invretB - Measuring Investment Returns II. Investment...

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Aswath Damodaran 268 Measuring Investment Returns II. Investment Interactions, Options and Remorse…
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Aswath Damodaran 269 Independent investments are the exception… In all of the examples we have used so far, the investments that we have analyzed have stood alone. Thus, our job was a simple one. Assess the expected cash Fows on the investment and discount them at the right discount rate. In the real world, most investments are not independent. Taking an investment can often mean rejecting another investment at one extreme (mutually exclusive) to being locked in to take an investment in the future (pre-requisite). More generally, accepting an investment can create side costs for a ±rm ` s existing investments in some cases and bene±ts for others.
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Aswath Damodaran 270 I. Mutually Exclusive Investments We have looked at how best to assess a stand-alone investment and concluded that a good investment will have positive NPV and generate accounting returns (ROC and ROE) and IRR that exceed your costs (capital and equity). In some cases, though, frms may have to choose between investments because They are mutually exclusive : Taking one investment makes the other one redundant because they both serve the same purpose The frm has limited capital and cannot take every good investment (i.e., investments with positive NPV or high IRR). Using the two standard discounted cash Fow measures, NPV and IRR, can yield di±±erent choices when choosing between investments.
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Aswath Damodaran 271 Comparing Projects with the same (or similar) lives. . When comparing and choosing between investments with the same lives, we can Compute the accounting returns (ROC, ROE) of the investments and pick the one with the higher returns Compute the NPV of the investments and pick the one with the higher NPV Compute the IRR of the investments and pick the one with the higher IRR While it is easy to see why accounting return measures can give different rankings (and choices) than the discounted cash Fow approaches, you would expect NPV and IRR to yield consistent results since they are both time-weighted, incremental cash Fow return measures.
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Aswath Damodaran 272 Case 1: IRR versus NPV Consider two projects with the following cash Fows: Year Project 1 CF Project 2 CF 0 -1000 -1000 1 800 200 2 1000 300 3 1300 400 4 -2200 500
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Aswath Damodaran 273 Project ` s NPV Profle
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274 What do we do now? Project 1 has two internal rates of return. The Frst is 6.60%, whereas the second is 36.55%. Project 2 has one internal rate of return, about 12.8%. Why are there two internal rates of return on project 1? If your cost of capital is 12%, which investment would you accept? a)
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This document was uploaded on 11/01/2011 for the course FINANCE 402 at NYU.

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invretB - Measuring Investment Returns II. Investment...

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