requirement to
implement and boost up the morale of employees in an organization, motivates them. Safety
measures, healthy environment, welfare projects, training and information development, research
and development, status level projects all are the basic requirements during housekeeping project

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execution. Quantity, financial aspects, sources and profitability are not under considered while
implement this project.( Mohan, V.,2017)
Capital budgeting process
Identifying investment opportunities: the first task of an organization is to identify a strategy to
select the opportunity of investment plan. It includes various purpose where it can be any of the
product line, expansion of project and new asset allocation. For example company add two new
product to product line for evaluation to derive profits, current investment fund with future
benefit.
Evaluating investment propose: After identification and selection next process has been
evaluated more options for investment purpose. Whenever new products add in product line ,
next step is of decision making for acquiring that new product. Various ways are available for
acquiring new products:
1) In house manufacture
2) Outsourcing of manufacturing processes
3) Purchase new product from the market segment
Chose profitability: After the discussed processes the important proposal is to select the most
appropriate investment suitable for the project to maximize its profit capital rationing is one of
the technique covered in earlier discussion helps to analyze the rank of projects with availability

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of best option. In the example given below technique wise option price and maintenance of
product to enhance the product and access the profitability.
Capital budgeting apportionment identification and selection plays a significant role and then the
sources of fund and its proper allocation. Sources of funds could consist of reserves, loans,
investment and many more channel for funding.
Performance review: this step is last and review the performance level an organization have
impact on cash flows, initial investment made for forecast situation associated with the return.
Comparison of estimated investments and actual performance of business look by an
organization. There are various examples in our example where some investment for the
expected return possible.( Chwastyk, A.,2017)
Advantages of capital budgeting
Time value of money in capital budgeting analysis used discounting for the earning of proposed
investment. The accuracy and reliability represent the data user friendly. The estimated projects
with long term objective ranked and evaluate the position of firm.
Value maximization of the company depends on the higher return earns during business. Returns
to shareholder are the major goal of project using good earning returns to business.
Limitation of capital budgeting
1) Estimation include every years cash flow and economic life of following project. The
actual economic life can be varied it may be decreased or increased. Actual cash inflows

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per annum either same or decline than the estimation . Hence capital expenditure to
control through capital budgeting can not be exercised.
2) Estimated cash inflows and outflow decision budgeting made through capital budgeting
process. Uncertainty means the future is uncertain, estimated cash flows may not be real.
sometimes selection of projects may be unreal.
3) The aspect having non-financial nature does not considered in evaluation of capital
budgeting process whereas they are the major role players in successful organization and
impact on profitability measures. Hence, real profit of planned project cannot be
highlighted.
4) Assumption for solution using mathematical technique is also incorrect to analyze,
accurate technique produce higher returns.
5) Presumption in every technique based on investment proposals mainly to mutually
exclusive projects may not practically correct in some situation.
6) Company’s reputation, goodwill and morale of employees cannot be quantitatively
measured. It is not possible for the capital budgeting implication to influence the
decision.
7) Risk measurement cannot be assumed accurate because the variation and fluctuation
leads to changes in the business environment.
8) For urgent situation and circumstances this technique cannot be used.
9) Known factors considered while applying decisions regarding capital budget. Different
unknown factors cannot be avoided and controlled.( Li, Y., et al 2016)
Functions

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Essential functions of budget provide measures to control initial investment, communication of
plans and motive of organization to evaluate performance and provide visibility. Capital
budgeting mainly focus on capital investment for long term purpose. Ranking its capital projects
that could reward the organization, to overcome from the hurdles and highest ranging among
other organization. Fund raising for capital projects means to determine the sources available
with the corporation to trade in preferred stock, corporate bonds, common stock and.
Managers involved in financial management ensure the risk related to funding. Corporate bonds
have low risk rather other bonds that’s why it is preferable in financial managements risk to
ascertain. Preferred stock also have no risk as such whereas dividends in relation to arrears with
dividend must paid to them before distribution among shareholders. Capital budgeting influences
profits where the total investment indulged at larger amount and the decisions are more effective
against short term decisions as to cover the various factors impact and risk involvement and most
importantly the future uncertainty. The goal behind capital budgeting is ranking its project.
Cash flows in accounting requires updated understanding foe every facture to affect particularly
the processes involving tracking the cash inflows and outflows. Assets and liabilities in balance
sheet are the determinant for resources implication. Cash flow analysis included rate of return ,
net present value are the core equipments in capital budgeting and it is based on investing ,
operating and financing activities.
Techniques of capital budgeting

