Meaning of Capital Budgeting:

Capital budgeting is concerned with designing and carrying through a systematic investment programme.
According to Charles T. Horngren, "capital budgeting is a long-term planning for making and financing
proposed capital outlays."

According to G.C. Philippatos, "capital budgeting is concerned with the allocation of the firm’s scarce
financial resources among the available market opportunities. The consideration of investment opportunities
involves the comparison of the expected future streams of earnings from a project with the immediate and
subsequent stream of expenditure for it."

Thus, the capital budgeting decision may be defined as the firm’s decision to invest its current funds most
efficiently in long-term activities in anticipation of an expects flow of future benefits over a series of years.
Such decisions may consist addition, disposition, modification, mechanization or replacement of any fixed
asset.

Type of Capital Budgeting Decisions:

Broadly speaking, capital budgeting decisions are long-term investment decisions. They include the following:

Mechanisation of a Process - A firm may intend to mechanise its existing production process by
installing machine. The machine is estimated to cost Rs. 1,50,000 and expected to save operating expenses of
Rs. 25,000 per annum for a period of ten years. Thus, it is an investment decision involving cost outlay for Rs.
1,50,000 and an annual saving of Rs. 25,000 for 10 years. The firm would be interested in analysing whether it
is worth to install the machine.

Expansion Decisions - Every company wants to expand its existing business. In order to increase the
scale of production and sale, the company may think of acquiring new machinery, addition of building, merger
or takeover of another business etc. This all would require additional investment which be evaluated in terms of
future expected earnings.

Replacement Decisions - A company may contemplate to replace an existing machine with a latest
model. The use of new and latest model of machinery may possibly bring down operating costs and increase the
production. Such replacement decision will be evaluated in terms of savings in operating costs and increase in
annual profits.

Buy or Lease Decisions - Capital budgeting is also helpful in making buying or lease decisions. The
fixed assets can be purchased or arranged on lease arrangements. Such decisions create a great different in the
demand of capital. Hence, a comparative study can be made with reference to future benefits from these two
mutually exclusive alternatives.

Choice of Equipment - A company needs an equipment (plant or machinery) to perform certain

process. Now a choice can be made between semi-automatic machine and fully automatic machine. Capital
budgeting process helps a lot in such selections.

Product and Process Innovation - The research and development department of a company may
suggest that a new product should be manufactured and/or a new process should be introduced. The intrduction
of new product and/or a new process will involve heavy capital expenditure and will earn profits also in the
future. So, inflows (i.e. future operating income) will be very useful and the ultimate decision will depend upon
the profitability of the product and/or process.

House-Keeping Projects - House-keeping projects are such projects which exert indirect impact on the
production. They are finanaced either on account of legal necessity or to boost up the morale and motivation
level of the employees, say :

(i) Health and Safety Projects.

(ii) Service Department Projects
(iii) Welfare Projects
(iv) Education, Training and Development Projects
(v) Status Projects
(vi) Research and Development Projects.

The decisions relating to financing of above-mentioned long-term projects are not made on the basis of
profitability. They are approved or rejected in terms of their urgency, need, compulsion and desirability.
Hence, no profitability analysis is made for them. The capital budgeting decisions exclude decisions
regarding current assets. The management and investment problems of current assets are discussed
under the head working capital management. The capital budgeting decisions are concerned with only
those type of decision areas which have long-term implications for the firm in terms of current
expenditure and future benefits. Current expenditure constitutes the outflow of cash and is represented
by cost. The future benefits are measured in terms of annual cash inflows. Hence, in capital budgeting, it
is the flow of cash outflow and inflow which is important, not the earnings determined in accordance
with the accrual concept of accounting.

Importance of Capital Budgeting:

Capital budgeting decisions are among the most crucial and critical business decisions. The
selection of the most profitable assortment of capital investment can be considered a key function of
management. On the other hand, it is the most important single area of decision-making for the financial
executives. Actions taken by management in this area affect the operations of the firm for many years to
come. The need and importance of capital budgeting can be numerated as follows :-

Heavy Investment - Almost all the capital expenditure projects involved heavy investment of
funds. These funds are accumulated by the firm from various external and internal sources at substantial
cost of capital. So their proper planning becomes invitable.

Permanent Commitment of Funds - The funds involved in capital expenditures are not only
large but more or less permanently blocked also. Therefore, these are long-term investment decisions.
The longer the time, the greater the risk is involved. Hence, a careful planning is essential.

Long-term impact on profitability - The capital expenditure decisions may have a great impact
on the profitability of the firm for a very long time. If properly planned, they can increase not only the
size, scale and volume of scales but firm growth potentiality also.

Complicacies of Investment Decisions - The long-term investment decisions are more

complicated in nature. They entail more risk and uncertainly. Further, the acquistions of capital assets is
a continuous process. So the management must be gifted ample prophetic skill to peep into future.
 Worth Maximization of Shareholders - Capital budgeting decisions are very important as their
impact on the well-being and economic health of the enterprise is far reaching. The main aim of this
process is to avoid overinvestment and under-investment in fixed assets. By selecting the most profitable
capital project, the management can maximize the worth of equity shareholder’s investment.

Process of Capital Budgeting:

Capital budgeting decisions of a firm have a pervasive influence on the entire spectrum of
entrepreneurial activities. Hence, they require a complex combination and knowledge of various
disciplines for their effective administration, such as, Economics, Finance, Mathematics, and Economic
Forecasting, projection Techniques and Techniques of Financial Engineering and Control. In order to
combine all these elements, a finance manager must keep in mind the three dimensions of a capital
budgeting programme: Policy, Plan and Programme. These three P’s constitute a sound capital
budgeting programme. However, the important steps involved in the capital budgeting process are: (i)
project generation; (ii) project evaluation, (iii) project selection; and (iv) project execution. These steps
are necessary, but more may be added to make the process more effective. Joel Dean a famous
economist has described the specific elements in an orderly investment programme which are as
follows:

Creative Search for Profitable Opportunities - The first stage in the capital expenditure
programme should be the conception of a profit making idea. It may be rightly called the origination of
investment proposals. The proposals may come from a rank and file worker of any department or from
any line executive. To facilitate the origination of such ideas a periodic review and comparision of
earnings, costs, procedures and product line should be made by the management on a continuous basis.

