Lecture_Week_05_6slides - 8/14/2011 Lectures so farWeeks...

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8/14/2011 1 Australian School of Business FINS1613 Business Finance Lecturer: Anh Tu Le FINS1613 – Semester 2, 2011 2 Lectures so far…Weeks 1-4 b Firm’s objective? b Capital Budgeting: s Invest if …? b Capital Budgeting Process 1. Generate project proposals 2. Screening 3. Evaluation 4. 5. Post-implementation Audit FINS1613 – Semester 2, 2011 3 b Evaluation Techniques: s Average Accounting Return (AAR) s s Net Present Value (NPV) s Profitability Index (PI) s Internal Rate of Return (IRR) s Modified Internal Rate of Return (MIRR) Lectures so far…Week 4 Lecture 5: Capital Budgeting Applications I Lecturer: Anh Tu Le FINS1613 – Semester 2, 2011 5 Lecture 5: Learning Objectives b To understand the decision rules and advantages/disadvantages of the IRR and MIRR techniques relative to NPV. b To identify the relevant cash flows to include in capital budgeting analysis FINS1613 – Semester 2, 2011 6 Internal Rate of Return (IRR) b 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 s IRR is the discount rate that results in a zero NPV. b It is also the expected rate of return on a project.
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8/14/2011 2 FINS1613 – Semester 2, 2011 7 IRR: Decision Rule b Independent Projects: s Accept project if IRR> the hurdle rate s Reject project if IRR<the hurdle rate b The hurdle rate is the required return on the project b Mutually exclusive projects: s Choose the project with the highest IRR. FINS1613 – Semester 2, 2011 8 IRR: Formula b In equation form: 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 ( ) 0 1 1 0 C R C NPV n t t t - + = = = FINS1613 – Semester 2, 2011 9 Internal Rate of Return: Calculation b The equation is solved either by using a spreadsheet/financial calculator or by trial and error. b ‘Trial and error’ involves picking a value for IRR and then finding the NPV. s If the result is positive, recalculate with a higher IRR s If the result is negative, recalculate with a lower IRR s Repeat this until the NPV =0 FINS1613 – Semester 2, 2011 10 Internal Rate of Return: An example b Consider a project with the following cash flows: Period (t) Net Cash Flows 0 -9000 1 5090 2 4500 3 4000 FINS1613 – Semester 2, 2011 11 b To solve using trial and error: b After trying several values, the result is: ( ) ( ) ( ) 0 1 4000 1 4500 1 5090 9000 3 2 1 = + + + + + + - R R R Internal Rate of Return: An example FINS1613 – Semester 2, 2011 12 Internal Rate of Return: Advantages b Simple decision rule b Easy to understand and communicate s The concept of IRR is intuitive to most and can be easily compared to rates of return on alternative investments b Does not depend on the interest rate in the market b Closely related to NPV, so often leads to identical decisions.
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This note was uploaded on 10/20/2011 for the course COMMERCE 3502 taught by Professor All during the One '11 term at University of New South Wales.

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Lecture_Week_05_6slides - 8/14/2011 Lectures so farWeeks...

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