Lecture15 - TOPIC 15 ALTERNATIVES TO NPV Reading Chapter 7 Practice problems online Objectives Understand the Internal Rate of Return Identify the

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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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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
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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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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.

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Lecture15 - TOPIC 15 ALTERNATIVES TO NPV Reading Chapter 7 Practice problems online Objectives Understand the Internal Rate of Return Identify the

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