Long-range Capital Plans- When a specific proposal is made to management, its consistency
with the long-range plans of the company must be verified. It requires the determination of over-all
capital budgeting policies beforehand based upon the projections of short and long-rum developments.

Short-range Capital Budget- Once the timelines and priority of a proposal have been
established, it should be listed on the one-year capital budget as an indication of its approval.

Measurement of Project Worth- This stage involves the tentative acceptance of the proposal
with other competitive projects, within the selection criteria of the company. Small projects under a
certain rupee amount could be approved by the departmental head. Larger projects should be ranked
according to their profitability. Any one or more tests of profitability may be used for it. For project
evaluation, different techniques may be used, such as, payback period, accounting rate of return and
discounted cash flow techniques.

Screening and Selection - This stage involves the comparison of the proposal with other
projects according to criteria of the firm. This is done either by financial manager or by a capital
expenditure planning committee. Such criteria should encompass the supply and cost of capital and the
expected returns from alternative investment opportunities. Once the proposal passes this stage, it is
authorized for outlays.

Establishing Priorities - Then comes the stage of establishing the priorities. When the accepted
projects are put in priority, it facilities their acquisition or construction, avoids costly delays and serious
cost overruns. This stage is also called the ranking of projects. It helps in capital rationing and better
utilization of capital.

Final Approval - Once the financial manager has reviewed the projects, he will recommended a
detailed programme, both of capital expenditures and of sources of capital to meet them, to the top
management. Possibly, the financial manager will present several alternative capital-expenditure budgets
to the top management, it will finally approve the capital budget for the firm.

Forms and Procedures - This is a continuous phase that involve the preparation of report for
every other phase of the capital expenditure programme of the company.

Retirement and Disposal - This phase marks the end of the cycle in the life of a project. It
involves more than the recovery of the original cost plus and adjustment for replacement programmes.
The old assets should be sold and realised sale price should be used for replacement financing.

Evaluation - An important step in the process of capital budgeting is an evaluation of the

programme after its implementation. The evaluation process answers such questions, say, was the
investment greater than anticipated? Were the expected net cash inflows actually realized? Was the
proper test of evaluating the profitability of project applied? Management can improve its capital
budgeting programme for the future from past experience. Such evaluation has also the advantage of
forcing departmental heads to be more realistic in their approach and careful in actual execution of the
projects.

Investment Evaluation Criteria

Because of the utmost importance of the capital budgeting decisions, a sound appraisal method
should be adopted to measure the economic worth of each investment project. In most business firms,
there are more than one investment proposals for a capital project than the firm is capable and willing to
finance. Here the problem of ranking them in order of preference arises. Hence, the management has to
select the most profitable project or to take up the most profitable project first. As we know that the
ultimate goal of financial management is the worth maximization of the firm, hence, in order to achieve
this objective, the management must select those projects which deserve first priority in terms of their
profitability. For evaluating the comparative profitability of capital projects many methods have been
evolved. Each method has its own merits and demerits. However, the method going to be used should, at
least, possess the following characteristics:

(a) it should provide a means of distinguishing between acceptable and unacceptable projects.

(b) It should provide clear cut ranking of the projects in order of the profitability or desirability.

(c) It should also solve the problem of choosing among alternative projects.

(d) It should be a criterion which is applicable to any conceivable investment projects.

(e) It should emphasize upon early and bigger cash benefits in comparison to distant and smaller
benefits.

(f) In the last but not the least, the method should be suitable according to the nature and size of
capital project to be evaluated.
 Method of Evaluating Investment Proposals

The various methods which are commonly used for evaluating the relative worth of investment
proposals are as follows:

I. Non-discounted Cash flow Techniques (NDCF)

(A) Payback Period Method (PB)

(B) Accounting Rate of Return Method (ARR)

II. Discounted Cash flow Techniques (DCF)

(A) Net Present Value Method (NPV)

(B) Present Value Index Method or Benefit-Cost Ratio Method (BCR) or Profitability Index
Method (PI)

(C) Internal Rate of Return Method (IRR)

1. Non-discounted cash flow Techniques (NDCF)

(A) Payback Period Method (PB)

This method is also known as pay-off, pay-out or recoupment period method. It gives the number
of years in which the total investment in a particular capital project pays back itself. This method is
based on the principle that every capital expenditure pays itself back over a number of years. It means
that it generates income regularly during its estimated economic life. When the total cash inflows from
investment equal the total outlay, that period is the payback period of that project. While comparing
between two or more projects, the project with lesser payback period will be acceptable.

Calculation or Payback Period - The payback period can be calculated in the following
manner:-

(A) In the case of even cash inflows:- If the pattern of annual cash inflow is of conventional
character or they are in the form of annuity, the computation of payback period is very
simple, as follow :

Payback Period = Initial Investment

Annual Cash Inflow

For example, if an investment of Rs. 10,000 in a machine is expected to produce annual cash
inflow of Rs. 2,500 for 6 years, then

Payback Period = Rs. 10,000 = 4 yrs.

Rs. 2,500

(b) In the case of uneven cash inflows - When a project’s cash flows are not equal, but vary
from year to year, i.e., they are of non-conventional nature, the calculation of payback period
takes a cumulative form of annual cash inflows. In such a situation, payback period is calculated
 by the process of cumulating cash inflows till the time when cumulative cash inflows become
equal to the original investment outlay. The following example will illustrate the point.

