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Overview of
Capital-Budgeting
Techniques
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Capital Budgeting Concepts
 Capital Budgeting involves evaluation of (and decision about) projects. Which projects should be
accepted? Here, our goal is to accept a project which maximizes the shareholder wealth. Benefits are
worth more than the cost.
 The Capital Budgeting is based on forecasting.
 Estimate future expected cash flows.
 Evaluate project based on the evaluation method.
 Classification of Projects
Mutually Exclusive - accept ONE project only
Independent - accept ALL profitable projects.
3
Meaning of Capital Budgeting
 Capital budgeting addresses the issue of strategic long-
term investment decisions.
 Capital budgeting can be defined as the process of
analyzing, evaluating, and deciding whether resources
should be allocated to a project or not.
 Process of capital budgeting ensure optimal allocation of
resources and helps management work towards the goal
of shareholder wealth maximization.
4
Types of Capital Budgeting
Decisions
 Should we add a new product to our existing product
line?
 Should we expand into a new market?
 Should we replace our existing machinery?
 Should we buy fully automatic or semiautomatic
machinery
 Where to locate manufacturing facility?
 Should we outsource components and parts?
5
Why Capital Budgeting is so
Important?
 Involve massive investment of resources
 Are not easily reversible
 Have long-term implications for the firm
 Involve uncertainty and risk for the firm
6
Techniques of Capital Budgeting
Analysis
1. Payback Period Approach
2. Discounted Payback Period Approach
3. Net Present Value Approach
4. Internal Rate of Return
5. Profitability Index
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Which Technique should we follow?

A technique that helps us in selecting projects that are


consistent with the principle of shareholder wealth
maximization.
A technique is considered consistent with wealth maximization
if
 It is based on cash flows
 Considers all the cash flows
 Considers time value of money
 Is unbiased in selecting projects
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Payback Period Approach
 The amount of time needed to recover the initial
investment
 The number of years it takes including a fraction
of the year to recover initial investment is called
payback period
 To compute payback period, keep adding the cash
flows till the sum equals initial investment
 Simplicity is the main benefit, but suffers from
drawbacks
 Technique is not consistent with wealth
maximization—Why?
9
Discounted Payback Period
 Similar to payback period approach with one
difference that it considers time value of money
 The amount of time needed to recover initial
investment given the present value of cash inflows
 Keep adding the discounted cash flows till the
sum equals initial investment
 All other drawbacks of the payback period
remains in this approach
 Not consistent with wealth maximization
10
Net Present Value Approach

 Based on the dollar amount of cash flows


 The dollar amount of value added by a project
 NPV equals the present value of cash inflows
minus initial investment
 Technique is consistent with the principle of
wealth maximization—Why?
 Accept a project if NPV > 0
11
Internal Rate of Return

 The rate at which the net present value of


cash flows of a project is zero, I.e., the rate at
which the present value of cash inflows
equals initial investment
 Consistent with wealth maximization
 Accept a project if IRR > Cost of Capital
12
Profitability Index (PI)

 A part of discounted cash flow family


 PI = PV of Cash Inflows/initial investment
 Accept a project if PI > 1.0, which means positive NPV
 Usually, PI consistent with NPV
 PI may be in conflict with NPV if
 Projects are mutually exclusive
 Scale of projects differ
 Pattern of cash flows of projects is different
 When in conflict with NPV, use NPV
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Capital Budgeting Methods
Payback Period
 Number of years needed to recover your initial outlay.
14
Capital Budgeting Methods
Payback Period
 Number of years needed to recover your initial outlay.

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
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Capital Budgeting Methods
Payback Period
 Number of years needed to recover your initial outlay.

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

0 1 2 3 4

(10,000) 3,500 3,500 3,500 3,500


16
Capital Budgeting Methods
Payback Period
 Number of years needed to recover your initial outlay.

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

0 1 2 3 4

(10,000) 3,500 3,500 3,500 3,500


Cumulative CF -6,500
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Capital Budgeting Methods
Payback Period
 Number of years needed to recover your initial outlay.

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

0 1 2 3 4

(10,000) 3,500 3,500 3,500 3,500


Cumulative CF -6,500 -3,000
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Capital Budgeting Methods
Payback Period
 Number of years needed to recover your initial outlay.

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

0 1 2 3 4

(10,000) 3,500 3,500 3,500 3,500


Cumulative CF -6,500 -3,000 +500
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Capital Budgeting Methods
Payback Period
 Number of years needed to recover your initial outlay.

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

0 1 2 3 4

(10,000) 3,500 3,500 3,500 3,500


Cumulative CF -6,500 -3,000 +500
Payback 2.86 years
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Capital Budgeting Methods
Payback Period
 Number of years needed to recover your initial outlay.

