Internal Rate Of Return And Capital Budgeting Techniques

Question 1:

• Part a

The monthly repayment will be $ 4159.87 which is calculated as below:

• Part b

Interest in 104^th instalment will be paid for $ 2770.17

• Part c

Rex and Rhonda would owe the bank immediately before making the 200th repayment:

$ 320503.52

Question 2

Annual Cash Flows = $ 6485.358 

Question 3

• Part a

The nominal rate is less than the effective rate because of presence of compounding effect in the effective rate. The nominal interest works on the basis of simple interest and does not consider the impact of compounding. The compounding means the calculation of interest on the interest element along with the principle amount and hence it enhances the overall effective rate of interest (Brigham & Houston, 2012).

• Part b

Difference between the ordinaries price index and accumulative index:

The accumulation index is also known as total return index and it assumes that the dividends are reinvested on the date of payment of ex-dividend. However, the ordinaries price index only gauges the changes in the price over a period of time. The ordinaries price index acts as the appropriate benchmark particularly for the traders whereas the accumulative index is the appropriate benchmark measure for the investors (Nicholson, 2018).  

Question 4

• Part a

Bond A

• Part b

Bond A

Duration = 4.13 Years

• Part c

Bond A

Bond B

Bond C

Question 5

Internal Rate of Return

Every business involves decision making in the course of its normal operations. Undertaking of right decisions at the right time leads to the success of the business. To reach at a prudent decision, a firm has to use various tools and techniques. Capital budgeting is also a part of decision making process which involves financial planning for generally a longer period of time and involves the investment of large sums of money. These decisions are usually irrevocable in nature due to the deployment of huge amount of funds. To evaluate the projects that are long term in nature there are various techniques available under financial management studies. These techniques are Net Present Value (NPV), Payback Period, Average Accounting Rate of Return (ARR), Profitability Index, Internal Rate of Return etc.

Internal rate of return is the key technique of project evaluation as it involves the determination of such rate of return at which the net present value of the project is zero because of the fact that the total cash inflows of the project is equal to the total cash outflows of such project (Shinoda, 2010). Net present value is the sum of all the cash flows of the project since year 0 to the end of useful life of project. Present value of cash flows is calculated using the discounting rate.  The IRR technique is recognised with different names such as yield on investment, marginal efficiency of capital, time-adjusted rate of return, rate of return etc. IRR totally depends on the initial investment of the project and its cash proceeds to evaluate whether the project is accepted or rejected. An IRR of the project is typically the rate of return that it will earn if the required investment is made in such project and it receives the specific cash inflows.

For any project proposal to be accepted under IRR technique, the rate of discounting must exceed the cost of capital of the project which is commonly termed as hurdle rate or the cut off rate. The IRR which is lower than the hurdle rate represents the cost to the shareholders of the project whereas the IRR which is higher than the hurdle rate represents the return on the investment made by the shareholders of the project and it maximises their wealth. Therefore, to decide whether a particular project must be accepted or rejected, it is necessary to compare the cost of capital with the internal rate of return. If the IRR is higher than the cost of capital, then the proposed project must be accepted and if the IRR is less than the project’s cost of capital, then it must not be accepted (Rossi, 2015).

The use of IRR technique of project evaluation enables the project manager to have a clear picture of the value of the project and also the associated risk with it. As IRR method takes into account the time value of money, it allows the project managers to know the actual return from the investment made in the project. The internal rate of return is often called as the project’s break-even financing rate. Unlike other techniques of capital budgeting such as payback period, IRR considers the project’s profitability across its entire economic life and not merely till the particular period of time.

The discounting rate at which the capital outlay of the project is equated with its cash flows is shown in the percentage terms and hence this method offers the uniform ranking and also the quick comparison of the related efficiency of alternative project proposals. Generally, the decisive results under both the techniques of capital budgeting i.e. NPV and IRR are same but there are certain circumstances where the cash flows are non-conventional in nature, mutually exclusive projects etc. The assumptions relating to reinvestment rate are different under both the methods.  Under NPV method, it is assumed that the cash flows would be reinvested at or around the cost of capital of the project while IRR method works on the assumption that the cash flows of the project can be reinvested at its IRR (Bierman & Smidt, 2012). In theoretical view, project’s manager usually finds NPV as the better technique to evaluate the worthiness of the project. However from the practical view point, IRR is more accepted technique of project evaluation due the general disposition of business executives towards the rate of return than the returns expressed in actual dollar terms. Since, all the interest rates, profitability ratios are often expressed as the annual rate of returns, the application of IRR technique makes more sense to the financial decision makers. The main strength of IRR method is that it has the ability to measure the benefits related to the invested funds in the project. Therefore, in case of individual projects, use of IRR technique is more beneficial as this method will provide the project managers with ultimate results that are more sophisticated and reliable in nature. The interpretation of results of IRR is more convenient for the financial analysts.

Investment in the real assets involves a certain set of real options that can be exercise to enhance the value of assets as well as to limit the losses. Real option evaluation eliminates the potential losses by way of project abandonment in the circumstances that are unfavourable in nature. Traditional methods such as NPV, IRR and discounted cash flows cannot capture the flexibility in managerial decision making (Bennouna, Meredith & Marchant, 2010). Rather, the decision trees serves as the more appropriate approach to identify the value of real options under which average expected cash flows are determined considering the probabilities linked to the cash flows. In situations that are quite dynamic or uncertain in nature, traditional techniques of capital budgeting fails to offer realistic results (Santos, Soares, Mendes & Ferreira, 2014).

It can now be concluded that, though the application of internal rate of return as a technique of project evaluation provides the project managers with realistic and sophisticated results but there are certain loopholes in this technique which makes it unable to serve its basic purpose of decision making. This technique cannot be used in the dynamic environment and hence such circumstances require use of more advanced tools such as decision tree analysis to evaluate the project’s worth.

Bennouna, K., Meredith, G.G. and Marchant, T., 2010. Improved capital budgeting decision making: evidence from Canada. Management decision, 48(2), pp.225-247.

Bierman Jr, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of investment projects. US: Routledge.

Brigham, E.F. and Houston, J.F., 2012. Fundamentals of financial management. US: Cengage Learning.

Nicholson, C., 2018. How is a Total Return (accumulation) index different to a price index? Available at: < https://www.bwts.com.au/index.cfm/resources/ask-colin/1163-how-is-a-total-return-accumulation-index-different-to-a-price-in/> Accessed on 18.08.2018

Rossi, M., 2015. The use of capital budgeting techniques: an outlook from Italy. International Journal of Management Practice, 8(1), pp.43-56.

Santos, L., Soares, I., Mendes, C. and Ferreira, P., 2014. Real options versus traditional methods to assess renewable energy projects. Renewable Energy, 68, pp.588-594.

Shinoda, T., 2010. Capital budgeting management practices in Japan: a focus on the use of capital budgeting methods. Economic Journal of Hokkaido University, 39, pp.39-50.