Illustration: A project requires an investment of Rs. 10,000. Its estimated (121) annual cash
inflows have been given below:

Year Annual Cash Inflows Cumulative Cash inflows

(ACF) (Rs.) (CCF) (Rs.)
1 2,500 2,500
2 3,500 6,000
3 4,000 10,000
4 5,000 15,000
5 3,000 18,000

Thus, Rs. 10,000 is recovered fully in 3rd year, hence, payback period is 3 yrs.

Illustration: A project requires an investment of Rs. 10,000 and its estimated annual cash
inflows are as follows:

Year (ACF) (Rs.) (CCF) (Rs.)

1 2,000 2,000
2 3,000 5,000
3 4,000 9,000
4 2,000 11,000
5 3,000 14,000

Here, payback period will be = 3 years + 10000 - 9000 = 3.5 yrs.

2000
Accept-Reject Criterion - The payback period can be used as a decision criterion to accept or reject investment
proposals. If only one independent project is to be evaluated its actual payable period should be compared with
a pre-determined (standard) payback, i.e., the payback set up by the management in terms of maximum period
during which the initial investment must be recovered. If the actual payback period is less than the standard
payback period, the project would be accepted, if not, it would be rejected. Alternatively, the payback can be
used as a ranking method also. When mutually exclusive projects are under consideration they may be ranked
according to the length of the payback period. Thus, the project having the shortest payback may be assigned
rank one, followed in that order so that project with the longest payback would be ranked the lowest.

Demerits of Payback Approach -

Major weakness of this approach is that it completely ignores all cash inflows arising after the payback
period. This could be very misleading in capital budgeting decisions. It may be possible that two projects have
similar payback period but their post-payback profitability differs significantly.
The following examples will illustrate the point.

Project A Project B
(Rs.) (Rs.)
Cost of Project 15,000 15,000
Year Annual Cash Inflows
1 5,000 4,000
2 6,000 5,000
3 4,000 6,000
4 0 6,000
5 0 4,000
6 0 3,000
Payback period 3 yrs. 3 yrs.

Thus, project B is certainly advantageous as its post-payback profitability is more in spite of similar
payback period of 3 years.

Look at this example also.

Project x Project y
(Rs.) (Rs.)
Total Investment 10,000 10,000
Year Annual Cash Inflows
1 5,000 3,000
2 5,000 4,000
3 2,000 3,000
4 1,000 4,000
5 500 2,000
Payback period 2 yrs. 3 yrs.

Thus, the payback period for project x is 2 years and for project y it is 3 years. Obviously, project x will
be preferable on the basis of payback period. However, if we look beyond the payback period, we see
that project x returns only Rs. 3,500 while project y returns Rs. 6,000. Thus, project y should be
preferred.

(ii) Earnings per Unit of Money Invested - As per this method, we find out the total net earnings (after
taxes) and then divide it by the total investment. This gives us the average rate of return per unit of
amount invested in the project, as follows:

Earnings per Unit of Investment = Total Earnings (after taxes)

Total Outlay of the Project

Higher the earnings per rupee, the project deserves to be selected.

(iii) Average Return on Average Investment - Under this method the percentage of average return on average
amount of investment is calculated. To calculate the average investment, the outlay of the project is divided by
two. ARR is calculated as follows:

Average Rate of Return = Average Profits (after taxes) x 100

Average Investment
The average profits after taxes - Average profits after taxes are found by taking the sum of the
expected after-tax profits of the project during its life and dividing the sum by the number of years of its life. In
the case of an annuity, the average after-tax profits are equal to any year’s profits.

The average investments - Any of the following three formulae may be applied to calculate average
investment:

(a) Initial Investment/2

(b) (Initial Investment + Scrap Value)/ 2

be gainfully employed under certain circumstances. In a politically unstable economy, a quick return of
investment is a must. Shortest payback period is the only answer to such investments. In case of foreign
investments, the firms experiencing sever shortage of liquidity, for assessing short-run and medium term capital
projects, the payback period is the only good technique for assessing their profitability. In fact, the payback
period is a measure of liquidity of investment rather than their profitability. Thus, the payback period should
more appropriately be treated as a constraint to be satisfied than as a profitability measure to be maximized.

(B) Accounting Rate of Return Method (ARR)

This method is also known as Financial Statement Method, Return on Investment Method or Unadjusted
Rate of Return Method. It is based on operating earnings computed in the Profit & Loss Account, hence, no
separate calculations are necessary to compute annual cash inflows. Finding the average rate of return is a quite
popular approach for evaluating proposed capital expenditures. Its appeal stems from the fact that the average
rate of return is typically calculated from accounting data (i.e. profits after taxes). According to this method,
capital projects are ranked in order of their rate of earnings. Projects which yield the highest earnings are
selected and others are ruled out. This return on investment can be expressed in several ways as below:

(i) Average Rate of Return on Total Investment - This method established the relationship between
the average annual profits to total outlay of capital project, as follows:

Average Rate of Return = Average Profits (after taxes) x 100

Total Outlay of the Project
(c) Recovered Capital + Scrap Value
2
The averaging process outlined above assumes that the firm is using straight line method of
depreciation.

Merits of ARR Method

The approach has the following merits:

(1) Like payback method it is also simple and easy to understand.

 (2) It is based on the accounting concept of operating income and accounting profit figures are used in
analyzing the profitability of alternative capital projects, hence no separate calculations are required.

(3) It takes into consideration the total earnings from the project during its entire economic life.

(4) This approach gives due weight to the profitability of the project.

(5) In investments with extremely long lives, the simple rate of return will be fairly close to the true rate
of returns. It is often used by financial analysts to measure current performance of a firm.

Demerits of ARR Method

This method has following demerits:

(1) One apparent disadvantage of this approach is this that its results by different methods are
inconsistent.

(2) It is simply an averaging technique which does not take into account the impact of various external
factors on overall profits of the firm.

(3) The method ignores the time factor of future cash streams which is crucial in business decisions as
the amount of interest and discount is substantially affected by it.

