50 back at the end of the class period Option 2 You give me 10 now and Ill give

# 50 back at the end of the class period option 2 you

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\$1.50 back at the end of the class period.Option #2: You give me \$10 now and I’ll give you \$11 back at the end of the class period. You can choose only one of two options. Assume a zero rate of interest because our class lasts only 2 hours. Which option would you choose?
34Example 4: NPV vs. IRR (Mutually Exclusive Projects)Project0123IRRIRRNPV NPV @5%@5%Long-10010608018.1%18.1%\$33\$33HigherHigherShort-10070502023.6%23.6%HigherHigher\$29\$29Which one should we take?Suppose r = 5%.
35Construct NPV ProfilesEnter CFs in CFjand find NPVLandNPVSat different discount rates: r05101520NPVL50 33197NPVS402920125 (4)
36 NPV (\$) Discount Rate (%) IRR L = 18.1% IRR S = 23.6% Crossover Point = 8.7% Microsoft Excel Worksheet Double click on the icon
37 To Find the Crossover Rate 1. Find cash flow differences between the projects. See data at beginning of the case. 2. Enter these differences in CF j register, then press IRR. Crossover rate = 8.68%, rounded to 8.7%. 3. Can subtract S from L or vice versa, but better to have first CF negative. 4. If profiles don’t cross, one project dominates the other.
38 Which project(s) should be accepted at r=5%? If S and L are independent , accept both. NPV > 0. IRR S and IRR L > r = 5%. If Projects S and L are mutually exclusive , accept L because NPV S < NPV L at r = 5%, although IRR S > IRR L . Conflict!!! Choose between mutually exclusive projects on basis of higher NPV . Adds most value in dollar.
39 NPV and IRR always lead to the same accept/reject decision for independent projects: r > IRR and NPV < 0. Reject. NPV (\$) r (%) IRR IRR > r and NPV > 0 Accept.
40 Mutually Exclusive Projects r 8.7 r NPV % IRR S IRR L L S r < 8.7: NPV L > NPV S , IRR S > IRR L CONFLICT r> 8.7: NPV S > NPV L , IRR S > IRR L NO CONFLICT
41 Reinvestment Rate Assumptions NPV assumes reinvest at r (opportunity cost of capital). IRR assumes reinvest at IRR. Reinvest at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to choose between mutually exclusive projects. reinvestment assumption
42 42 Another Problem with IRR Another Problem with IRR IRR has another problem so-called IRR has another problem so-called “Multiple IRRs.” “Multiple IRRs.”
43 Normal Cash Flow Project: Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal Cash Flow Project: Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine. Two kinds of Cash Flows
44 Inflow (+) or Outflow (-) in Year 0 1 2 3 4 5 N NN - + + + + + N - + + + + - NN - - - + + + N + + + - - - N - + + - + - NN
45 Example 5: NPV vs. IRR (Multiple IRRs) 0 1 2 3 4 5 NPV @5.62% NPV @27.78% NPV @10% -22 15 15 15 15 -40 ? ? \$0.7M Greenspan Mining Co. is considering a project to strip mine coal. The project requires an investment of \$22 million and is expected to produce a cash inflow of \$15 million in each Year 1 through 4. However, the Company is obligated to pay \$40 million in Year 5 to restore the terrain. The Company’s opportunity cost of capital is 10%. What are the IRR(s) and NPV?
46 Multiple IRRs
47 Could find IRR with calculator: 1. Enter CFs as before.

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• Fall '08
• Olander

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