CAPITAL BUDGETING DECISION: NPV VS IRR

CONFLICTS AND RESOLUTION

COURSE TITLE: CORPORATE FINANCE

COURSE CODE: FIN 801

A PRESENTATION SUBMITTED TO THE DEPARTMENT OF ACCOUNTING AND

FINANCE, FACULTY OF MANAGEMENT SCIENCES, UNIVERSITY OF ILORIIN, KWARA
STATE, NIGERIA.

BY

NASIRUDEEN ABDULLAHI
UIL/PG2020/1432

LECTURER IN CHARGE: DR. I.B ABDULLAHI

SEPTEMBER, 2021
CAPITAL BUDGETING DECISION

INTRODUCTION
Capital Budgeting is the process of making investment decisions in capital expenditures. A
capital expenditure may be defined as an expenditure the benefit of which are expected to be
received over period of time exceeding one year. The benefits (returns) may be monetary or non-
monetary (e.g. government projects) or partially monetary. Our major emphasis will be on
monetary benefits. Capital Budgeting technique helps to determine the viability of the
investment proposal or taking long-term investment decision. On the other hand, it can also be
defined as the process of planning expenditures that gives rise to revenues over a number of
years.

Capital budgeting decision is also known as capital investment decision or project evaluation
decision.

Features and importance of capital budgeting decision are as follows:

i. It is complex in nature because it involves the assessment of uncertain future events
which are difficult to predict.
ii. It involves costs and gives rise to revenues over a long period of time usually greater than
one year.
iii. The decision is usually irreversible, once an organization has committed funds to a
project, it must see to the end of the project or else it might lose all the money initially
committed.
iv. It entails suspending today’s benefits so as to realize future benefits.

CLASSIFICATION OF INVESTMENT PROJECT

Capital budgeting also includes planning major advertising campaigns, employee training
programmes, research and development, decisions to purchase or rent production facilities or
equipment, and any other investment project that would result in costs and revenues over a
numbers of years. In general, firms classify investment projects into the following categories:

a. Expansion of output capacity: investment to expand production facilities in response to

increased demand for the firm’s traditional products in its existing markets.
b. Replacement: investment to replace equipment that is worn out in the production process.
 c. Government regulation: investment to comply with government regulations such as
health and safety, pollution control, and to satisfy legal requirements.
d. Cost reduction: investments to replace working but obsolete equipment with new and
more efficient equipment, expenditures for training programmes aimed at reducing labour
costs and expenditures to move production facilities to areas where labour and other
inputs are cheaper.
e. Diversification (production and market): investment to develop, produce and sell new
products and/or enter new geographical locations or markets.

Another method of classifying investment project is on the relationship which the project has
with other projects. These include:

a. Mutually exclusive investments: these are two or more investments that serve the same
purpose and compete with each other. If one investment is undertaken, the other will have
to be excluded.

b. Independent investments: these are investment that serve different purposes and do not
compete with each other. Depending on the availability of funds and their profitability,
the company can undertake many independent project investments at the same time.

c. Contingent investments: these are dependent projects, the choice of one investment
necessitate the need to undertake one or more other investments.

Investment decision relates to the determination of total amount of assets to be held in the firm,
the composition of these assets and the business risk complexions of the firm as perceived by its
investors .It is the most important financial decision that the firm makes in pursuit of making
shareholders wealth.
On the other hand, the investment decision to produce new products and move into new markets
are likely to be more complex because of the much greater risk involved. They are also likely to
be the most essential and financially rewarding in the long run since a firm’s product lines tend
to become obsolete over time and its traditional markets may shrink or even disappear.

Finally, investment decisions to meet government regulations often give rise to special legal
evaluation and monitoring problems requiring outside expert assistance.

CAPITAL BUDGETING DECISION PROCESS

Long term funds are used in a project for various fixed assets and also for current assets. The
investment of funds in a project has to be made after careful assessment of the various projects
through capital budgeting .A part of long term fund is also to be kept for financing the working
capital requirements. Also, if wrong investment decision is made, it might ruin the fortune and
future of the organization. The important steps in the decision process are:

1. Identification of investment proposals: this involves identifying possible investment

opportunities. Project ideas can originate from any level or department within the
organization. As long as there is a need gap to be filled or an objective to be achieved in
the firm, project to be implemented will always be identified. Project idea generation
should be continuous activities in the organization.
2. Screening the proposals: this involves acquiring relevant information on the project
identified. It involves finding useful information about costs and benefits of the projects
that will influence the organization decision making.
3. Fixing priorities: this involves identifying possible alternative projects to the projects
under consideration. The alternative project will serve as a basis for comparing costs and
benefits with the main project under consideration.
4. Evaluation of various proposals: this involves carrying out financial appraisal and
evaluation of the projects based on the information gathered and the criteria the firm uses.
The financial evaluation will enable the firm to determine the worthwhileness of the
project. Evaluation involves: (i) estimation of cash flows (inflows and outflows), (ii)
estimation of the required rate of return (iii) application of decision rule for making the
choice.
5. Final approval and preparation of capital expenditure budget: this is where a final
decision is made on the project. Out of all the alternative projects under consideration, a
project will be selected for implementation on the basis of the financial evaluation.
Because it is a long term investment decision, the Board of Directors will use their
experiences to decide the projects to be selected among recommended projects.
6. Implementing proposal: this involves the actual commitment of funds to the selected
project. Efforts should be made as much as possible to carry out the decision taken.
7. Performance review: this involves monitoring the progress of the project to assess
effectiveness and whether the expected benefits are being realized. Review such as post
audit might need to be carried out.
CAPITAL BUDGETING TECHNIQUES
The capital budgeting appraisal methods or techniques for evaluation of investment proposals
will help the company to decide the desirability of an investment proposal, depending upon their
relative income generating capacity and rank them in order of their desirability. These methods
provide the company a set of norms on the basis of which either it has to accept or reject the
investment proposal. Therefore, a sound appraisal method should enable the company to measure
the real worth of the investment proposal.

Capital budgeting techniques are those techniques that help us to make decisions in investing
money in high risk projects, investments and business proposals. There are two classes of capital
budgeting techniques:

1. Non-discounted cash flow methods: Payback Period and Accounting Rate of Return.
2. Discounted cash flow methods: Net Present Value (NPV); Internal rate of return (IRR),
Profitability Index.

This work will be restricted to just NPV and IRR but before then let me quickly say few things
about the non-discounting methods.

It should be noted that the non-discounted cash flow methods ignore the time value of money,
that is, it assumes that N 1,000 today will maintain the same value years to come, which is not
true due to inflation.

THE NON-DISCOUNTED CASHFLOW TECHNIQUES

Payback period
It is the length of time required to recover the initial cash outlay on the project. This method is
based on the principle that every capital expenditure pays itself back within a certain period out
of the additional earnings generated from the capital assets.

Accounting Rate of Return

Accounting rate of returns is calculated based on the accounting concept of profit rather than
cash flow. Under this method the average profit after interest, depreciation and tax is calculated
and then is divided by the total capital outlay of the project.

ARR= Average annual profit/Average investment x 100

THE DISCOUNTED CASHFLOW TECHNIQUES:

Discounting refers to taking a future amount and finding its value today. Future values differ from
present values because of the time value of money. Financial management recognizes the time
value of money because of the following factors:

a. Inflation reduces values over time; i.e. N 1,000 today will have less value five years from
now due to rising prices (inflation).

b. Uncertainty in the future; i.e. we think we will receive N 1,000 five years from now, but a lot
can happen over the next five years.

c. Opportunity Costs of money; N 1,000 today is worth more to us than N 1,000 five years
from now because we can invest N 1,000 today and earn a return.

There are three methods of discounted cash flow but only two will be mentioned. They are:-

NET PRESENT VALUE (NPV)

The net present value (NPV) of an investment is the value obtained by discounting all future
cash flows from a project at a chosen cost of capital and then subtracting the initial cost of the
project. It is the sum of the present values of the cash inflows minus the sum of the present
values of the cash outflows.

Where:

Ct = the net cash receipt at the end of year t

Io = the initial investment outlay
r = the discount rate/the required minimum rate of return on investment
n = the project/investment's duration in years.

Net Present Value Rule (NPV): An investment should be accepted if the net present value is
positive and rejected if the net present value is negative. Positive NPV projects create
shareholder value.

NPV Decision Rules

The following NPV signs explain whether the investment is good or bad

1. NPV > 0: The present value of cash flows is more than the present value of cash
outflows. The money earn on an investment is more than the
money invested. Hence it is a good investment.

2. NPV = 0: The present value of cash flows is more the present value of cash
outflows. The money earn on the investment is equal to the money
invested. Therefore there is no differences between the cash flows and
the cash outflows.

3. NPV < 0: The present value of a cash flows is less than the present value of a cash
outflows. The money earn on a investment is less than the money
invested. Hence, it not a fruitful investment.