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
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Capital Budgeting Methods
Payback Period
 Number of years needed to recover your initial outlay.

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

0 1 2 3 4

(10,000) 500 500 4,600 10,000


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Capital Budgeting Methods
Payback Period
 Number of years needed to recover your initial outlay.

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

0 1 2 3 4

(10,000) 500 500 4,600 10,000


Cumulative CF -9,500
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Capital Budgeting Methods
Payback Period
 Number of years needed to recover your initial outlay.

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

0 1 2 3 4

(10,000) 500 500 4,600 10,000


Cumulative CF -9,500 -9,000
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Capital Budgeting Methods
Payback Period
 Number of years needed to recover your initial outlay.

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

0 1 2 3 4

(10,000) 500 500 4,600 10,000


Cumulative CF -9,500 -9,000 -4,400
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Capital Budgeting Methods
Payback Period
 Number of years needed to recover your initial outlay.

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

0 1 2 3 4

(10,000) 500 500 4,600 10,000


Cumulative CF -9,500 -9,000 -4,400 +5,600
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Capital Budgeting Methods
Payback Period
 Number of years needed to recover your initial outlay.

P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

0 1 2 3 4

(10,000) 500 500 4,600 10,000


Cumulative CF -9,500 -9,000 -4,400 +5,600
Payback = 3.44 years
27
Capital Budgeting Methods
Payback Period
 Number of years needed to recover your initial outlay.

P R O J E C T Evaluation:
Time A B Company sets maximum
0 (10,000.) (10,000.) acceptable payback. If
1 3,500 500 Max PB = 3 years,
2 3,500 500
accept project A and
3 3,500 4,600
4 3,500 10,000
reject project C

0 1 2 3 4

(10,000) 500 500 4,600 10,000


Cumulative CF -9,500 -9,000 -4,400 +5,600
Payback 3.44 years
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•Payback Method

The payback method is not a good method as it does not


consider the time value of money.

Which project should you choose?

CF0 CF1 CF2 CF3


A -100,000 90,000 9,000 1,000
B -100,000 1,000 9,000 90,000
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•Payback Method

The Discounted payback method can correct this


shortcoming of the payback method.
To find the discounted pay back
(1) Find the PV of each cash flow on the time line.
(2) Find the payback using the discounted CF and NOT the
CF.
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•Payback Method

Also, the payback method is not a good method as it does not


consider the cash flows beyond the payback period.
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Payback Method

Also, the payback method is not a good method as it


does not consider the cash flows beyond the payback
period.

Which project should you choose?


CF0 CF1 CF2 Cf3 CF4
A -100000 90000 10000 0 0
B -100000 90000 9000 80000 1000000
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Payback Method

Also, the payback method is not a good method as it does not


consider the cash flows beyond the payback period.

Which project should you choose?


CF0 CF1 CF2 Cf3 CF4
A -100,000 90,000 10,000 0 0
B -100,000 90,000 9,000 80,000 100,0000

These two shortcomings often result in an incorrect decisions.


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Capital Budgeting Methods

Methods that consider time value of money and all cash flows

Net Present Value:


Present Value of all costs and benefits of a project.
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Capital Budgeting Methods
Net Present Value
Present Value of all costs and benefits of a project.
Concept is similar to Intrinsic Value of a security but
subtracts cost of the project.

NPV
NPV == PV
PV of
of Inflows
Inflows -- Initial
Initial Outlay
Outlay
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Capital Budgeting Methods
Net Present Value
 Present Value of all costs and benefits of a project.
 Concept is similar to Intrinsic Value of a security but
subtracts of cost of project.

NPV
NPV == PV
PV of
of Inflows
Inflows -- Initial
Initial Outlay
Outlay

CF1 CF2 CF3 CFn


NPV = (1+ k )
+ (1+ k )2
+ +···+ – IO
(1+ k )3
(1+ k ) n
36
Capital Budgeting Methods
Net Present Value P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

k=10%
0 1 2 3 4

(10,000) 500 500 4,600 10,000


37
Capital Budgeting Methods
Net Present Value P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

k=10%
0 1 2 3 4

(10,000) 500 500 4,600 10,000


$500
455 (1.10)
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Capital Budgeting Methods
Net Present Value P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

k=10%
0 1 2 3 4

(10,000) 500 500 4,600 10,000


$500
455
(1.10) 2
413
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Capital Budgeting Methods
Net Present Value P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

k=10%
0 1 2 3 4

(10,000) 500 500 4,600 10,000


455
$4,600
413
(1.10) 3
3,456
40
Capital Budgeting Methods
Net Present Value P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

