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INTERNAL RATE OF RETURN (IRR)How is a project’s IRR similar to a bond’s YTM?•They are the same thing.•Think of a bond as a project. The YTM on the bond would be the IRR of the “bond” project.•EXAMPLE: Suppose a 10-year bond with a 9% annual coupon and $1,000 par value sells for $1,134.20.•Solve for IRR = YTM = 7.08%, the annual return for this project/bond.
INTERNAL RATE OF RETURN (IRR)Summary of IRR for Project Evaluation•If IRR > WACC, the project’s return exceeds its costs and there is some return left over to boost stockholders’ returns.If IRR > WACC, accept project.If IRR < WACC, reject project.•If projects are independent, accept both projects, as both IRR > WACC = 10%.•In the example, if projects are mutually exclusive, accept S, because IRRS > IRRL.
INTERNAL RATE OF RETURN (IRR)NPV Profiles•A graphical representation of project NPVs at various different costs of capital.WACCNPVLNPVS0$50$40533291019201571220(4)5
INTERNAL RATE OF RETURN (IRR)Independent Projects•NPV and IRR always lead to the same accept/reject decision for any given independent project.r > IRRand NPV < 0.Reject.NPV ($)r (%)IRRL = 18.1%IRR > rand NPV > 0Accept.r = 18.1%
INTERNAL RATE OF RETURN (IRR)IRR Pitfall – 1: Mutually Exclusive Projects•IRR may lead to the different accept/reject decision for any given mutually exclusive projects.
INTERNAL RATE OF RETURN (IRR)Finding the Crossover Rate•Find cash flow differences between the projects.•Enter the CFs in CFj register, then press IRR. Crossover rate = 8.68%, rounded to 8.7%.•If profiles don’t cross, one project dominates the other.
INTERNAL RATE OF RETURN (IRR)Reasons Why NPV Profiles Cross•Size (scale) differences: The smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so a high WACC favors small projects.•Timing differences: The project with faster payback provides more CF in early years for reinvestment. If WACC is high, early CF especially good, NPVS > NPVL.
INTERNAL RATE OF RETURN (IRR)IRR Pitfall – 2: Lending or Borrowing•When lending we love high required rates of return•When borrowing we dislike high required rates of payment•Project H is a lending-type project where as Project I is a borrowing-type project
NPV OR IRR?Reinvestment Rate Assumptions•NPV method assumes CFs are reinvested at the WACC.•IRR method assumes CFs are reinvested at IRR.•Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. •NPV method should be used to choose between mutually exclusive projects.•Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.