Chap005 - Oct 19th Lecture (1)

Chap005 - Oct 19th Lecture (1) - 6-15.5 Problems with...

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Unformatted text preview: 6-15.5 Problems with IRRMultiple IRRsAre We Borrowing or LendingThe Scale ProblemThe Timing Problem6-2Modified IRRCalculate the net present value of all cash outflows using the borrowing rate.Calculate the net future value of all cash inflows using the investing rate.Find the rate of return that equates these values.Benefits: single answer and specific rates for borrowing and reinvestment6-3Mutually Exclusive vs. IndependentMutually Exclusive Projects: only ONE of several potential projects can be chosen, e.g., acquiring an accounting system. RANK all alternatives, and select the best one.Independent Projects: accepting or rejecting one project does not affect the decision of the other projects.Must exceed a MINIMUM acceptance criteria6-4The Scale ProblemWould you rather make 100% or 50% on your investments?What if the 100% return is on a $1 investment, while the 50% return is on a $1,000 investment?6-56-6The Timing Problem 1 2 3$10,000 $1,000$1,000-$10,000Project A 1 2 3$1,000 $1,000 $12,000-$10,000Project B6-7The Timing Problem($5,000.00)($4,000.00)($3,000.00)($2,000.00)($1,000.00)$0.00$1,000.00$2,000.00$3,000.00$4,000.00$5,000.000% 10% 20% 30% 40%Discount rateNPVProject AProject B10.55% = crossover rate16.04% = IRRA12.94% = IRRB6-86-9Calculating the Crossover RateCompute the IRR for either project A-Bor B-AYearProject AProject B Project A-B Project B-A ($10,000) ($10,000)$0$01$10,000$1,000$9,000($9,000)2$1,000$1,000$0$03$1,000$12,000($11,000)$11,000($3,000.00)($2,000.00)($1,000.00)$0.00$1,000.00$2,000.00$3,000.000% 5% 10% 15% 20%Discount rateNPVA-BB-A10.55% = IRR6-10NPV versus IRRNPV and IRR will generally give the same decision.Exceptions:Non-conventional cash flows cash flow signs change more than onceMutually exclusive projectsInitial investments are substantially differentTiming of cash flows is substantially different6-115.6 The Profitability Index (PI)Minimum Acceptance Criteria: Accept if PI > 1Ranking Criteria: Select alternative with highest PIInvestentInitialFlowsCash FutureofPVTotalPI=6-126-13The Profitability IndexDisadvantages:Problems with mutually exclusive investmentsAdvantages:May be useful when available investment funds are limitedEasy to understand and communicateCorrect decision when evaluating independent projects6-14A closer look into cash flowsUnderstand how to determine the relevant cash flows for various types of capital investmentsBe able to compute depreciation expense for tax purposesIncorporate inflation into capital budgetingUnderstand the various methods for computing operating cash flowApply the Equivalent Annual Cost approach(next class)6-15...
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This note was uploaded on 12/05/2011 for the course ENGINEERIN 111 taught by Professor Melihabulu-taciroglu during the Fall '11 term at UCLA.

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Chap005 - Oct 19th Lecture (1) - 6-15.5 Problems with...

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