FM11_Ch_10_Tool_Kit

# Net cash flows project s project l 1000 1000 500 100 4

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Unformatted text preview: ,000 \$500 \$100 \$4 00 \$300 \$300 \$4 00 \$100 \$600 Year 0 1 2 3 4 WACC = 10.0% Project S Project L NPV = \$78.82 \$ 4 9.18 IRR = 14 .4 9% 11.79% Crossover = 7.17% Pro jec t S's N PV P ro f ile Data Table used to make g raph: Project NPVs S L WACC \$78.82 \$ 4 9.18 0% \$300.00 \$4 00.00 5% \$180.4 2 \$206.50 7.17% \$134 .4 0 \$134 .4 0 10% \$78.82 \$4 9.18 11.79% \$4 6.10 \$0.00 14 .4 9% \$0.00 -\$68.02 15.0% -\$8.33 -\$80.14 20% -\$83.72 -\$187.50 25% -\$14 9.4 4 -\$277.4 4 Bo t h P ro ject s ' P ro f iles \$200 \$10 0 Conflict NPVs Accept No conflict NPV L Reject Crossover IRRS = 1 4.49% = 7 .17% \$0 0% % 5% 10 % 1 5% 20% 25 % \$0 0% 5% 1 0% 15% 20% 25% WACC WACC Points about the g raphs: 1. In Panel a, we see that if WACC < IRR, then NPV > 0, and vice versa. 2 . Thus, for "normal and independent" projects, there can be no conflict between NPV and IRR ranking s. 3. However, if we have mutually exclusive projects, conflicts can occur. In Panel b, we see that IRR S is always greater than IRRL, but if WACC < 11.56%, then IRRL > IRRS, in which case a conflict occurs. 4 . Summary: a. For normal, independent projects, conflicts can never occur, so either method can be used. b. For mutually exclusive projects, if WACC > Crossover, no conflict, but if WACC < Crossover, then there will be a conflict between NPV and IRR. Previously, we had discussed that in some instances the NPV and IRR methods can give conflicting results. First, we should attempt to define what we see in this graph. Notice, that the two project profiles (S and L) intersect the x-axis at costs of capital of 14% and 12%, respectively. Not coincidently, those are the IRR's of the projects. If we think about the definition of IRR, we remember that the internal rate of return is the cost of capital at which a project will have an NPV of zero. Looking at our graph, it is a logical conclusion that the IRR of a project is defined as the point at which its profile intersects the x-axis. Looking further at the NPV profiles, we see that th...
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