(4) This method does not determine the fair rate of return on investments. It is left at the discreation of
the management. Hence, the use of this arbitrary rate of return may cause serious distortions in the selection of
profitable projects.

II. Discounted Cash Flow Techniques (DCF)

Although, return on investment has been considered a satisfactory technique of capital budgeting in
accounting circles for long. Next came the payback approach which is based on cash flow technique. But the
lacuna of the above methods is that they do not take the time factor of the income into account. The earlier
receipts are certainly more important than the income to be received in later years. A bird in hand is worth than
the two in the bush, is aptly applicable to the management of capital. Accordingly, a rupee in the hand has more
worth than a rupee to be received five year later, because the use of money has a cost (interest) just as the use of
building or an automobile may have a cost (rent). The DCF techniques take care of these both aspects, i.e., time
value of money and cost of capital. As a capital project yields returns spread over a number of years, correct
assessment of its profitability can be made only if the annual returns of the future years are brought to their
present value after applying a discounting rate (i.e. cost of capital or interest rate). Similarly, if the investment is
to be made over a number of years, the cash outflows have to be brought down to their present value. Thus
these techniques recognize time-adjusted rate of return as well as the cost of capital. The aggregate of future
cash flows discounted at a given rate of cost of capital is called the present value of those cash inflows.

The calculation of present value consists of the following steps:

(a) Estimating future cash inflows from the project.

(b) Selecting a discount rate which is commonly known as opportunity cost or cost of capital also.
 (c) Discounting those cash inflows with the discount factors or present value factors picked up from the
present value tables according to the rate of cost of capital.

There are three methods to judge the profitability of different proposals on the basis of discounted cash
flow technique. These are as follows:

(A) Net Present Value Method (NPV)

The calculation of net present value (NPV) of project is one of the most commonly used capital budgeting
techniques. This method is also known as Excess Present Value of Net Gain Method. The definition of net
present value can be expressed as follows:

NPV = Total Present value of Future Cash inflows - Initial Investment.

The total present value of future cash inflows is calculated with the help of the following formula:

P= S1 + S2 + ..................+ Sn
(1+i) (1+i) 2 (1+i) n

Where, P = Present Value of future cash inflows.

S = Future Value of cash inflows for n years.
i = Rate of interest
n = number of years (1, 2, 3,……..)

Based on the above equation, the present value factors tables have been prepared. In these tables, the
present value of Re. 1 at different rates of interest has been given. The second type of present value tables
provides us the cumulative amount of an annuity of Re. 1 for a given rate of interest. If the annual cash inflows
are of even nature, the compound present value factor should be used and if it is of uneven nature, the simple
present value factor should be applied. If the NPV is in positive the project should be accepted. If it is in
negative, it should be rejected. In mutually exclusive projects, the project with higher NPV should be preferred.

The following example will explain the procedure.

Illustration: Suppose a project costs Rs. 5,000. Its estimated economic life is 2 years. The firm’s cost of capital
is estimated to be 10%. The estimated cash inflows from the project are Rs. 2,800 p.a. calculate its NPV.

Solution: As the firm’s cash inflows are of conventional pattern (i.e. even amount), the compound value factor
can be used for calculating their NPV.

Rs.
Total Present Value = Rs. 2,800 x 1.813 5,272
Less:- Cost of the Project 5,000
Net Present Value 272

Merits of NPV Method

(1) The NPV method takes into consideration the time factor of earnings as well as cost of capital.
(2) It is very easy to calculate, simple to understand and useful for simply "accept" or "reject" type of projects.

(3) It can be applied to both types of cash inflows patterns - even and uneven cash inflows.

(4) The NPV method is generally preferred by economists. If one wishes to maximize profits, the use of NPV
always finds the correct decisions.

(5) It takes care of entire earnings.

(6) The concept of the present value of series of cash flows is an important feature in the analysis of different
investment potentialities. The net present worth technique analyses the merit of relative capital investments in a
nice and exact manner.

Demerits of NPV Method

(1) It involves a good amount of calculations. Hence, it is a complicated method.

(2) The use of this method requires the knowledge of cost of capital. If it is unknown, the method cannot be
used.

(3) It leads to confusing and contradictory answers for the ranking of complicated projects.

(4) Keeping in view the substantial difference in time-span and involved risk in various capital projects, the use
of one common rate of cost of capital for discounting cash inflows is not desirable.

B. Profitability Index Method

This method is also known as Benefit-Cost Ratio. One major demerit of NPV method is that it cannot be
applied to compare those mutually exclusive projects which differ in costs substantially. To compare and
evaluate such projects, the profitability index should be calculated. The profitability index is the relationship
that exists between the present values of net cash inflows and cost outlays of the projects. It can be calculated in
two manners:

Gross BCR = Total Present Values of Cash Inflows

Initial Investment

Net BCR = Net Present Values of Cash Inflows

Initial Investment
(Where NPV of cash inflows in Total Present value of cash inflows minus initial investment)

These both can be expressed in percentage also. Their expression in percentage helps in comparing the
relative profitability of capital projects. The higher the profitability index, the more desirable is the investment.

(B) Internal Rate of Return (IRR) Method

The third DCF technique is the Internal Rate of Return Method which is commonly known as Time-
adjusted Rate of Return method also. Like the present value method, the IRR method also considers the time
value of money by discounting the annual cash inflows. But present value method can be applied only when the
discount rate (i.e. cost of capital) is known to us. On the other hand, in IRR technique we find out that rate of
return which will equate the present value of future cash streams to the present cash outlay of the project. It is
usually the rate of return that the project earns. "It may be defined as the discount rate (r) which equates the
aggregate present value of the net cash inflows with the aggregate present value of cash outflows of a project".
In other words, "IRR is the maximum rate of interest that could be paid for the capital employed over the life of
an investment without loss on the project". Thus, it is that rate which gives the projects NPV of zero.

