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Chap005 - Oct 19th Lecture (1)

# Chap005 - Oct 19th Lecture (1) - 5.5 Problems with IRR...

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6-1 5.5 Problems with IRR Multiple IRRs Are We Borrowing or Lending The Scale Problem The Timing Problem

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6-2 Modified IRR Calculate 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 reinvestment
6-3 Mutually Exclusive vs. Independent Mutually 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 criteria

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6-4 The Scale Problem Would 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?
6-5

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6-6 The Timing Problem 0     1          2               3 \$10,000     \$1,000 \$1,000 -\$10,000 Project A 0     1          2               3 \$1,000         \$1,000     \$12,000 -\$10,000 Project B
6-7 The 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 \$5,000.00 0% 10% 20% 30% 40% Discount rate NPV Project A Project B 10.55% = crossover rate 16.04% = IRR A 12.94% = IRR B

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6-8
6-9 Calculating the Crossover Rate Compute the IRR for either project A-B or B-A Year Project A Project B Project A-B Project B-A 0 (\$10,000) (\$10,000) \$0 \$0 1 \$10,000 \$1,000 \$9,000 (\$9,000) 2 \$1,000 \$1,000 \$0 \$0 3 \$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 \$3,000.00 0% 5% 10% 15% 20% Discount rate NPV A-B B-A 10.55% = IRR

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6-10 NPV versus IRR NPV and IRR will generally give the same decision. Exceptions: Non-conventional cash flows – cash flow signs change more than once Mutually exclusive projects Initial investments are substantially different Timing of cash flows is substantially different
6-11 5.6 The Profitability Index (PI) Minimum Acceptance Criteria: Accept if PI > 1 Ranking Criteria: Select alternative with highest PI Investent Initial Flows Cash Future of PV Total PI =

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6-12
6-13 The Profitability Index Disadvantages: Problems with mutually exclusive investments Advantages: May be useful when available investment funds are limited Easy to understand and communicate Correct decision when evaluating independent projects

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6-14 A closer look into cash flows Understand how to determine the relevant cash flows for various types of capital investments Be able to compute depreciation expense for
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Chap005 - Oct 19th Lecture (1) - 5.5 Problems with IRR...

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