k=10%
0 1 2 3 4

(10,000) 500 500 4,600 10,000


455
413
$10,000
3,456
(1.10) 4
6,830
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Capital Budgeting Methods
Net Present Value P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

k=10%
0 1 2 3 4

(10,000) 500 500 4,600 10,000


455
413
3,456
6,830
$11,154
42
Capital Budgeting Methods
Net Present Value P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

k=10%
0 1 2 3 4

(10,000) 500 500 4,600 10,000


455
413 PV Benefits > PV Costs
3,456 $11,154 > $ 10,000
6,830
$11,154
43
Capital Budgeting Methods
Net Present Value P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000

k=10%
0 1 2 3 4

(10,000) 500 500 4,600 10,000


455
413 PV Benefits > PV Costs NPV > $0
3,456 $11,154 > $ 10,000 $1,154 > $0
6,830
$11,154
$1,154 = NPV
44
Capital Budgeting Methods
Net Present Value P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4

(10,000) 3,500 3,500 3,500 3,500


45
Capital Budgeting Methods
Net Present Value P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4

(10,000) 3,500 3,500 3,500 3,500


3,500 3,500 3,500 3,500
NPV = (1+ .1 ) + (1+ .1)2 + (1+ .1 )3+ (1+ .1 )4 – 10,000
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Capital Budgeting Methods
Net Present Value P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4

(10,000) 3,500 3,500 3,500 3,500


3,500 3,500 3,500 3,500
NPV = (1+ .1 ) + (1+ .1)2 + (1+ .1 )3+ (1+ .1 )4 – 10,000

PV of 3,500 Annuity for 4 years at 10%


47
Capital Budgeting Methods
Net Present Value P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4

(10,000) 3,500 3,500 3,500 3,500


3,500 3,500 3,500 3,500
NPV = (1+ .1 ) + (1+ .1)2 + (1+ .1 )3+ (1+ .1 )4 – 10,000
= 3,500 x PVIFA 4,.10 - 10,000
= 11,095 – 10,000 = $1,095
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Capital Budgeting Methods
NPV Decision Rules
 If projects are independent then ACCEPT A & B
accept all projects with NPV ³ 0.
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Capital Budgeting Methods
NPV Decision Rules
 If projects are independent then ACCEPT A & B
accept all projects with NPV ³ 0.
 If projects are mutually exclusive, ACCEPT B only
accept projects with higher NPV.
50
Capital Budgeting Methods
Internal Rate of Return
Measures the rate of return that will make the PV of future CF equal to
the initial outlay.

Definition:
The IRR is that discount rate at which
NPV = 0

IRR is like the YTM. It is the same cocept but


the term YTM is used only for bonds.
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Capital Budgeting Methods
Internal Rate of Return
Determine the mathematical solution for IRR
52
Capital Budgeting Methods
Internal Rate of Return
Determine the mathematical solution for IRR

CF1 CF2 CFn


0 = NPV = + +···+ – IO
(1+ IRR ) (1+ IRR )2
(1+ IRR ) n
53
Capital Budgeting Methods
Internal Rate of Return
Determine the mathematical solution for IRR

CF1 CF2 CFn


0 = NPV = + +···+ – IO
(1+ IRR ) (1+ IRR )2
(1+ IRR ) n

CF1 CF2 CFn


IO = + +···+
(1+ IRR ) (1+ IRR )2
(1+ IRR )n

Outflow = PV of Inflows
54
Capital Budgeting Methods
Internal Rate of Return
Determine the mathematical solution for IRR

CF1 CF2 CFn


0 = NPV = + +···+ – IO
(1+ IRR ) (1+ IRR )2
(1+ IRR ) n

CF1 CF2 CFn


IO = + +···+
(1+ IRR ) (1+ IRR )2
(1+ IRR )n

Outflow = PV of Inflows
Solve for Discount Rates
55
Capital Budgeting Methods
Decision Rule for Internal Rate of Return

Independent Projects
Accept Projects with
IRR required rate

Mutually Exclusive Projects


Accept project with highest
IRR required rate
56
Capital Budgeting Methods
Profitability Index
Very Similar to Net Present Value

PI = PV of Inflows
Initial Outlay
57
Capital Budgeting Methods
Profitability Index
Very Similar to Net Present Value

PI = PV of Inflows
Initial Outlay

Instead of Subtracting the Initial Outlay from the PV


of Inflows, the Profitability Index is the ratio of Initial
Outlay to the PV of Inflows.
58
Capital Budgeting Methods
Profitability Index
Very Similar to Net Present Value

PI = PV of Inflows
Initial Outlay

Instead of Subtracting the Initial Outlay from the PV


of Inflows, the Profitability Index is the ratio of Initial
Outlay to the PV of Inflows.

