Capital budgeting and decision making

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Unformatted text preview: urn, reject. reject Rationale for the IRR method Rationale If IRR > WACC, the project’s rate of If return is greater than its costs. There is some return left over to boost stockholders’ returns. stockholders’ IRR Acceptance Criteria IRR If IRR > k, accept project. If IRR < k, reject project. If projects are mutually exclusive, accept If the highest IRR(must > k). the IRR is a good decision-making tool as IRR long as cash flows are conventional. conventional (- + + + + +) ( Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +) (- IRR is a good decision-making tool as IRR long as cash flows are conventional. conventional (- + + + + +) ( Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +) (- (500) 200 100 (200) 400 300 0 1 2 3 4 5 IRR is a good decision-making tool as IRR long as cash flows are conventional. conventional (- + + + + +) ( Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +) (1 (500) 200 100 (200) 400 300 0 1 2 3 4 5 IRR is a good decision-making tool as IRR long as cash flows are conventional. conventional (- + + + + +) ( Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +) (1 2 (500) 200 100 (200) 400 300 0 1 2 3 4 5 IRR is a good decision-making tool as IRR long as cash flows are conventional. conventional (- + + + + +) ( Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +) (1 2 3 (500) 200 100 (200) 400 300 0 1 2 3 4 5 Multiple IRRs IRR IRR When project cash flows have multiple sign changes, there can be multiple IRRs. 63 63 Which IRR do we use? NPV Profiles NPV A graphical representation of project NPVs at various graphical different costs of capital. different k 0 5 10 15 20 NPVL NPV $50 33 19 7 (4) NPVS NPV $40 29 20 12 5 Drawing NPV profiles Drawing NPV 60 ($) . 40 . 50 30 . . 20 Crossover Point = 8.7% . 10 IRRL = 18.1% L . . 0 5 -10 10 15 S . . 20 . 23.6 IRRS = 23.6% Discount Rate (%) Comparing the NPV and IRR methods Comparing If projects are independent, the two If methods always lead to the same accept/reject decisions. accept/reject If projects are mutually exclusive … If k > crossover point, the two methods lead If to the same decision and there is no conflict. to If k < crossover point, the two methods lead If to different accept/reject decisions. to Reinvestment rate assumptions Reinvestment NPV method assumes CFs are reinvested at k, NPV the opportunity cost of capital. the IRR method assumes CFs are reinvested at IRR IRR. IRR. Assuming CFs are reinvested at the Assu...
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