How are they related to the firms market value do the

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Unformatted text preview: the acceptance criteria for IRR? How are they related to the firm’s market value? Do the net present value (NPV) and internal rate of return (IRR) always agree with respect to accept–reject decisions? With respect to ranking decisions? Explain. CHAPTER 9 LG5 LG6 Capital Budgeting Techniques 407 9.5 Comparing NPV and IRR Techniques To understand the differences between the NPV and IRR techniques and decision makers’ preferences in their use, we need to look at net present value profiles, conflicting rankings, and the question of which approach is better. Net Present Value Profiles net present value profile Graph that depicts a project’s NPVs for various discount rates. EXAMPLE Projects can be compared graphically by constructing net present value profiles that depict the projects’ NPVs for various discount rates. These profiles are useful in evaluating and comparing projects, especially when conflicting rankings exist. They are best demonstrated via an example. To prepare net present value profiles for Bennett Company’s two projects, A and B, the first step is to develop a number of “discount rate–net present value” coordinates. Three coordinates can be easily obtained for each project; they are at discount rates of 0%, 10% (the cost of capital, k), and the IRR. The net present value at a 0% discount rate is found by merely adding all the cash inflows and subtracting the initial investment. Using the data in Table 9.1 and Figure 9.1, we get For project A: ($14,000 $14,000 $14,000 $14,000 $14,000) $42,000 $28,000 $12,000 $10,000 $10,000 $10,000) $45,000 $25,000 For project B: ($28,000 The net present values for projects A and B at the 10% cost of capital are $11,071 and $10,924, respectively (from Figure 9.2). Because the IRR is the discount rate for which net present value equals zero, the IRRs (from Figure 9.3) of 19.9% for project A and 21.7% for project B result in $0 NPVs. The three sets of coordinates for each of the projects are summarized in Table 9.4. Plotting the data from Table 9.4 results in the net present value profiles for projects A and B shown in Figure 9.4. The figure indicates that for any discount TABLE 9.4 Discount-Rate–NPV Coordinates for Projects A and B Net present value Discount rate Project A Project B $28,000 $25,000 11,071 10,924 19.9 0 — 21.7 — 0 0% 10 408 PART 3 Long-Term Investment Decisions FIGURE 9.4 40 NPV ($000) NPV Profiles Net present value profiles for Bennett Company’s projects A and B Project A 30 20 10 IRRB = 21.7% Project B 0 –10 10.7% –20 0 5 10 IRRA = 19.9% 15 20 25 Discount Rate (%) B A 30 35 rate less than approximately 10.7%, the NPV for project A is greater than the NPV for project B. Beyond this point, the NPV for project B is greater. Because the net present value profiles for projects A and B cross at a positive NPV, the IRRs for the projects cause conflicting rankings whenever they are compared to NPVs calculated at discount rates below 10.7%. Conflicting Rankings conflicting rankings Conflicts in the ranking given a project by NPV and IRR, resulting from differences in the magnitude and tim...
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This document was uploaded on 01/19/2014.

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