Capital Budgeting and Capital Rationing Issues University of Wisconsin, MilwaukeeFINANCE 350350week8

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Capital Budgeting and Capital Rationing Issues  Knowing the IRR is Advantages intuitively appealing of IRR  It is a simple way to communicate the value of a project to someone who doesn’t ... know all the estimation details  Not dependent on the size of the project  If the IRR is high enough, you may not need to estimate a required return, which is often a difficult taskCalculating IRRs with Excel +@IRR(C8:C12)NPV vs. IRR  NPV and IRR will generally give us the same decision With Two Exceptions: 1. Non-conventional cash flows – cash flow signs change more than once  There can be multiple IRRs for the same project  Discussed last class by counting ‘sign changes.’ 2. Mutually exclusive projects  Initial investments are substantially different  Timing of cash flows is substantially different4  IRR and Mutually Exclusive Projects  Mutually exclusive projects  If you choose one, you can’t choose the other  Example: You can choose pursue an MBA at either the UWM or Marquette, but not both  Intuitively you would use the following decision rules:  NPV – choose the project with the higher NPV  IRR – choose the project with the higher IRRExample With Mutually Exclusive Projects Period Project A Project B 0 -500 -400 1 325 325 2 325 200 IRR 19.43% 22.17% NPV 64.05 60.74 The required return for both projects is 10%. Which project should you accept and why?6 NPV Profiles IRR for A = 19.43% IRR for B = 22.17% Crossover Point = 11.8%7 MUTUALLY EXCLUSIVE • With the cross– over in the NPV profiles, we find that the better project depends critically on the required return. • When the required return is low (less than 11.8%), pick project A. • When the required return is high (greater than 11.8%), pick project B.8 Conflicts Between NPV and IRR  NPV directly measures the increase in value to the firm  Whenever there is a conflict between NPV and another decision rule, you should always use NPV  IRR is unreliable in the following situations: 1. Non-conventional cash flows 2. Mutually exclusive projects Modified Internal Rate of Return (MIRR)  Controls for some problems with IRR Three Methods: 1. Discounting Approach = Discount future outflows (negative numbers) to present value and add to CF0 2.Reinvestment Approach = Compound all CFs except the first one forward to end (FV) 3.Combination Approach = Discount outflows to present; compound inflows to the end (FV)  MIRR will be different number for each method  For this reason, some of us call it the Meaningless IRR rather than the Modified IRR.MIRR Method 1 Discounting Approach Step 1: Discount future outflows (negative cash flows) to present and add to CF0 Step 2: Zero out negative cash flows which have been added to CF0. Step 3: Compute IRR normally [Show More]

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