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Aswath Damodaran288¨Assume that you can pick only one of these two projects. Your choice will clearly vary depending upon whether you look at NPV or IRR. You have enough money currently on hand to take either. Which one would you pick?a.Project A. It gives me the bigger bang for the buck and more margin for error.b.Project B. It creates more dollar value in my business.¨If you pick A, what would your biggest concern be?¨If you pick B, what would your biggest concern be?
289Capital Rationing, Uncertainty and Choosing a RuleAswath Damodaran289¨If a business has limited access to capital, has a stream of surplus value projects and faces more uncertainty in its project cash flows, it is much more likely to use IRR as its decision rule.¤Small, high-growth companies and private businesses are much more likely to use IRR.¨If a business has substantial funds on hand, access to capital, limited surplus value projects, and more certainty on its project cash flows, it is much more likely to use NPV as its decision rule.¨As firms go public and grow, they are much more likely to gain from using NPV.
290The sources of capital rationing…Aswath Damodaran290Cause Number of firms Percent of total Debt limit imposed by outside agreement 10 10.7 Debt limit placed by management external to firm 3 3.2 Limit placed on borrowing by internal management 65 69.1 Restrictive policy imposed on retained earnings 2 2.1 Maintenance of target EPS or PE ratio 14 14.9
291An Alternative to IRR with Capital RationingAswath Damodaran291¨The problem with the NPV rule, when there is capital rationing, is that it is a dollar value. It measures success in absolute terms.¨The NPV can be converted into a relative measure by dividing by the initial investment. This is called the profitability index.¤Profitability Index (PI) = NPV/Initial Investment¨In the example described, the PI of the two projects would have been:¤PI of Project A = $467,937/1,000,000 = 46.79%¤PI of Project B = $1,358,664/10,000,000 = 13.59%¤Project A would have scored higher.
293Why the difference?Aswath Damodaran293¨These projects are of the same scale. Both the NPV and IRR use time-weighted cash flows. Yet, the rankings are different. Why?¨Which one would you pick?a.Project A. It gives me the bigger bang for the buck and more margin for error.b.Project B. It creates more dollar value in my business.
294NPV, IRR and the Reinvestment Rate AssumptionAswath Damodaran294¨The NPV rule assumes that intermediate cash flows on the project get reinvested at the hurdle rate (which is based upon what projects of comparable risk should earn).¨The IRR rule assumes that intermediate cash flows on the project get reinvested at the IRR. Implicit is the assumption that the firm has an infinite stream of projects yielding similar IRRs.