CF1 CF2 CF3 CFn


(1+ k )
+ (1+ k )2
+ +···+
(1+ k )3 (1+ k )n
PI =
IO
59
Capital Budgeting Methods
Profitability Index for Project B P R O J E C T
Time A B
500 500 4,600 10,000
+ + +
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4
0 (10,000.) (10,000.)
PI = 1 3,500 500
10,000 2 3,500 500
3 3,500 4,600
4 3,500 10,000
60
Capital Budgeting Methods
Profitability Index for Project B P R O J E C T
Time A B
500 500 4,600 10,000
+ + +
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4
0 (10,000.) (10,000.)
PI = 1 3,500 500
10,000 2 3,500 500
3 3,500 4,600
11,154
PI = = 1.1154 4 3,500 10,000
10,000
61
Capital Budgeting Methods
Profitability Index for Project B P R O J E C T
Time A B
500 500 4,600 10,000
+ + +
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4
0 (10,000.) (10,000.)
PI = 1 3,500 500
10,000 2 3,500 500
3 3,500 4,600
11,154
PI = = 1.1154 4 3,500 10,000
10,000

Profitability Index for Project A

3,500 x PVIFA 4, .10


PI =
10,000
62
Capital Budgeting Methods
Profitability Index for Project B P R O J E C T
Time A B
500 500 4,600 10,000
+ + +
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4
0 (10,000.) (10,000.)
PI = 1 3,500 500
10,000 2 3,500 500
3 3,500 4,600
11,154
PI = = 1.1154 4 3,500 10,000
10,000

Profitability Index for Project A


1 1
3,500(.10 .10(1+.10) )
4

PI =
10,000
11,095
PI = = 1.1095
10,000
63
Capital Budgeting Methods
Profitability Index Decision Rules
 Independent Projects
Accept Project if PI ³ 1
 Mutually Exclusive Projects
Accept Highest PI ³ 1 Project
64
Comparison of Methods

Project A Project B Choose


Payback < 3 years < 4 years A
NPV $1,095 $1,154 B
IRR 14.96% 13.50% A
PI 1.1095 1.1154 B
65
Comparison of Methods
 Time Value of Money
Payback - Does not adjust for timing differences (ignore
Discounted Payback)
NPV, IRR and PI take into account the time value of
money
66
Comparison of Methods
 Time Value of Money
Payback - Does not adjust for timing differences
NPV, IRR and PI take into account the time value of money
 Relevant Cash Flows?
NPV, IRR and PI use all Cash Flows
Payback method ignores Cash Flows that occur after the Payback Period.
67
Comparison of Methods
 Time Value of Money
Payback - Does not adjust for timing differences
NPV, IRR and PI take into account the time value of money
 Relevant Cash Flows?
NPV, IRR and PI use all Cash Flows
Payback method ignores Cash Flows that occur after the Payback Period.

Project 1
0 1 2

(10,000) 5,000 5,000


68
Comparison of Methods
 Time Value of Money
Payback - Does not adjust for timing differences
NPV, IRR and PI take into account the time value of money
 Relevant Cash Flows?
NPV, IRR and PI use all Cash Flows
Payback method ignores Cash Flows that occur after the Payback Period.

Project 1
0 1 2
Both Projects have
(10,000) 5,000 5,000
Identical Payback
Project 2
0 1 2 3

(10,000) 5,000 5,000 10,000


69
Comparison of Methods
NPV & PI indicated accept Project B while IRR indicated that Project A should be accepted. Why?
Sometimes there is a conflict between the decisions based on NPV and IRR methods.
The conflict arises if there is difference in the timing of CFs or sizes of the projects (or both).
The cause of the conflict is the underlying reinvestment rate assumption.
Reinvestment Rate Assumptions
 NPV assumes cash flows are reinvested at the required rate, k.
 IRR assumes cash flows are reinvested at IRR.
Reinvestment Rate of k more realistic as most projects earn approximately k (due to competition)
NPV is the Better Method for project evaluation
70
IRR

Because of its unreasonable reinvestment rate assumption, IRR method can


result in bad decisions.

Another problem with IRR is that if the sign of the cash flow changes more
than once, there is a possibility of multiple IRR. See p 340.

The problem of unreasonable assumption can be addressed by using


Modified IRR
71
MIRR

To find MIRR
1.Find the FV of all intermediate CFs using the cost of
capital (the hurdle rate) as the interest rate.
2.Add all FV.
3. Find that discount rate which makes the PV of the FV
equal to the PV of outflows.

Drop MIRR computations.