Using the NPV:

A project with a 3 year life and a cost of N100,000 generates revenue of N25,000 in year 1, N
45,000

in year 2, and N 65, 000 in year 3. If the discount rate is 8%, what is the NPV of the project?
Costs:

Year Cash Flow Discounting Factor Present Value

(8%)

0 (100,000.00) 1.000 (100,000.00)

1 25,000.00 0.9259 23,148.15

2 45,000.00 0.8573 38,580.25

 3 65,000.00 0.7938 51,599.10

NPV 13,327.49

NPV = 13,327.49

NPV is positive then project should be accepted.

Advantages Disadvantages
The NPV criterion is profit oriented and takes The NPV is relatively more difficult to
into account time value of money. calculate compared either with the PBP or
ARR.
It is consistent with the objective of It does not provide measure of a project’s
maximizing shareholders’ wealth. actual rate of return.

INTERNAL RATE OF RETURN

This technique is also known as yield on investment, marginal productivity of capital, marginal
efficiency of capital, rate of return, and time-adjusted rate of return and so on. It also considers
the time value of money by discounting the cash flow streams, like NPV. While computing the
required rate of return and finding out present value of cash flows-inflows as well as outflows are
not considered. But the IRR depends entirely on the initial outlay and the cash proceeds of the
projects which are being evaluated for acceptance or rejection. It is, therefore, appropriately
referred to as internal rate of return. The IRR is usually the rate of return that a project earns.

The internal rate of return (IRR) is the discount rate that equates the NPV of an investment
opportunity with (Net Present Value Zero) N.0 (because the present value of cash inflows equals
the initial investment). It is the compound annual rate of return that the firm will earn if it invests
in the project and receives the given cash inflows.

IRR Rule: An investment is accepted if its IRR is greater than the required rate of return. An
investment should be rejected otherwise.

n
CF t
IRR: ∑ (1 + IRR ) t = $0 = NPV
t=0
Using the IRR:
The IRR is usually calculated using trial and error until a rate is obtained which makes the NPV
of the project equal to zero. However, under examination conditions, this can be time wasting. A
shortcut method is to choose a rate that gives positive NPV and another that gives a negative
NPV. One can then use interpolation to obtain the appropriate IRR as shown below:

Example: Invest N 9,000 now, receive 3 yearly payments of N 2,500 each, plus N 4,000 in the
3rd year.

Find IRR.

Year Cash Flow Discounting Factor Present Value

(10%)

0 (9,000.00) 1.000 (9,000.00)

1 2,500.00 0.9091 2,272.73

2 2,500.00 0.8264 2,066.12

3 2,500.00 0.7513 1,878.29

3 4,000.00 0.7513 3,005.26

NPV = 222.39

Method 2
Let us try 10%

Now: PV = -N. 9,000

Year 1: PV = N. 2,500 / 1.10 = N. 2,272.73

Year 2: PV = = N. 2,500 / 1.102

= N. 2,066.12

Year 3: PV = = N. 2,500 / 1.103

= N. 1,878.29
Year 3 (final payment): PV = N. 4,000 / 1.103

= N. 3,005.26

Adding those up gets: NPV = N 222.39

Let us try 12% discount rate:

Year Cash Flow Discounting Factor Present Value

(12%)

0 (9,000.00) 1.000 (9,000.00)

1 2,500.00 0.8929 2,232.14

2 2,500.00 0.7972 1,992.98

3 2,500.00 0.7118 1,779.45

3 4,000.00 0.7118 2,847.12

NPV = (148.30)

 Now: PV = -N. 9,000

 Year 1: PV = N 2,500 / 1.12 = N. 2,232.14

 Year 2: PV = = N 2,500 / 1.122 = N 1,992.98

 Year 3: PV = = N. 2,500 / 1.12 3 = N 1,779.45

 Year 3 (final payment): PV = N 4,000 / 1.123 = N 2,847.12

 Adding those up gets: NPV = N (148.30)

So close. Maybe 11.2%

Year Cash Flow Discounting Factor Present Value

(11.2%)

0 (9,000.00) 1.000 (9,000.00)

1 2,500.00 0.8993 2,249

2 2,500.00 0.8088 2,022

3 2,500.00 0.7273 1,819

3 4,000.00 0.7273 2,910

NPV = (148.30)

