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# The irr rule accounts for time value because it is

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Unformatted text preview: gher NPV 9-47 NPV Profiles \$160.00 IRR for A = 19.43% \$140.00 IRR for B = 22.17% \$120.00 Crossover Point = 11.8% \$100.00 NPV \$80.00 A B \$60.00 \$40.00 \$20.00 \$0.00 (\$20.00) 0 0.05 0.1 0.15 0.2 0.25 0.3 (\$40.00) Discount Rate 9-48 Conflicts Between NPV and IRR • NPV directly measures the increase in value to the firm • Whenever there is a conflict between NPV and another decision rule, you should always use NPV • IRR is unreliable in the following situations • Non-conventional cash flows • Mutually exclusive projects 9-49 Decision Criteria Test - IRR • Does the IRR rule account for the time value of money? • The IRR rule accounts for time value because it is finding the rate of return that equates all of the cash flows on a time value basis. • Does the IRR rule account for the risk of the cash flows? • The IRR rule accounts for the risk of the cash flows because you compare it to the required return, which is determined by the risk of the project. • Does the IRR rule provide an indication about the increase in value? • The IRR rule provides an indication of value because we will always increase value if we can earn a return greater than our required return. 9-50 Profitability Index 9.5 • Measures the benefit per unit cost, based on the time value of money • Profitability index = Present value of future cash flows / cost • Recall that NPV = Present value of future cash flows - cost • If the profitability index is greater than 1, then the NPV > 0 and the project should be approved. 9-51 Profitability Index example • With a discount rate of 12%, then the PV of the future cash flows is 177,627. • Note that I computed this in my calculator by putting a zero at the top of my cash flow list before hitting the NPV key. Time 0 1 2 3 Amount -165,000 63,120 70,800 91,080 • Profitability index = 177,627 / 165,000 = 1.076 • Compare to NPV = 12,627 and IRR = 16.13% 9-52 Advantages and Disadvantages of Profitability Index • Advantages • Closely related to NPV, generally leading to identical decisions • Easy to understand and communicate • May be useful when available investment funds are limited • Disadvantages • May lead to incorrect decisions in comparisons of mutually exclusive investments 9-53 The Practice of Capital Budgeting 9.6 • NPV and IRR are the most commonly used primary investment criteria • Payback is a commonly used secondary investment criteria • Capital budgeting techniques vary with industry. • Firms that are better able to estimate cash flows precisely are more likely to use NPV • These methods should be used with considerable judgment and thought. There may be more risk than we have considered or we may want to pay additional attention to our cash flow estimations. 9-54...
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## This document was uploaded on 02/06/2014.

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