Corporate Finance

Free Cash Flow Valuation 
 191

Consider the following example:
There are two mutually exclusive investments: A and B. Investment A needs an outlay of Rs 100,000 and
returns Rs 120,000 a year later. Investment B needs an outlay of Rs 150,000 and returns Rs 177,000 a
year later. The cost of capital is 13 percent.

NPVA= [120000/1.13] – 100000

= Rs 6194.69

NPVB= [177000/1.13] – 150000

= Rs 6637.16

Based on NPV, project B is better.

IRRA= [120000/100000] – 1

= 20 percent

IRRB= [177000/150000] – 1

= 18 percent

Based on IRR, project A is better. Why did this happen? The answer lies in the outlay (size) of the project.
IRR does not control for the size of the investment. The outlay for the second project is more. To find out
which investment is more profitable, we need to figure out if the incremental outlay of Rs 50,000 on project
B is profitable.

(in Rs)

Investment Cash flow

A 100,000 120,000

B 150,000 177,000

Increment 5,000 5,700

IRR = [57000/50000] – 1

= 14 percent > cost of capital.

So investment B can be accepted. Since the two projects are mutually exclusive, A has to be rejected.

If the discount rate was 15 percent:

NPVA= [120000/1.15] – 100000

= Rs 4347.80

NPV B= [177000/1.15] –150000

= Rs 3913

Project A is better on both measures. The result can be plotted on a graph (Exhibit 9.6).
For discount rates less than 14 percent, project B has a higher NPV and, for discount rates greater than
14 percent, project A has a higher NPV. In any case, NPV is a better decision rule.

Reinvestment Assumption

Now consider an example where the cash outlay for both the projects is the same. Discount rate = 9 percent.