 Now: PV = - N 9,000

 Year 1: PV = N 2,500 / 1.112 = N 2,249

 Year 2: PV = N 2,500 / 1.1122 = N 2,022

 Year 3: PV = N 2,500 / 1.1123 = N 1,819

 Year 3 (final payment): PV = N 4,000 / 1.1123 = N 2,910

 Adding those up gets: NPV = N 0

Then IRR is 11.2 %

Advantages disadvantages
Like the NPV method, the IRR takes the time The IRR may fail to indicate a correct choice
 value of money into consideration. between mutually exclusive projects under
certain conditions.
It is more appealing because the percentage The IRR may sometimes produce negative or
figure is more meaningful and acceptable to multiple rates in certain situations.
managers. This makes it easy to use when
explaining desirability of individual projects.
Causes of conflict between NPV and IRR and suggested
resolutions

In capital budgeting, NPV and IRR conflict refers to a situation in which the NPV method ranks
projects differently from the IRR method. Net present value (NPV) and internal rate of return
(IRR) are two of the most widely used investment analysis and capital budgeting techniques.
They are similar in the sense that both are discounted cash flow models i.e. they incorporate the
time value of money. But they also differ in their main approach and their strengths and
weaknesses. NPV is an absolute measure i.e. it is the Naira amount of value added or lost by
undertaking a project. IRR, on the other hand, is a relative measure i.e. it is the rate of return that
a project offers over its lifespan.

The underlying cause of the NPV and IRR conflict are;

a. Nature of project (independent vs mutually-exclusive).

b. Nature of cash flows (normal vs non-normal).

c. Size of the project.

d. Reinvestment Assumption

Also, it is important to distinguish between conventional and non-conventional investment when

discussing the comparison between NPV and IRR methods.

A conventional investment is one whose cash flows take a pattern of an initial cash outlay
followed by cash inflows i.e. -+++ while a non-conventional investment on the other hand is one
whose cash flows are not restricted to the initial period but are dispersed with inflows throughout
the life of the project. Non-conventional projects have more than one changes in sign of cash
flows e.g. -+-+.
In the case of conventional investments which are economically independent of each other, the
NPV and the IRR methods result in the same accept/reject decision.

In the case of non-conventional investment there is a serious shortcoming of the IRR method.
This is because it can yield multiple internal rates of returns due to more than one reversal of
sign in cash flows. The reason for this lies in the algebra of IRR equation. In solving for r as the
unknown, the analyst is actually solving for n root of r.

Nature of project (independent vs mutually-exclusive). In case of mutually-exclusive projects,

an NPV and IRR conflict may arise in which one project has a higher NPV but the other has
higher IRR. Mutually exclusive projects are projects in which acceptance of one project excludes
the others from consideration. The conflict either arises due to relative size of the project or due
to the different cash flow distribution of the projects. Since NPV is an absolute measure, it will
rank a project adding more Naira value higher regardless of the initial investment required. IRR
is a relative measure, and it will rank projects offering best investment return higher regardless of
the total value added.
If the initial cash outlays of two projects under consideration are different, both the NPV and
IRR criterion can give us conflicting results. Hence, this conflict can be resolved through the
incremental approach. Incremental cash flow is the additional operating cash flow that an
organization receives from taking on a new project. A positive incremental cash flow means that
the company's cash flow will increase with the acceptance of the project. A positive incremental
cash flow is a good indication that an organization should invest in a project, this involves
finding the differential cash flows.

ICF= Revenues − Expenses − Initial Cost

Nature of cash flows (normal vs non-normal).

Two projects of the same length may have different patterns of cash flow. The cash flow of one
project may continuously increase over time, while the cash flows of the other project may
increase, decrease, stop, or become negative. Let us consider two projects: A and B, both need
N10 million investment each. Project A generates N 15 million in Year 1 and N 10 million in
Year 2. Project B generates 0 in Year 1 and N 30 million in Year 2. You can verify that Project
A has NPV of N 11.9 million at 10% discount rate and IRR of 100%. Project B has NPV of N
14.8 million and IRR of 73.2%. As the NPV is not skewed by the overstated reinvestment rate
assumption, hence it is the preferred method.
Reinvestment Assumption
A major source of conflict between NPV and IRR is the reinvestment assumption implicit in the
NPV and IRR. The NPV assumes that the cash flow of project should be reinvested at the cost of
capital, while the IRR assumes that the cash flow of the project should be invested at the IRR. By
making explicit reinvestment assumption using any rate arbitrarily, the inconsistency between
the two methods could be eliminated.

Differences in Project sizes and lives

There are reasons why the NPV and the IRR are sometimes in conflict: the size and life of the
project being studied are the most common ones. A 10-year project with an initial investment of
N100,000 can hardly be compared with a small 3-year project costing N 10,000. Actually, the
large project could be thought of as ten small projects. So if you insist on using the IRR and the
NPV methods to compare a big, long-term project with a small, short-term project, don’t be
surprised if you get different selection results.

