Appraisal Criteria II

1. Fisherian Rate of Return:

It is that discount rate at which NPV of two project
is equal. It is given by the point of intersection of
the NPV graphs of the two projects, as shown below:

1
Fisherian Rate of Return
NPV
2

Discount Rate
 Fisherian rate may not always exist for two competing
projects because NPV profiles may not intersect or may
intersect more than once making interpretation different.
Adjusted Net Present Value:
It is the project’s net present value adjusted for side effects
of the financing decision. Adjusted net present value is
calculated in the following steps:
i. First the base case NPV should be calculated. Base
case NPV is the project’s NPV assuming that the
project is all equity financed.
ii. Then, the base case NPV should be adjusted to give
effect to the financing decisions i.e. for issue
expenses, tax shield on debt etc.
Illustration:
1. Consider a project which requires an initial investment outlay of
Rs. 30 lakh and generates cash inflow equal to Rs. 5 lakh per annum
for 5 years. Debt capacity is Rs. 10 lakh carrying an interest of 14%
p.a. The opportunity cost of equity is 16% and tax rate is 30%.
Assume issue expenses of 5% of the gross proceeds of equity.
The debt is to be repaid in 5 equal annual installments.
Solution:
Base case NPV = -30 + 5xPVIFA( 16%, 5) = -30 + 5 x 3.274
= -30 + 16.37 = -13.73
Issue expenses = Equity required x 0.05 = 1.05 lakh
.95
PV of tax shield on debt
Year Debt at the Interest Tax shield PV of tax
beginning @ 14% @ 30% shield
@ 14%
11 10 1.40 0.420 0.368
12 8 1.12 0.336 0.258
13 6 0.84 0.252 0.170
14 4 0.56 0.168 0.099
15 2 0.28 0.084 0.044
PV of tax shield on interest 0.939
Adjusted NPV = -13.73 – 1.05 + 0.939 = -13.741
2. In the above example, what should be the minimum post-tax
cash flow from the project so that it is acceptable?
Solution:
Adjusted cost of capital, the minimum acceptable rate of
return and the minimum post-tax cash flow to make the
project acceptable can be calculated as follows:
The adjusted NPV should be zero to make it acceptable.
So, the base case NPV = -(PV of tax shield – Issuing cost)
= - ( 0.939 – 1.05) = + 0.111
Let X be the annual income from the project.
So, +0.111 = -30 + X PVIFA(16%, 5)
X = 30.111/3.274 = 9.197
For minimum adjusted cost of capital,
9.197 PVIFA(%,5) = 30(Initial investment)
PVIFA(%,5) = 30/9.197= 3.2619
From the PVIFA table, looking in 5 years row,
corresponding rate is approximately 15.5%
Analysis of Simple, Non-simple, Pure and Mixed Investment:
Simple investment – the cash outflows are followed by cash
inflows.
Non-simple investment- cash outflow occur more than once.
Pure investment – the uncovered investment balance is
either negative or zero throughout the
life of the project and zero at the end
of the project.
Mixed investment – which is not pure investment.
Illustration:
A project has the following cash flow stream associated with it:
Year Cash flow
0 -4,000
1 1,500
2 800
3 750
4 -800
5 3,523
Calculate a. The uncovered investment balances over the project life
b. What type of investment is it?
Solution:
The IRR of the project is the value of ‘r’ for which
-4,000 + 1500 + 800 + 750 – 800 + 3,523 = 0
(1+r) (1+r)² (1+r)³ (1+r) (1+r)5
4

IRR r = 12% by trial and error method.

Uncovered Investment Balances
Year Uncovered Interest for Cash flow at the Uncovered
investment at the year end of the year investment
the beginning ( 1+r) CFt balance at the
( Ft - 1) end of the year
Ft-1 +( 1+ r) - CFt
1 -4000.0 480 1500 -2980.0
2 -2980 -357 800 -2537.0

3 -2537.6 -304.5 750 -2092.1

4 -2092.1 -251.1 -800 -3143.2

5 -3143.2 -377.2 3523 +2.6
 The project is not a mixed investment as the uncovered
investment balance is not greater than zero in any year of
the project duration. The investment is non-simple pure
investment.
Interactions of Investment and financial decisions:
We cannot separate the financing and investment decisions
and the capital budgeting exercise can be extended to
include the financing decisions. This can be done in two
ways as follows:
i) Adjust the discount rate or ii) the net present value to
consider the side effects of financing the project such as the
tax shield that can be claimed on the debt raised, subsidies
allowed, issue expenses etc.
The side effect of financing decision can be accounted for
in the discount rate that has to be employed to the cash
flows to calculate the NPV. Formulas developed by
A. Modigliani and Miller
B. Miles and Ezzel
According to M&M,
r* = r( 1-TL)
where, r = Opportunity cost of capital, if the project is
totally equity financed
T = Tax rate applicable to the firm
L = Marginal contribution of the project to the
firm’s debt capacity
As per Miles and Ezzell formula,
r* = r –LT x (1 +r) /1 + r(D) , rD = cost of debt.
Illustration:
Investment outlay = Rs. 30 lakh
Cash inflow = Rs. 5 lakh per annum perpetually
Debt capacity = Rs. 10 lakh with an interest of 14%
The opportunity = 16%
cost of capital or
cost of equity Tax rate = 30%
Calculate adjusted cost of capital using the above
formulas
 A. r* = 0.16( 1 –0.3 x 10/30) = 14.4%
B. r* = ).16 – 10/30 x 0.14 x 0.3 x (1.16)/1.14 = 14.6%
M&M formula is based on the assumption that the project
generates a constant perpetual cash flow and supports
permanent debt. The M&E formula considers the
proportion of debt to be constant and does not follow any
cash flow pattern.
Economic Rate of return:
In this method, the return actually earned on the uncovered
balances is compared with the required rate of return
(or the opportunity cost of capital).
Steps:
The uncovered investment balance at the beginning of
the period under evaluation is compounded at the
opportunity cost of capital. This is what the value of the
investment should be, assuming there is no withdrawal of
money from the project.
 From the above, the cash flow from the project during
year is reduced. The balance remaining will become the
opening balance of unrecovered investment for
investment for the succeeding year.
The difference between the value of the investment at the
beginning of the year and the end is called economic
depreciation
The economic income is calculated by reducing the economic
depreciation from the cash inflow during the tear.
The economic income expressed as a percentage of the
investment balance at the beginning of the year is called
“the economic rate of return”.
Illustration: Projected cash flows of a company are as follows:
Year 1 2 3 4 5 6 After 6
Cash flow 10 20 25 29.8 29.8 29.8 0
(Rs.lakh)
Initial investment = Rs. 100 lakh, and the cost of capital =10%.
Find the economic rate of return.
Year 1 2 3 4 5 6
Cash Flow 10.0 20.0 25.0 29.8 29.8 29.8
Present value*, @ 10% 100.0 100.0 90.0 74.0 51.6 27.0
start of the year
Present value, end of 100.0 90.0 74.0 51.6 27.0 0.0
the year
Change in value 0.0 -10.0 -16.0 -22.4 -24.6 -27.0
During the year
Economic Income 10.0 10.0 9.0 7.4 5.2 2.8
Rate of Return 0.1 0.1 0.1 0.1 0.1 0.1
Economic Depreciation 0.0 10.0 16.0 22.4 24.6 27.0
As can be seen from the above table, the return expected by
the investors from this project is 10 percentage, uniformly
for all the years.
* Ft = Ft –1 (1 + r) - C t