Question
Discuss the notions of conventional and nonconventional cash flows in capital budgeting.
Which investment evaluation criteria would you use for unconventional cash flows and why?
Provide a fictitious example and apply the NPV, IRR, and MIRR methods to your example.
Interpret the results.
Notions of conventional and non-conventional cash flows in capital budgeting
Capital Budgeting helps in the organization’s long-term investment planning and is a crucial
decision-making tool to determine investment opportunities based on a positive return on
investment (Stephen, Randolph, & Bradford, 2013). For example, Bhat-Bhateni's superstore
plans to open its store in a new place would be an essential capital budgeting decision as this
involves huge investment and the payback period is longer. Thus, capital budgeting decision is
essential for making an investment decision for large scale projects. Such projects may have
conventional or non-conventional cash flows. If cashflows have only one change in sign, either
plus to minus or vice versa, then such cash flow is conventional cash flow and the project
associated with it is called conventional project (Kastro & Kulakov, 206). If the project has
multiple changes in sign (plus and minus) in cashflows then such a project can be called nonconventional project and cash flow associated with it can be called non-conventional cashflows.
Projects that involve periodic repair, maintenance or replacement of tools show non-conventional
cashflows.
Example of conventional cash flow
Year
0
1
2
4
5
6
Cash Inflows (+) in NPR
Cash Outflows (-) in NPR
-50,00,000
1,00,000
3,00,000
2,00,000
5,00,000
8,00,000
Example of Non-conventional cash flow
Year
0
Cash Inflows (+) in NPR
Cash Outflows (-) in NPR
-50,00,000
1
2
4
5
6
1,00,000
-3,00,000
2,00,000
5,00,000
-8,00,000
Investment Evaluation Criteria for Non-conventional Cash Flows
Internal Rate of Return (IRR) is the rate of return for projects having conventional cash flows
and represents the highest rate of interest that can be bearded by an investor to pay all debts
without losing money to the project such that all money to finance the project is borrowed
(Kulakova & Kulakov, 2012). So, it can be said that if the project’s IRR is equal to the rate of
return then such a project is conventional. So, IRR is not suitable for an investment of nonconventional cash flows. For non-conventional cash flows, the framework of Net Present Value
(NPV) method, is not sufficient to determine the rate of return (Kulakova & Kulakov, 2012) For
this Kulakova and Kulakov (2012), have proposed GNPV (Generalized Net Present Value)
method for investment evaluation for Non-Conventional Project. GNPV method uses two
different interest rate i.e. finance interest rate and re-investment interest rate are different instead
of a single rate of interest and this enable to determine the rate of interest of non-conventional
projects more accurately (Kastro & Kulakov, 206).
Fictitious Example to demonstrate NPV, IRR, and MIRR method
The NPV uses an actual value of money to measure the return on investment whereas the
IRR calculates the earning in return on the investment (Kulakova & Kulakov, 2012). In general
practice project investors prefer IRR over the NPV to determine whether money should be
invested in the project or not (Kulakova & Kulakov, 2012). Moreover, investors prefer MIRR
over IRR. MIRR stands for Modified Internal Rate of Return which considered that positive cash
flows are reinvested at the company’s capital cost. MIRR is considered more accurate and
precise than IRR.
Mathematical formulae to calculate NPV is as follows
NPV = Kt/(1+i)t – K0 ……… (i)
(Jagerson, 2019)
Here,
Kt = Cash flows represent cash flows in each period of the time.
i = Discount rate or interest rate
t = time period
K0 = Initial investment is the amount invested in the initial stage of the project.
Mathematical formulae to calculate IRR is as follows
If NPV of all cash flows is zero for the particular project then the discount rate becomes the
internal rate of return. Thus from (i), we can say
NPV = 0 = Kt /(1+IRR)t – K0 ………………. (ii)
Mathematical formulae to calculate MIRR is as follows
MIRR = √(n&TVCI/PVCO) – 1
Here,
n = The number of year of investment
TVCI = Terminal Value of Cash Inflows (i.e. Cash inflows in future is assumed to be re-invested
as the rate of interest throughout investment.)
PVCI = Present Value of Cash inflows (i.e. Cash outflows at present incurred during the
investment period at the present rate of interest)
Excel Formulae
For Calculating NPV
=NPV (rate,value1,[value2],….)
For Calculating IRR
=IRR(values,[guess])
For Calculating MIRR
=MIRR(values,finance_rate,reinvest_rate)
Suppose we have a project say Project Alfa. For ease of calculation, we consider cashflow is
conventional. The discount rate or interest rate (i) is considered 9%. For calculation of MIRR
let us consider re-invest rate is equivalent to the discount rate. It is also considered that interest
rate and re-invest rate remain constant throughout the five-year period. I will be using MS
excel for calculation and safe is attached along with this post.
9%
9%
0
Discount Rate (i)
Re-Invest Rate
Period (in Years)
For Project Alfa
$
1
2
Cash Flows (in $)
(10,000.00)
2000
4000
NPV
IRR
MIRR
3
4
5
1000
2000
2000
The calculation for Project Alfa
($1,201.40)
3.5%
6.0%
As we can see NPV is negative so we can say that the project is not profitable so it is better not
to do this project. We would select a project only if NPV is positive. For mutually exclusive
projects, if we need to select among two projects then projects have high NPV value should be
considered only if NPV is positive. If NPV is negative for both project then neither of the
projects should be selected.
Here, IRR is less than the discount rate or interest rate so this project won’t be able to pay
interest in the debt invested in the project so this project is not feasible.
Also, MIRR is less than interest rate so this project is not feasible from an investment point of
view.
References
Jagerson, J. A. (2019, April 11). What Is the Formula for Calculating Net Present Value (NPV)? Retrieved
from https://www.investopedia.com/ask/answers/032615/what-formula-calculating-netpresent-value-npv.asp
Kastro, A. N., & Kulakov, N. Y. (206). Definition of the concepts of conventional and non-conventional
projects. Information Systems and Technologies in Business, 36(2), 16-23. doi:10.17323/19980663.2016.2.16.23
Kulakova, A. N., & Kulakov, N. J. (2012). Capital Budgeting Technique for Non-Conventional Projects. IIE
Annual Conference Proceedings, (pp. 1-8). Norcross.
Stephen, R. A., Randolph, W. W., & Bradford, J. D. (2013). Fundamentals of Corporate Finance (10 ed.).
New York: McGraw-Hill Education.