Lecture 19 - Capital Budgeting - NPV and Other Criteria (II)

Compare 1 with 500 and it is clear one should not

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Unformatted text preview: ear one should not rely solely on IRR when comparing mutually exclusive projects That is, the ranking criteria for IRR rule does not work well. BAFI 355 – Spring 2010 19-9 Problems with IRR: Timing Recall the S and L Projects. Let’s compute their NPV profile curves $500.00 NPV $400.00 Project L’s Net Present Value $300.00 $200.00 Project S’s Net Present Value $100.00 Discount rate $0.00 0 1 2 3 4 5 6 7 8 ($100.00) Crossover rate; both rate; both projects have the same NPV 9 10 11 12 13 14 15 16 IRRL=11.79% IRR =14.49% S NPV or IRR? It is unclear. Below the crossover, NPV indicates project L as better but IRR rule indicates S. BAFI 355 – Spring 2010 19-10 Problems with IRR: Timing (cont.) (cont Take the cost of capital at 5%, which is below the crossover NPV NPV indicates project L as better but IRR rule indicates S is better IRR Cash Flows, Project S 0 1 2 3 500 400 300 1 2 3 4 100 300 400 600 r=5% - 1,000 4 100 Cash Flows, Project L 0 r=5% - 1000 BAFI 355 – Spring 2010 The problem is how each model deals with the reinvestment assumption. For project S, NPV discount flows at 5%, while IRR method discount t...
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