Assuming conventional cash inflows, mathematically, the IRR is represented by that rate, r, such that,

C= ACF1 + ACF2 + ACF3 + --------------- + ACFn + S+Wn

(1+r) 1 (1+r) 2 (1+r) 3 (1+r) n (1+r) n

Here:
C = Cost of the Project
ACF = Annual Cash Inflows
S = Scrap Value of the Project
W = Working capital involved and recovered
r = estimated rate of interest
Fortunately tabular values of present values of future earnings are readily available. So, usually these
tables are used for this purpose.

Computation of IRR
(a) In the case of even cash inflows - If the cash inflows are uniform each year then the computation of
IRR involves the following two steps:

(i) Calculate Present Values Factor by applying the following formula:

P.V. Factor = Initial Investment

Annual Cash Inflow

(ii) Locate the factor calculated in (i) in the compount Present Value Table on the line corresponding the
life span of investment in years. The interest rate of the line of that factor will be the required IRR.

It is to be noted that the present value of cash inflows at this computed rate must be equal to the present
value of cash outflows.

Illustration: A project costs Rs. 10,000 and is expected to generate cash inflows of Rs. 1,750 annually for 10
years. Its salvage value is nil. Calculate its IRR

Solution: P.V. Factor = Investment ÷ Annual Cash Inflow

= 10,000 ÷ 1,750 = 5.714

Locating this factor in the compound present value table on the line corresponding to the 10 th year. We
find that this factor is most close to the factor in the table at 12%. Hence, the approximate rate of return is 12%.

As the factor given in the table is less than the factor computed above, actual rate will be a bit less than
12%. It can, however, be ascertained by applying the interpolation technique as follows:
V1-V
IRR = r1 + -------------- (r2 -r1)
V1 -V2
+6.145 - 5.714
= 10% + ------------------------ x (12% - 10%)
+6.145 - 5.652
 = 10% + 1.74% = 11.74%

Alternative Formula:
V - V2
IRR = r2 --------------- (r2 -r1)
V 1 – V2

5.714 - 5.650
= 12% ------------------------ x (12% - 10%)
6.145 - 5.650
0.064
= 12% - ------------ x 2
0.495
= 12% - 0.26% = 11.74%

Where,
r1 = Lower Rate of return
r2 = Higher rate of Return
V1 = PVF at lower rate of return
V2 = PVF at higher rate of return
V = PVF for which IRR to be interpolated

(b) In the case of uneven cash inflows –

Here the computation of IRR involves a trial and error procedure. To find the rate of interest that equates
the cash inflows with the cash outflows, we start with an assumed rated and calculate the NPV. This NPV may
be more than zero, less than zero or just equal to zero. If more than zero, a higher rate of interest should be tried
to calculate NPV. Conversely, when the NPV is less than zero, a lower rate would be used. The procedure will
go on till we find the rate which gives zero for the NPV.

Under IRR approach, the calculated IRR (i.e. actual rate) is compared with the required rate of return,
also known as the cut-off rate or hurdle rate (i.e. the cost of capital or interest rate on which the funds will be
available). If the actual IRR is higher than the cut-off rate, the project is accepted, if lower it is rejected.

If the IRR and cut-off are just equal, the firm will be indifferent as to whether to accept or reject the
project.

Illustration: A project requires an initial outlay of Rs. 32,400. Its estimated economic life is 3 years. The cash
streams generated by it are expected to be as follows:

Years Estimated ACF

(Rs.)
1 16,000
2 14,000
3 12,000
Computed its IRR. If the cost of capital to the firm is 12% advise the management whether the project should be
accepted or rejected.

Solution: To compute IRR, we have to follow the trial and error procedure with various rate of interest. The
following table presents the calculations:
Table showing calculations of IRR for unequal cash inflows

Total Present Values at different rate of interest

Year ACF DF at 14% P.V. DF at 16% P.V. DF at 15% P.V.
(Rs.) (Rs.) (Rs.) (Rs.)
1 16,000 0.877 14,032 0.862 13,795 0.870 13,920
2 14,000 0.769 10,766 0.743 10,402 0.756 10,584
3 12,000 0.675 8100 0.641 7,692 0.658 7,896
32,898 31,886 32,400
Less:- Cost of Project 32,400 32,400 32,400
+498 -514 0

