LE0AFA~1

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

This preview shows page 1. Sign up to view the full content.

This is the end of the preview. Sign up to access the rest of the document.

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...
View Full Document

Ask a homework question - tutors are online