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To access organization in selection of investment for long term there are different types of
techniques available to ensure compared data of cash flows and cash outflows.
Payback period( traditional approach)
This method analyze the proposed period and reduce risk, consider the earning to expand project.
What to select and reject is organized in measuring risk based on certain calculations done. Time
value of money is not considered and will circulate cash for the initial stages investment done in
an organization. The importance of this method is to estimated quotation of informed investment
to get back the investment cost. Time period of an project directly linked to the project risk
involvement. (Guerrero-Baena, M. D.,2015)
Payback period = Initial capital expenditure ÷ expected cash flow after deducting tax
Payback reciprocal: Average annual cash flow ÷ Initial capital expenditure
For example, project costing $ 30,00,000 for initial capital expenditure and expected cash flow
after deducted tax is $ 6,00,000.
$ 30,00,000
$ 6,00,000 = 5years
Hence n = 5 years
Accounting rate of return
Loopholes of payback period overcome through this method. Earning percentage depend on rate
of return for the respective projects. Lifetime of project decide in which asset the investment

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made to enhance the capacity of machinery and capital expenditure made to evaluate average
rate of return. The importance of this method that it does not used any special type of data, only
used general data, measure the profitability of an entire organization .
Accounting rate of return = Average annual net income ÷ Investment
A project require initial expenditure of $ 20,00,000 and the profit for 6 years is 6,00,000
ARR = $ 6,00,000
6 = $ 1,00,000 = $ 1,00,000
$ 20,00,000 =5%
Discounted cash flow analysis
Assets life emphasize the discounted cash flow method in calculation of cash inflow and cash
outflow. This analysis also known as time adjusted method where NPV, IRR and Profitability
index comprised of. By the help of discounting factor discount rates analyzed different
conclusion and ranking in its application and accordingly show the result.
Discounted cash flows examples
Make or buy decision
The sunk cost concept applies to every financing decisions. Company have options to
manufacture its own tools or purchasing from other suppliers. If company purchases it will cost
$70.00 per part. Operating capacity of company is 70% and total cost to manufacture the parts
are:

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Direct materials $ 22
Direct labor $ 15
Overhead- (fixed) $ 17
- (variable) $ 26
Total cost $ 80
Purchasing cost as compared to manufacturing cost $70 - $63(22+15+26)=$7
However operating capacity is 70%, increase in fixed overhead we don’t expect because it is
sunk cost. Company would manufacture at cheap cost as it is $7 /part cheaper.
Discontinuing product
Company consider product dropping product from product line because the Income Statement
Traditional Relevant
Sales $ 15,000 $ 15,000
COGS - (Fixed) $ (800)
- (Variable) $ (8,000) $ (8,000)
Operating expenses
- (Fixed) $ (1,800)
-(Variable) $ ( 5,400) $ (5,400)

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Income (Loss) $ (1,000) $ 1,600
Company should selling its product however earns $ 1,600 income.
Acceptance of special offer
To justify customers order as Customer X has offered a product for 4,500 units costing $ 20.00
for. Company usually sells that product for $30.00. Company should accept this offer?
Production during the year sell of 50,000 units at maximum capacity of 60,000 units, cost
incurred on manufacturing is of $23/ unit with fixed cost $ 6.5 and variable as $13.5.
Revenues(change) $ 90,000 4500 × $ 20
Expenses (change) $(60,750) (4500× $ 13.5)
Net (change) $ 29,250
$29,250 should be acceptable as it results to gain extra income.
Calculation of capital projects Relevant Cash Flows
Company engage in installation of new assembly machine to purchase costing $ 30,000, new
installed machinery will cost $4,0000 with a expectation to increase working capital $2,000. Will
decrease operating cost annually by $ 8,000 with expectation to save maintenance cost $ 600
during the year. The new machinery requirement for technical support will $ 850 each.

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Depreciation over useful life of 6 years with expectation of salvage value of $ 6,000, the tax rate
is 33%.(using straight line method)
Savings in operating cost per annum 8,000
Saving in maintenance per annum $ 600
Technical support cost per annum $(850)
Depreciation per annum $ (4,000)
Revenues $ 3750
Tax 33% (1237.5)
Net income 2513
+Non cash item(depreciation) 4,000
Projects relevant cash flow $ 6,513
Company will receive cash flow per annum $ 6,513 by investment in new line assembly
machine. However due to salvage value terminal cash flow associated with this project.
Terminal cash flow for proposed projects
Estimated 6 years salvage value $ 6,000
(less) taxes ( 1237.5)
Terminal cash flow $ 4,762
Present value cash flows

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Project cash flow per annum $ 6,513
Discounted rate factor ×4.355
28364
Terminal cash flow $ 4,762
Discounted rate factor ×.4355
2073
Total present value $ 30,437
Net investment
We have present value cash flow of $ 30,437 by comparing this value to investment value,
company’s investment in total cash outlay where the total cash paid for proposed project for
installation, maintenance services. Further proceeds in expenses when replacement takes place
in place of old machinery. Taxes paid and its benefits from the investment making.
Calculation of net investment
By observing relevant cash flows example, we can calculate net investment and here will assume
that the machinery sod for $ 10,000
Acquisition expenses $ 30,000
Installation expenses $ 4,000
Working capital $ 2,000