Since NPV is zero at 15% discount rate, it is its IRR. If the cost of capital is 12%, the project must be
accepted as its internal return is 15% while cost of funds is only 12%. The project will contribute 3% to the
value of the firm.
12324564789A2BC7
 123456783152
1 1234565378962A586B4C5659D7EF5F58C543F45725
657575F57C459D7EFC54A5375372F24575
D46F25459D7EFC5FF2545378962A57D54A5375
96A575459D7EFC57545724DC57E545EFD85F2545
E7D857E512321451678
45FF42597F3A543FCF725F274C5754CF72C5
565ED63F7257E546D2F2C5C75 4596F575725
64D645 74D5F84!5
"565A9457E5FF42597F3A5C7545EFD85E77!5
#45FCC4C5C356C544D5F5C7586F26F25C46A5
FF42597F3A57D56597F3A5F23D46CF25FF425D75
D645435
1 1254574D5625$626484256C575C6FCEA56DF7C5
C6B474DC5ED785459D7EF5157E545%6B474DC5
 123245647158292A6
1 9A48 B23214518 B4C262D55FC5 7245 7E5 45 3D3F65 43FCF72C5 8645 A5
45 EF262345 86264D5 D46F25 75 45 96A7C5 75 45 C6D474DC5
45 96A75 FC5 45 9D797DF725 7E5 '6D2F25 (4D5 %6D45 F425 75 45
C6D474DC5F2545E7D857E5FF42C
1 45 378962F4C5 3625 96A5 4F4D5 FF425 75 45 C6D474DC5 7D5
D46F25 45 46D2F2C5 FF25 45 EFD85 45 68725 75 45 FC DC45
4942C5725459D4E4D423457E545C6D474DC562545F24C8425
7997D2FF4C59D46FF25FF2545EFD8
1 4579F865FF42543FCF725FC5425454657E5C6D474DC5
F23D46C4C5F545F23D46C45F25456457E5C6D4C57E545378962A5
4D4E7D4545EF262345496D84258C5372CF4D5654543FCF72C5
F)5 #24C8425 *F2623F25 625 +FF425 F45 3789F25 45
96A7C
 12321451
1 45 4D85 FF425 D4E4DC5 75 65 97DF725 7E5 9D7EF5 ,6E4D5 6-5
F35 FC5 FCDF 45 68725 45 724DC5 .5 C6D474DC5 7E5 45
EFD8
1 +FF42586A5 454EF2456C545D4D256565C6D474D54C5
ED78545378962A5757E5FC59D7EFC5725FC5C6D47F2C/
1 5 #25 74D5 7DC5 FF425 FC5 65 96D5 7E5 45 245 46D2F2C5 7E5 65
37D97D6F725 65 FC5 FCDF 45 75 FC5 C73B74DC5 #5 FC5 65
96A8425864575454FA5C6D474DC5E7D54FD5F24C8425
F2545378962A
1 +FF425 FC5 65 D46D5 75 4FA5 C6D474DC5 E7D5 4FD5
F24C8425F2545378962A5
1 #5 FC5 65 6CF35 DF5 7E5 4FA5 C6D474DC5 75 45 FF425 ED785
45 46D2F2C5 7E5 65 378962A5 4FD5 C6D45 C75 45 FCDF 45
6872545848 4DC5FF2545F8F57E5625635625F5D6F7265
46F7D57E5FD437DC
 BCDEF7711E1F

1 06CCFEF36F72C57E5FF42C56D45 6C4572545
E7D85F25F354A56D4596F5*77F25F425
4756D4545FEE4D425A94C57E5FF42C5
1 06C5FF425
1 172C5%6D4C5D4E4DD45756C5C73B5FF425F25
2%35
1 (D794DA5FF425
1 #24DF85FF42
1 32265FF425
1
1 EF6A8 12321451 5078962F4C5 87CA5 96A5
FF42C5 F25 36C5 35 078962A5 C75 645
4275 36C5 F25 FC5 62B5 633725 425 36C5
FF42C5 6D45 436D45 #E5 F5 74C5 275 645
4275 62B5 6623456DD6248425C75 45
8645 75 7DD75 E2C5 425 45 078962A5
E77C5 65 C6 45 FF425 97F3A5 F5 C75
9D496D45 65 36C5 45 E7D5 45 378F25 94DF75
75 F2F3645 45 2434CC6DA5 E2C5 F35 75
45 24445 75 8445 45 D46D5 FF425
96A842C57E545378962A
1 D568 AF468 8 ,145 %73B5 &FF425 F25 2%35
325 FCC45 7E5 72C5 C6D45 FC5 45 FCDF F725 7E5
C6D4C5ED4457E537C575454-FCF25C6D474DC5
1 55F81232145184256226A5378962A5
436D4C562596A5FF425FC54EF2456C5
62265FF425
1 5428123214515+DF2545A46D562A5F845
378962A5436D4C565FF425F5FC54EF2456C5
#24DF85FF42
1 4C2F81232145185#25C943F653FD38C6234C5
078962A5436D4C5%943F65FF42C5
6424D6A5378962A5436D4C5C943F65
FF425F2536C457E56 27D8659D7EFC
1 D4812321451684C45FF42C56D45
96A6 45F256CC4C57E54537D97D6F72574D5
62536C5*7D54-6894565EFD8586A5FCDF 45
 8A9758267123245647
DA28
9 !8"E9#  9 !8"E9#

