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Calculation of irrs for bennett companys capital

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Unformatted text preview: ime lines depicting the cash flows and IRR calculations for projects A and B Project A 0 End of Year 1 $42,000 2 $14,000 $14,000 0 1 $45,000 5 $14,000 $14,000 $14,000 3 4 5 $10,000 $10,000 $10,000 IRRA = 19.9% Project B 0 4 IRR? 42,000 NPVA = $ 3 $28,000 IRR? 2 End of Year $12,000 IRR? 45,000 IRR? IRR? IRR? NPVB = $ 0 IRRB = 21.7% CHAPTER 9 EXAMPLE Capital Budgeting Techniques 405 We can demonstrate the internal rate of return (IRR) approach using Bennett Company data presented in Table 9.1. Figure 9.3 (page 404) uses time lines to depict the framework for finding the IRRs for Bennett’s projects A and B, both of which have conventional cash flow patterns. It can be seen in the figure that the IRR is the unknown discount rate that causes the NPV just to equal $0. Calculator Use To find the IRR using the preprogrammed function in a financial calculator, the keystrokes for each project are the same as those shown on page 403 for the NPV calculation, except that the last two NPV keystrokes (punching I and then NPV) are replaced by a single IRR keystroke. Comparing the IRRs of projects A and B given in Figure 9.3 to Bennett Company’s 10% cost of capital, we can see that both projects are acceptable because IRRA IRRB 19.9% 21.7% 10.0% cost of capital 10.0% cost of capital Comparing the two projects’ IRRs, we would prefer project B over project A because IRRB 21.7% IRRA 19.9%. If these projects are mutually exclusive, the IRR decision technique would recommend project B. Spreadsheet Use The internal rate of return also can be calculated as shown on the Excel spreadsheet on page 405. It is interesting to note in the preceding example that the IRR suggests that project B, which has an IRR of 21.7%, is preferable to project A, which has an IRR of 19.9%. This conflicts with the NPV rankings obtained in an earlier example. Such conflicts are not unusual. There is no guarantee that NPV and IRR will rank projects in the same order. However, both methods should reach the same conclusion about the acceptability or nonacceptability of projects. 406 PART 3 Long-Term Investment Decisions FOCUS ON PRACTICE In Practice EVAlue Creation Answering the question “Does the company use investors’ money wisely?” is one of the financial manager’s chief responsibilities and greatest challenges. At many firms—from Fortune 500 companies and investment firms to community hospitals—economic value added (EVA®) is the measurement tool of choice for making investment decisions, measuring overall financial performance, and motivating management. Developed in 1983 by financial consultants Stern Stewart and protected by trademark, EVA® is the difference between an investment’s net operating profits after taxes and the cost of funds used to finance the investment (the amount of capital times the company’s cost of capital). An investment with a positive EVA® exceeds the firm’s cost of capital and therefore creates wealth. The EVA® calculation is similar to calculating internal rate of return (IRR), except...
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