The explanation for the superiority of NPV criterion in this situation can be found in Hirsleifer
(1990) and Copeland and Weston (1983). Thus, discussion on projects with different lives will
focus on the NPV criterion.
To properly evaluate projects with different lives, the following approaches can be used;
i. Common horizon view point
ii. Equivalent Annual Cash flow
iii. Replication at constant scale infinitely

i. Common horizon view point: This approaches assumes that projects can be replicated.
Here the projects are extended (i.e. replicated) to be of equal lives i.e. lowest common
multiple (LCM) of the life span of the projects is determined and the NPV is determined
for the number of times of the project can be undertaken for the LCM years.
Example :
Consider the following two projects and advise on the acceptable project:
Cash flow
Year 0 1 2 3
Project A (55) 60 40 40
Project B (52) 65 50 -
Cost of capital = 10%

Solution
Year DF at CF PV CF PV DF at PVA PVB
10% 90%
0 1.0000 (55) (55) (52) (52) 1.0000 (55) (52)
1 0.9091 60 54.55 65 9.09 0.5293 31.76 34.40
2 0.8264 40 33.06 50 41.32 0.2770 11.08 13.85
3 0.7513 40 30.05 - - 0.1457 5.83 -
NPVA = 62.66 48.41 (6.33) (3.75)

62.66
IRR A =10 %+ ( 62.66+6.33 ) x 90 %−10 %
62.66
¿ 10 %+ (
68.99 )
x 80 %

IRRA = 82.67%
48.41
IRR B=10 % + ( 48.41+3.75 ) x 90 %−10 %
48.41
¿ 10 %+ (
52.16 )
x 80 %

= 84.25%
NPVA = 62.66 IRRA = 82.67%
NPVB = 48.41 IRRB = 84.25%
There is a conflict between NPV and IRR. Common horizon view point can be used to detect the
right project.
LCM of the life of project = 2 x 3 = 6 years
The project will be replicated to terminate in year 6 as follows:
For project A.
Year Cash flow Chain Cash flow Net cash flow DF at 10% PV
1 Chain 2
0 (55) - (55) 1.0000 (56)
1 60 - 60 0.9091 5454
2 40 - 40 0.8264 33.06
3 40 (55) (15) 0.7513 (11.27)
4 - 60 60 0.6830 40.98
5 - 40 40 0.6109 24.84
6 - 40 40 0.5645 22.58
NPV = 109.73
IRR of replicated project A as shown above is 82.67%
For project B
Year Cash flow Cash flow Cash flow Net cash DF at 10% PV
chain 1 chain 2 chain 3 flow
0 (52) - - (52) 0.0000 (52)
1 65 - - 65 0.9091 59.09
2 50 (52) - (2) 0.8264 1.65
3. - 65 - 65 0.7513 48.83
4 - 50 (52) (2) 0.6830 (1.37)
5 - - 65 65 0.6209 40.36
6 - - 50 50 0.5645 28.23
124.79
IRR of replicated project B as shown above is 84.25%

Therefore
NPVB > NPVA
IRRB > IRRA
Therefore, project B is the preferable project

ii. Equivalent Annual cash flow method (EAC): it involves calculating equivalent annual
cash flow (EAC) of each project and selecting the alternative with the highest EAC.
EAC = NPV for each project
PVAF at K
Where EAC = Equivalent annual cash flow of each project
PVAF at K = present value of annuity factors for the time span of the project at the
discount rate or cost of capital.
For instance example 3:
EACA = NPVA
PVAF at 10% for 3 years
= N62.66
2.4869
= N25.20
EACB = NPVB
PVAF at 10% for 2 years
= 48.41
1.7355
= 27.89

Since EACB = EACA; project B is preferable project

iii. Replication at constant scale infinitely
This approach also assumes that projects can be replicated. It involves computing the
NPV of an n year project replicated at constant scale and infinite number of times. It is given by
(Copeland and Weston, 1983):
(1+ k) n
NPV (N, œ) = NPV (N)
[ (1+k )n−1 ]
Where k = cost of capital
Example 3: NPV (Nœ) for two projects are given as follows:
For project A
(1+1)3
NPV (3, œ) = 62.66
(1+1)3−1 [ ]
= 62.66 ( 1.331
0.331 )
 = N251.97

Project B
(1+1)2
NPV (2, œ) = 48.41
[
(1+1)2−1 ]
= 48.41 ( 1.21
0.21 )
= N278.93
Since NPV (2, œ) > NPV (3, œ), project B is the preferable project.

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