Professional Documents
Culture Documents
NPV Vs IRR
NPV Vs IRR
NPV Vs IRR
NPV vs IRR: Independent Projects NPV vs IRR: Dependent Projects Differences in the Scale of Investment Timing of the Cash flow Reinvestment Rates The Horizon Problem A Theoretical Justification for Net Present Value Capital Structure Irrelevancy Dividend Policy Irrelevancy Non-conventional Cash Flow Capital Rationing
4-1
NPV
Increase in productivity
NPV (K1)
0 NPV (K2)
R K1 Discount rate
K2
4-3
4-4
NPV
2700 2000
Project B
Project A
1089 908
10%
K0
20% 28%
Discount rate
4-5
Proje Initial Net cash IRR NPV ct investm inflow ent A 10000 12000 28% 908 B 15000 17700 20% 1089
Cost of capital
10%
10%
4-6
IRR
NPV
28% 163636
20% 454545
5000000
6000000
4-7
4-8
NPV 4000
Project B
515
Project A
15% 16.58%
17%
Discount rate
24%
4-9
A B A Minus B
4-10
NPV 40
32 Project A
Project B
A minus B
4-11
3. Reinvestment Rate
The use of NPV method implicitly assumes that the opportunity rate at which cash flows generated by a project can be reinvested at the cost of capital, whereas use of IRR method implies that the firm has the opportunity to reinvest at the IRR. Thus NPV method evaluates the cash flows at the cost of capital, while the IRR method evaluates cash flows at the projects IRR.
4-12
Reinvestment Rate
Therefore, we simply must come to the conclusion that the correct reinvestment rate assumption is the cost of capital, which is implicit in the NPV method. This in turn, leads us to prefer the NPV method, at least firms willing and able to obtain capital at a cost reasonably close to their current cost of capital. In addition to this, in case of nonnormal cash flows, IRR is not usable because there is existence of multiple IRR.
4-13
4. Horizon Problem
Horizon problem arises when alternative investment projects have different lives. Example:
Project Invest ment CF1 CF2 CF3 CF4
NPV @ 10%
IRR
A B
100 100
120 -
174
9 19
20% 15%
4-14
Horizon Problem
Since project A earns its cash inflow of 120 at the end of the 1st year, while in project B the cash inflow of 174 at the end of 4th year, it has been argued that the appropriate comparison is with the cash flow of the earlier project repeated three more times. Denoting the repetitive project A*, cash flows can be rewritten as follows by assuming reinvestment of earlier years cash inflows:
4-15
Horizon Problem
Project Invest ment CF1 CF2 CF3 CF4 NPV @ 10 IRR
A*
100
100
120
31.7
20%
174
19.0
15%
4-16
1. It maximizes investors utility by maximizing shareholders wealth. 2. It takes into account investment size. 3. It reinvest interim cash flows at the relevant rate. 4. It can be applied in case of both conventional and non-conventional cash flows.
4-17
Important Terms:
1. 2. 3. 4. 5. Investment schedule. The meaning of indifference curve. Optimal investment decisions The money market line. Separation of investment and financing decisions
4-18
1,256 950
Project D
c
Project C
350
Project B
200
0
a
Project A W0= 1,000 First period cash flow
4-19
B C D Total
12% 10% 8%
4-20
Indifference Curve
C1
I1 I
M1 M N b a
C0
4-21
d
C*
C1* I2 I1 I0 0
C0* W0
First period cash flow
4-22
Through consideration of investment opportunity schedule and indifference curve point where these two lines tangent each other i.e. slopes of these two lines are equal.
4-23
C1
C0
4-24
schedule and marginal cost of capital line point where these two lines intersect each other.
4-25
Capital rationing
Firms commonly operate under capital rationing i.e. they have more acceptable independent projects than they can fund. Management internally imposes capital expenditure constraints to avoid what it deems to be excessive levels of new financing. The objective of capital rationing is to select the group of projects that provides the highest overall net present value and does not require more amount than are budgeted.
4-30
Capital rationing
As prerequisite to capital rationing, the best way to any mutually exclusive projects must be chosen and placed in the group of independent projects. It is occurred when the situation that exists if a firm has positive NPV projects but can not find the necessary financing.
4-31
B
C
70000
100000
145000
119000
20
16
2.07 X Selection
1.19 X
D
E F
40000
60000 110000
100000 106500
60000
8
15 11
2.50 X
1.78 X 0.55 X
based on PI- D, B, E, A
4-32
4-33