For the reasons espoused in the classroom example NPV is correct Hence Sherry

# For the reasons espoused in the classroom example npv

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For the reasons espoused in the classroom example, NPV is correct. Hence Sherry is right. However, Stanley is very stubborn where IRR is concerned. How can Sherry justify the large budget to Stanley using the IRR approach? This is where comes in. Sherry calculates the incremental cash flows from choosing the large budget instead of the small budget as follows:
This chart shows that the incremental cash flows are –\$15 million at date 0 and \$25 million at date 1. Sherry calculates incremental IRR as follows: IRR equals 66.67 percent in this equation, implying that the incremental IRR is 66.67 percent. Incremental IRR is the IRR on the incremental investment from choosing the large project instead of the small project. In addition, we can calculate the NPV of the incremental cash flows: We know the small-budget picture would be acceptable as an independent project because its NPV is positive. We want to know whether it is beneficial to invest an additional \$15 million to make the large-budget picture instead of the small-budget picture. In other words, is it beneficial to invest an additional \$15 million to receive an additional \$25 million next year? First, our calculations show the NPV on the incremental investment to be positive. Second, the incremental IRR of 66.67 percent is higher than the discount rate of 25 percent. For both reasons, the incremental investment can be justified, so the large-budget movie should be made. The second reason is what Stanley needed to hear to be convinced. In review, we can handle this example (or any mutually exclusive example) in one of three ways: 1. . The NPV of the large-budget picture is greater than the NPV of the small-budget picture. That is, \$27 million is greater than \$22 million. 2. . Because the incremental NPV equals \$5 million, we choose the large-budget picture. 3. . Because the incremental IRR is 66.67 percent and the discount rate is 25 percent, we take the large-budget picture. All three approaches always give the same decision. However, we must compare the IRRs of the two pictures. If we did, we would make the wrong choice. That is, we would accept the small-budget picture. Although students frequently think that problems of scale are relatively unimportant, the truth is just the opposite. No real-world project comes in one clear-cut size. Rather, the firm has to the best size for the project. The movie budget of \$25 million is not fixed in stone. Perhaps an extra \$1 million to hire a bigger star or to film at a better location will increase the movie’s gross. Similarly, an industrial firm must decide whether it wants a warehouse of, say, 500,000 square feet or 600,000 square feet. And, earlier in the chapter, we imagined McDonald’s opening an outlet on a remote island. If it does this, it must decide how big the outlet should be. For almost any project, someone in the firm has to decide on its size, implying that problems of scale abound in the real world.

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