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Sale proceeds $ 10,000
(less) tax 33% (3,300 )
Net proceed from sale $ (6,700)
Net investment $ 29,300
We have present value cash flows is of $ 30,437 and net investment is of $ 29,300. This value we
calculated from various types of cash flows: Relevant cash flows per annum, terminal project for
the ending and last one is initial investment cash flow.
NPV (Net Present Value)
One of the method used extensively for proposed project analization. The total of cash inflow
and outflow comes to net present value evaluation. This method cash flows statement
determines the time value of money. Net present value often considers present time as per ranks
of projects, signifies the acceptance of project if NPV calculation is higher or equal to zero. It
means we should carry further the investment if NPV is positive and we should stop to make
investment if NPV comes negative. ( Abor, J. Y. 2017)
Profitability index
Future cash flows present value of capital projects in initial investment represent the ratio of
profitability index. Every technique comprised advantages and disadvantages. Best investment
technique chose to assist capital budgeting process. Different techniques can be selected and
ensure to compare the derived results.

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Capital Projects Economic Criteria
The three major stages included discounted cash flow analysis calculation, the another one
covered the economic criteria for those projects evaluation and then one can use this Net Present
Value, MIRR stands for modified rate of return and last one discounted payback period.
There are three economic life criteria for the capital project evaluation and that are discussed
below:
Net Present Value
The first economic criteria examine Net Present values evaluation NPV means the sum of cash
inflows and outflows recognized what to add and what to deduct if we takes place investment in
any of the planned project. Keep on referring the already discussed examples and calculated as
follows:
Net investment (outflow) = $ (29300)
Present value (inflows) =$ 30437
Net present value = $ (1137)
It is based on the positive and negative aspect if it becomes positive we should keep further
proceeds and if it becomes negative no investment should made.

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Internal rate of return
This rate of return at discount reflect the present value cash flows and initial cash outflow to be
equal. Acceptance of project of higher IRR depends upon weighted average method calculation.
Here in this technique the discount rate is unknown then also cash inflow and cash outflow are
known. Acceptance and rejection of projects IRR depends on its own rate and cut off rate. The
situation define that whenever the IRR is higher than the cut off rate it referred to project
acceptance and in another condition whenever there is IRR is lower than the cut off rate it
referred to project rejection. This is the simple technique in its use and an improved technique
over NPV.
Modified Rate of Return (MIRR)
Modified internal rate of return equal annual cash flows can easily evaluate IRR. By using
discount rate we can calculate internal rate of return and it is identified by the managers for the
same to determine with rates of return. $ 6513 × discounted factor = $ 29300 OR $29,300 ÷ $
6513= 4.49
Mutually Exclusive Project
Mutually exclusive projects when seems having different life span, we can consider capital
budgeting decision based on NPV Analysis or replacement chain method. With the help of
highest NPV or IRR we can represent the analysis having same life span.
Net present value often consider present time as per ranks of projects. Discount rates analyzed
different conclusion and ranking in its application and accordingly show the result. Replacement
chain method helps to find out common life approach in between. This method determine project

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with different life span based on long term projects. Here treating all the projects considering
long term project having equal life.
Example- Among investing companies Project A and Project B. One has a life of 6 years costing
$30 million and generate $10.5 million p.a. Other has a life of 10 years cost $45 million and
generate $11 million p.a. Considering rate of return 10%, evaluate these two projects. (Bora, B.
2015).
Solution - Project A) NPV = $ 10.5 million ×4.355−$ 30 million=$ 15.72 milliion
Project B) NPV =$ 11million × 6.144−$ 45 million=$ 22million
Conclusion
NPV of Project B has highest value. Project B should be preferable. Change in the capital does
cause a change in the IRR ranking of two such projects. Project having varied term accordingly
only for shorter or longer term then IRR ranking remain unchanged. NPV is better because it
determine the profitable decision to investors.
Conclusion
Capital budgeting right decision making can achieve big business heights. Long term investment
in today can provide the value for tomorrow. Hence, capital budgeting is crucial to create value

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in financial management. Uncertainty is the only certainty present in capital budgeting analysis.
So it is concluded that the challenges of an organization is to have uncertain position to possess.
Organization can comes to conclusion with each examples discussed earlier in capital budgeting
mechanism. With uncertainty management it is to ensure to manage risk also.
References
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of Research in Banking and Finance, 7(4), 57-74.

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Chwastyk, A., & Pisz, I. (2017). OFN Capital Budgeting Under Uncertainty and Risk. In Theory
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