6424D65C6457E5'37278A +4CFD457E5%6D474DC

069F65$6DB4C *F2623F65244C57E5078962A

746544CDF3F72C 86D457E5'6D2F2C

072D636544CDF3F72C +4CFD457E5072D7

6-6F725(7F3A 7FFFA5(7CFF72
$45F8"FCD68%8B23214518D2C
2 6424D65C6457E5'37278A595F2536C4C57E5234D6F2A549D4CCF725
F2545437278A5458586A5FB4575D46F254546D2F2C5625 F595
D4C4D4C5756 C7D 5C73BC5F2545ED456259D4C4D45FFFA
2 069F65$6DB4C595FE565EFD856C546CA56334CC575369F6586DB4C575
D6FC45E2C5F586A5E775F 4D65FF42597F3A5625F3454DC6
2 746544CDF3F72C59545858C53789A57565465D4CDF3F72C5
C356C5D62CE4D575D4C4D4C543
2 072D636544CDF3F72C59542F25EF2623F65F2CFF72C586A595
D4CDF3F72C5725FF42596A842C5759D74354FD5F24D4CC
2 6-6F725(7F3A595372CF4D6F7257E537D97D6456-4C5625FF425
FCDF F7256-575 4596F5 A545378962F4C
545F8"FCD68%8B23214518D2C
2 +4CFD457E5%6D474DC59545C6D474DC5 4F2545724DC57E545
378962A5F2E4234545FF42596A754FD54-9436F725E7D5FF425
49F3C5378962F4C5CD42534D6F2A5625FFFA
2 *F2623F65244C57E5078962A595EF2623F65244C57E545378962A586A5
FD43A5372EF35F5C6D474DC:54CFD45078962A:C5FCF725E7D5ED45
D756259D7EF6 FFA586A5 A96CC545FF4254-9436F72
2 86D457E5'6D2F2C59565EFD85F565C6 45F23784536256EE7D575645
F4D5FF42596A75625F3454DC6
2 +4CFD457E5072D7595F4D5FF425F89F4C5FFFA53D235653625 45
845 A52454FA5FCC458454FA5F4C585372D7
2 7FFFA5(7CFF725959DF845F897D62345E7D5FF42596A842C5378962A5
24457586F26F25FC5FFFA5F25 CF24CC5C7586A543F4575FCDF 454CC5
FF42
 167689A8BCDE6F
1
+FF42C5,F23F25F24DF85FF4256D45D4D2C5F42575
C6D474DC5757E59D7EFC546D245 A565378962A
1
(6A84257E5FF42C527572A54942C597259D7EF6 FFA5 56C75
45D43788426F7257E5+FD437DC5F45B27256C5;12324564789A2BCDE
1
+FF42597F3A544D8F24C545F8645FCDF F7257E545EFD8<C5
46D2F2C5 44425D442F725,65FC5D4F24C842562536C5FF425
96A842C57E5C6D474DC
1
F674232456479A2BC7272745B2454797B79279A47574225477
42324564764797B79757577553575265475626E
1
%6D474DC5699D74545FF4256C5D437884245 A545+FD437DC5
+FF425D6453625 45D4345 A5C6D474DC5 5362275 45
F23D46C4
 1232145167892AB6C6D2E52F2A5A4
3
1E757E536C59D4CCD45725FFFA57E545378962A
3
1997D2FA537C57E545E2C5FCDF 4
3
+FF425 96A8425 86-F8F)4C5 C6D474DC:5 3DD425
465 F45 D442F725 E63FF64C5 ED45 465
424D6F72
3
+FF42596A8425FC565CF257E577F56256597CFF45
F89635725F24C7DC5625F25D254586DB459DF345.5C6D4
3
4442F72546C575E6C4D5D75D4CF25F25F4D5
9D7EF6 FFA5625F23D46C45F25C6D474DC:546
3
96C755567C97!75562967"75C7E745B2296
 39ABCD5ED61F16B26DA5189
1 +FF42597F3F4C586A56DA5 444256DF7C5
EFD8C56C544DA5EFD85C4C5FC572597F3A5E7D5
FF425FCDF F72
& '454D68D82(4F8123214518D2C5*FD8C5
65E775FC597F3A5D46D5C6D474DC5
424D7CA5 A5C499F2595FF42574D545
F845
& F(48123214518D2C853337DF2575FC5
97F3A54594D3426457E546D2F2C596F5757E5
FF42C5D486F2C5372C62545FF42C5
F5E3645F54546D2F2C57E545
378962A5%6 45D9445,F2E6F7256=C45
E&8!D)84*F8123214518684$F8123214518
D2C883C594D5FC597F3A56575D46D5
FF425FC586F26F245625425F84C56D45
7756254-D65FF425FC596F5'-D65FF425FC5
456FF7265FF42579F726A596F5 A545
EFD85FE546D2F2C56D45F4D562527D865F2565
F42594DF7537545D46D597DF725F5
459D4F36 4545765FF425F5 45
29D4F36 45
B&84621F8123214518D2C88224D5FC597F3A5
FF42C56D4596F5757E546D2F2C52752444575
EF262345245633496 45369F659D7=43C545
FF42C5F5E36454942F25725
F24C84257997D2FF4C566F6 457545
&8+24812321451825C4F648D2C88%7845EFD8C5
E7754597F3A57E54DA5ED4425625C865FF425
F23D46C4C5457 =43F45FC575F45C6D474DC5625
FCF7257E58748425625D75
"&8F2C8123214518D2C88+FF42C56D4596F5
4DD6F36A542545862648425E44C5F5F5275CD6F25
45D4C7D34C57E545EFD85#24D4CC57E545C6D474DC5
6D452756B42536D457E5F4586BF2545FF425
43FCF72C5#56C5 44257 C4D45 A56DF7C5D4C46D34DC5
65EFD8C5424D6A59D4E4D575E77565C6 457D565
D66A5DFCF25FF42597F3A5
'&8,52-D8EF6A812321451868D568D2C88224D5
FC597F3A5458F2F885D6457E5FF42594D5C6D45FC5
96F5F2536C59C5 72C5C6D4C56D45FCC45757E5
6338645D4C4D4C55744D5 72C5C6D4C56D45275
F4253789C7DFA572562562265 6CFC54A586A5 45
B23214518
B262(2D58
9A4D246
B23214518B262(2D589A4D246
4 '37278FCC5@5F2B4DC5
CF45457378457E5
FF425725456457E5 1234567
45EFD8 89A53
4 'C6 FC565D46F72CF95
44425FF425
96A84256256457E5
45EFD8
4 4547DF4C595
E7D6D59D7F45
B23214518
4-D4845F4C
1262(2D5
4 +FF4256256457E5
EFD856D45D46456C545
6C576A52D464543 C96A9D7 89ABC3B2DB
8B33567E88F
89A53 89A53
7 .F4/68+D148%
