Capital Budgeting Techniques (cntd.) Lecture 10 SEPPA 08 Aug 2016

Internal Rate of Return (IRR) IRR is the interest rate earned on the unrecovered project balance of investment such that, when the project terminates, the unrecovered project balance will be zero. NPV = A0/(1+i*)0 + A1/(1+i*)1 + A2/(1+i*)2 …….+ An/(1+i*)n =0 1/11/2019

Internal Rate of Return (IRR) Simple Investments A simple investment is defined as that investment, when the sign change in the project cash flow occurs only once. A non-simple investment is that investment where the sign change occurs more than once. 1/11/2019

Investment Classification Investment type 0 period 1 2 3 4 5 Simple - + Non-simple _ 1/11/2019

Internal Rate of Return (IRR) Methods of project Evaluation by IRR If IRR>MARR, accept the project If IRR = MARR, remain indifferent  If IRR < MARR, reject the project 1/11/2019

Methods for determining IRR 1.   The direct-solution method 2.   The trial-and-error method, and 3.   The graphic method 1/11/2019

Direct Solution Method Project 1 Project 2 1 -$1,000 _$2,000 2 1,300 3 1,500 4 5 1/11/2019

Direct Solution Method Project 1 1/11/2019

Direct Solution Method Project 2 1/11/2019

DCF Model A hydropower plant of 900 KW needs an investment of Rs 18 crores. The plant does not have to pay income taxes for 10 years and Nepal Electricity Authority (NEA) has given assurance to buy the power at Rs 6 NR per KWh. After 10 years the income tax rate is 50% of the existing income tax rate (25%).The economic life of the plant is 20 years. The annual operating and maintenance cost is 5% of the revenue. The annual escalation rate for the O & M cost is 5%. The depreciation rate is 15% of the fixed assets with declining balance method. The fixed assets are 95% of the investment. The annual insurance cost is 0.25% of revenue. The price at which NEA buys power will be increased every year at 6% for the initial five years, but after five years it will be constant. The annual capital expenditure needed will be 2.5% of the revenue. The Hydropower plant has to be handed over to the Govt. after 15 years. Develop a Discounted Cash Flow (DCF) model for the project and find out whether the project is feasible or not.