11 which is one of the correct irrs the other is 4266

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Unformatted text preview: ead to incorrect decisions in comparisons of mutually exclusive investments 9-41 IRR and Non-conventional Cash Flows • Consider the following non-conventional cash flow: • • • • Year 0: -90,000 Year 1: 132,000 Year 2: 100,000 Year 3: -150,000 • When the cash flows change sign more than once, then mathematically there is more than one IRR • When you solve for the IRR, you are solving for the root of an equation. When you cross the x-axis more than once, there will be more than one return that solves the equation. • Your calculator should give you a result of 10.11%, which is one of the correct IRRs. The other is 42.66%. 9-42 NPV Profile IRR = 10.11% and 42.66% $4,000.00 $2,000.00 NPV $0.00 ($2,000.00) 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55 ($4,000.00) ($6,000.00) ($8,000.00) ($10,000.00) Discount Rate 9-43 So what’s the IRR? • Is the IRR 10.11% or 42.66%? • There really isn’t an answer to this question, since both are IRRs. • The best way to resolve the question of whether to approve the project or not is to use NPV to sort it out. • Note: you must recognize that the problem is not straightforward if there are unconventional cash flows. Don’t rely on your calculator. 9-44 Using NPV to sort it out • • • Calculate the NPV of this project using three different discount rates: 10.11%, 15% and 42.66%. • Year 0: -90,000 • Year 1: 132,000 • Year 2: 100,000 • Year 3: -150,000 Answer: The NPV is zero when the discount rate is 10.11% and 42.66%. The NPV is $1,769 when using 15%. So if the NPV rule is being used and the required rate of return is 15%, then the project should be approved. 9-45 IRR and Mutually Exclusive Projects • This is the second disadvantage to IRR relative to NPV • Mutually exclusive projects • If you choose one, you can’t choose the other • Example: You can choose to attend graduate school next year at either Harvard or Stanford, but not both • Intuitively you would use the following decision rules: • NPV – choose the project with the higher NPV • IRR – choose the project with the higher IRR 9-46 Example With Mutually Exclusive Projects Period Project A Project B 0 -500 -400 1 325 325 2 325 200 IRR 19.43% 22.17% NPV 64.05 60.74 The required return for both projects is 10%. Which project should you accept and why? Project A, hi...
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