Lecture 7-NPV & IRR

Lecture 7-NPV & IRR - 1. IRR can favour quick...

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Introduction to Capital Budgeting We want to invest is new capital projects that make a net contribution to shareholders wealth.
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Investment Criteria Rules for decision making Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) Payback Period
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NPV Estimate future expected cash flows Estimate the cost of capital (i.e. required return) Calculate the NPV
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IRR Discount Rate that make NPV=0
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NPV / IRR Example
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Problems with IRR Mutually exclusive projects Proceeding with one project precludes proceeding with another project. (e.g. an electric utility might build an gas fired power plant or a coal fired plant, but not both) Given a choice you should accept the project with the higher NPV. This is not necessarily the project with the higher IRR.
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Problems with IRR 1. IRR can favour small projects with high returns.
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Problems with IRR
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Unformatted text preview: 1. IRR can favour quick payback projects with high returns Problems with IRR 1. Lending vs. Borrowing Problems with IRR 1. Multiple Rates of Return Capital Rationing Limit on the amount of funds available for investment Profitability Index Highest PV(of benefits) per dollar invested PI = PV(cash inflows) / Investment The PI was invented to select projects with the most bang for the buck. This is an appropriate criteria when capital is limited. Dont use PI otherwise it can lead to the same types of problems as the IRR. PI Example Payback Period How long does it take to recover your initial investment Problems with Payback Period Doesnt take TVM into account Attaches no importance to cash flows beyond the payback period Have to decide on a cutoff period Payback Period Example...
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This note was uploaded on 03/15/2010 for the course BUSINESS MGT200 taught by Professor Manjuris during the Spring '08 term at Ryerson.

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Lecture 7-NPV & IRR - 1. IRR can favour quick...

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