21 3337DF2575(D7E5A684C564D545FD6F9BDB867689A8BDE6FB
EB9FB9B7E9BDB9B6
21 4564D587454-F FC565C4F84F2D56A28 4442545EFD8:C5
D6457E5D4D25,537C57E5369F65,5625FF42597F3A
21 662D568%
3 4D45FC572A5F24D265EF2623F257E5F24C842C5F452754 C5275
4FA
3 46457E5D4D25,562537C57E54FA5,56D4566AC5372C62
3 *FD856C5654DA5725FE4
21 3C594D54547DA564D56C536CCFEF45EFD8C5F275>53647DF4C5F)5
6D75EFD8C5,5577#7587D865EFD8C5,5577$75625
+43F2F25EFD8C5,5577%7
B23214518B262(2D589A4D246
2 3337DF257564D587459
5 DB6546D25F4D5D4D257254FD5F24C842C5,7#75
6254234545EFD85C75526727562654C45EFD8C5
86-F8F)456457E5C6D474DC5CF23454FD546D2F2C5,56D45
D464D5625C6D474DC:54-9436F72C5,5F45F0482C48
)2825C4F647
5 5DEB6546D2565D4D257254FD5F24C842C546575FC537C5
7E5369F65,7$75#25C3536C4C545FF42597F3A56C5ADB99FB
967573A57975725F4586DB452C48486AF48268CD56F57
5 19FE6A6AB6546D2574D5D4D257254FD5F24C842C5,7%75
B6457E5EFD85FC5F4C542565FC546D2F2C56D45FCDF 456C5
FF4254586DB459DF34594D5C6D45 4F2586-F885#24C7DC5
7E5C35EFD8C5FB45FC546D2F2C575 45FCDF 4575485C7565
4A586A5C9425F57D546D2565F4D5D4D254C44D4
B23214518B262(2D589A4D246
7 .F4/68+D148%
21 3337DF257564D5874586486F365E7D865E7D5
3636F7257E54-9434586DB459DF34594D5C6D459
$(5C5+5D5,D5.5B5E5,'595+
55555B
4D45
3 $(5C5$6DB459DF34594D5C6D4
3 +5C5+FF42594D5C6D4
3 '5C5'6D2F2C594D5C6D4
3 D5C5*FD8:C5D6457E5D4D2
3 B5C507C57E5369F6
7 'D1D5/68+D148%
21 $AD72567D725C4545FF425369F6F)6F725699D763575D348A48
4--4C8D-8123214518D2C8D586DC082C4813F48D-8-2&
21 67D72587454DFEF4C5454F2D58(4)4458F8-2/68123214518D2C8)2A8
A484$4CF2D58D-8A486AF4AD1467
21 662D568%
3 45EFD85FC5625654FA5EFD85F45F56C52754 5F25FC5369F65CD3D4
3 4D45FC572A5F24D265EF2623F257E5F24C842C5F452752454FA
3 46457E5D4D25562537C57E54FA556D4566AC5372C62
3 4442F725D6F755D486F2C5372C625,5562967$7&7"742324564729
3 07C57E5369F655FC566AC5D464D5625D75D6457$7'
3 *FD856C5654DA5725FE4562594D946546D2F2C
3 07D97D6456-4C574C52754-FC
B23214518B262(2D589A4D246
7 'D1D5/68+D148%
21 3C594D567D72:C58745;45573A57977
57275(A7975755673A5797672626257
4232456475797575B4E7C75759A457267
575D
21 67D72:C587456CC84C565F24C7DC56D45
D6F7265625DFCB&64DC454A59D4E4D53DD425
FF42C562567F5DFCB5F25ED4
21 3C75B27256C5/24)26)64F56D8425
4D4565 FD5F25625FC5 44D562575F2545
C5C458123214518(448AF58-48
4F525*681)A2CA8F485C4F25&
21 C5E7D575EFD8C5F5C684546D2F25974D5
B23214518B262(2D589A4D246
7 'D1D5/68+D148%
21 3337DF257567D725874586486F365E7D865E7D5
3636F7257E54-9434586DB459DF34594D5C6D459
$(5C5'5,595 
55555B595 D
3 $(5C5$6DB459DF34594D5C6D4
3 5C5D442F725D6F75
3 '5C5'6D2F2C594D5C6D45
3 B5C537C57E5369F65
3 D5C5D6457E5D4D2
B23214518B262(2D589A4D246
E7 +D12*2F528+2481++&8DFCA8%
21 3337DF2575$7FF62F5625$F4D524D56594DE43586DB45
CF6F725A48123214518D2C8D-8F8-282682443F58F518281D468
5D8F--4C8A483F48D-8A48-27
21 3C594D5$$5699D76353F48D-8F8-28452481445168D58268
4F525*625F356D4565D4C57E5FC5F24C842597F3A
21 662D568%
3 EF2F8F0468F484-4C284F648D-8F2625*8
-516
3 #24C7DC56D45D6F7265F2E7D86F725ED44A5
66F6 4
3 D62C63F725625E766F72537CC574C52754-FC
3 875F2FF656-4C
3 45EFD856C5EF-45F25F24C842597F3A
3
B23214518B262(2D589A4D246
E7 +D12*2F528+2481++&8DFCA8%
21 3337DF2575$$5699D76354D456D45>5CF6F72C59
6 *FD856C5CEEF3F42536C57596A5FF42C595425
FF425FC596F5C6D474DC5D434F4536C5625
EFD8:C56CC4C56D45D4345,36C5 65542345
C6D474DC56F2536C56257C459D797DF7265
36F857256CC4C54D45FC5=C5D62CE4D57E5465625
6457E5EFD85FC55F--4C417
 *FD85FCC4C5245C6D4C57596A5FF42595'-FCF25
C574DC54536C5 54FD5C6D45F257656CC4C5
D434C5845C574DC596A536C5625D434F45
9D797DF7264536F857256CC4C55423456457E5EFD85
5F--4C417
3 *FD8574C527596A5FF42C5982-8F86AF4AD148
544168CF6A28A48F8648A2686AF468D86F26-8A268
B23214518B262(2D589A4D246
E7 +D12*2F528+2481++&8DFCA8%
21 3337DF2575$$5699D76354586DB456457E5C6D456545
4F22F257E54594DF75FC546575459D4C4256457E5
FF42C596F565454257E594DF75,9C586DB459DF3456545
4257E594DF75F45(5C5(G55,5D5H45&5+
4D4
3 (G5C59D46FF2586DB459DF345,C6D57E594DF7
3 +5C5FF42575 45D435654257E594DF7
3 (5C586DB459DF345654257E594DF7
3 H45C537C57E54FA5369F6
21 85C5#595,I5&58+ ,245C6D4C575 45FCC45E7D5
FF42596A842 555555555(
21 B6457E5EFD85C5,85D585(595,#595' J585C53DD425
C6D4C585C5245C6D4CK5 5D5H45 J5#5C5
F24C8425D45I5C59D7EFCK