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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? 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
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
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This document was uploaded on 01/19/2014.
- Fall '13