Week05_LectureNotes_6SlidesPerPage - Lectures so farWeeks...

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1 Lectures so far…Weeks 1-4 Firm’s objective? Capital Budgeting: – Invest if …? Capital Budgeting Process 1. Generate project proposals 2. Screening 3. Evaluation 4. Implementation & Control 5. Post-implementation Audit 1 FINS1613_s2_2010_L5 Lectures so far…Week 4 Evaluation Techniques: – Average Accounting Return (AAR) – Payback & Discounted Payback – Net Present Value (NPV) – Profitability Index (PI) Internal Rate of Return (IRR) Modified Internal Rate of Return (MIRR) 2 FINS1613_s2_2010_L5 FINS1613 Business Finance Lecture 5 Lecture 5: Capital Budgeting Applications I Readings: RTBWJ Chapters 8 & 9 Lecture 5: Learning Objectives To understand the decision rules and advantages/ disadvantages of the IRR and MIRR techniques relative to NPV. To identify the relevant cash flows to include in capital budgeting analysis 4 FINS1613_s2_2010_L5 Internal Rate of Return (IRR) The Internal Rate of Return (IRR) is the discount rate that equates the PV of a project’s cash inflows with the PV of its cash outflows – IRR is the discount rate that results in a zero NPV. It is also the expected rate of return on a project. 5 FINS1613_s2_2010_L5 IRR: Formula In equation form: where  0 1 1 0 C R C NPV n t t t where: C t = the cash flow generated by the project in year t C 0 = the initial cost of the project (initial cash flow, if any) n = the life of the project in years R = the internal rate of return of the project FINS1613_s2_2010_L5 6
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2 Internal Rate of Return: Calculation The equation is solved either by using a spreadsheet/financial calculator or by trial and error. ‘Trial and error’ involves picking a value for IRR and then finding the NPV. – If the result is positive , recalculate with a higher IRR – If the result is negative , recalculate with a lower IRR – Repeat this until the NPV =0 7 FINS1613_s2_2010_L5 IRR: Decision Rule Independent Projects: – Accept project if IRR> the hurdle rate – Reject project if IRR<the hurdle rate • The hurdle rate is the required return on the project Mutually exclusive projects: – Choose the project with the highest IRR. 8 FINS1613_s2_2010_L5 Internal Rate of Return: An example Consider a project with the following cash flows: Period (t) Net Cash Flows 0 -9000 1 5090 2 4500 3 4000 FINS1613_s2_2010_L5 9 Internal Rate of Return: An example To solve using trial and error: After trying several values, the result is:  0 1 4000 1 4500 1 5090 9000 3 2 1 R R R 10 FINS1613_s2_2010_L5 % 25 R Internal Rate of Return: Investment or Financing Project 0 1 IRR (%) NPV@ 10% A -100 130 30 18.18 B 100 -130 30 -18 18 Need to reverse the decision rule for financing project because NPV negative when discount rate is below IRR 130 18.18 FINS1613_s2_2010_L5 11 Internal Rate of Return: Multiple IRR’s It is also possible for a project to have multiple IRR values.
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This note was uploaded on 07/25/2011 for the course FINS 1613 taught by Professor Drkhshim during the Two '10 term at University of New South Wales.

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Week05_LectureNotes_6SlidesPerPage - Lectures so farWeeks...

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