4 if we review each projects cash inflow pattern as

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Unformatted text preview: ew each project’s cash inflow pattern as presented in Table 9.1 and Figure 9.1, we see that although the projects require similar initial investments, they have dissimilar cash inflow patterns. Table 9.7 indicates that project B, which has higher early-year cash inflows than project A, would be preferred over project A at higher discount rates. Figure 9.4 shows that this is in fact the case. At any discount rate in excess TABLE 9.7 Preferences Associated with Extreme Discount Rates and Dissimilar Cash Inflow Patterns Cash inflow pattern Discount rate Lower early-year cash inflows Higher early-year cash inflows Low Preferred Not preferred High Not preferred Preferred CHAPTER 9 Capital Budgeting Techniques 411 of 10.7%, project B’s NPV is above that of project A. Clearly, the magnitude and timing of the projects’ cash inflows do affect their rankings. Although the classification of cash inflow patterns in Table 9.7 is useful in explaining conflicting rankings, differences in the magnitude and timing of cash inflows do not guarantee conflicts in ranking. In general, the greater the difference between the magnitude and timing of cash inflows, the greater the likelihood of conflicting rankings. Conflicts based on NPV and IRR can be reconciled computationally; to do so, one creates and analyzes an incremental project reflecting the difference in cash flows between the two mutually exclusive projects. Because a detailed description of this procedure is beyond the scope of an introductory text, suffice it to say that IRR techniques can be used to generate consistently the same project rankings as those obtained by using NPV. Which Approach Is Better? It is difficult to choose one approach over the other, because the theoretical and practical strengths of the approaches differ. It is therefore wise to view both NPV and IRR techniques in each of those dimensions. Theoretical View On a purely theoretical basis, NPV is the better approach to capital budgeting as a result of several factors. Most important is that the use of NPV implicitly assumes that any intermediate cash inflows generated by an investment are reinvested at the firm’s cost of capital. The use of IRR assumes reinvestment at the often high rate specified by the IRR. Because the cost of capital tends to be a reasonable estimate of the rate at which the firm could actually reinvest intermediate cash inflows, the use of NPV, with its more conservative and realistic reinvestment rate, is in theory preferable. In addition, certain mathematical properties may cause a project with a nonconventional cash flow pattern to have zero or more than one real IRR; this problem does not occur with the NPV approach. Practical View Evidence suggests that in spite of the theoretical superiority of NPV, financial managers prefer to use IRR.7 The preference for IRR is due to the general disposition of businesspeople toward rates of return rather than actual dollar returns. Because interest rates, profitability, and so on are most often expressed as annual rates of return, the use of IRR makes sense to financial decision makers. They tend to find N...
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This document was uploaded on 01/19/2014.

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