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89
T
OPIC
15
A
LTERNATIVES TO
NPV
Reading:
Chapter 7
Practice problems: online
Objectives:
Understand the Internal Rate of Return
Identify the weaknesses of Internal Rate of Return, understand the
superiority of NPV, and be able to make a strong argument as to
why companies should use NPV
and not
IRR
Use NPV to choose between mutually exclusive projects
Understand the payback period and book rate of return and be able
to explain why they make for poor investment criteria
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View Full Document 90
I
NTERNAL
R
ATE OF
R
ETURN
Internal Rate of Return
is the discount rate that implies a zero net present
value for a series of cash flows.
3
3
2
2
1
1
0
)
1
(
)
1
(
)
1
(
0
IRR
CF
IRR
CF
IRR
CF
CF
+
+
+
+
+
+
=
Determining IRR is like solving for yield to maturity
Internal rate of return depends only on the characteristics of the cash flows.
What is the internal rate of return of the following investment?
0
1
2
3
$200
$50
$100
$150
91
C
OMPUTING
I
NTERNAL
R
ATE OF
R
ETURN
Solve the following for the discount rate, r:
Below is a net present value profile for this investment:
r
NPV
0%
$100
5
68
10
41
15
18
20
2
25
19
Between what two values of r does IRR fall?
IRR= .1944, or 19.44%
0
200
50
1
100
1
150
1
23
=−
+
+
+
+
+
+
rr
r
()
($20)
$0
$20
$40
$60
$80
$100
0%
5
10
15
20
25
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View Full Document 92
D
ECISION RULE BASED ON INTERNAL RATE OF RETURN
Accept project if:
IRR > WACC
Reject project if:
IRR < WACC
The IRR and NPV criteria lead to the same investment decision when:
1. The initial net cash flow is negative and the subsequent cash flows are
all positive (or positive followed by all negative cash flows).
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This note was uploaded on 12/02/2009 for the course FIN 350 taught by Professor Schonlau during the Spring '08 term at University of Washington.
 Spring '08
 SCHONLAU
 Finance

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