Aswath Damodaran 288 Assume that you can pick only one of these two projects

Aswath damodaran 288 assume that you can pick only

This preview shows page 289 - 296 out of 331 pages.

Aswath Damodaran 288 ¨ 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?
Image of page 289
289 Capital Rationing, Uncertainty and Choosing a Rule Aswath Damodaran 289 ¨ 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.
Image of page 290
290 The sources of capital rationing… Aswath Damodaran 290 Cause 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
Image of page 291
291 An Alternative to IRR with Capital Rationing Aswath Damodaran 291 ¨ 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.
Image of page 292
292 Case 3: NPV versus IRR Aswath Damodaran 292 Cash Flow Investment $ 5,000,000 $ 10,000,000 Project A Cash Flow Investment Project B NPV = $1,191,712 IRR=21.41% $ 4,000,000 $ 3,200,000 $ 3,000,000 NPV = $1,358,664 IRR=20.88% $ 10,000,000 $ 3,000,000 $ 3,500,000 $ 4,500,000 $ 5,500,000
Image of page 293
293 Why the difference? Aswath Damodaran 293 ¨ 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.
Image of page 294
294 NPV, IRR and the Reinvestment Rate Assumption Aswath Damodaran 294 ¨ 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.
Image of page 295
Image of page 296

You've reached the end of your free preview.

Want to read all 331 pages?

  • Fall '16
  • Test, Aswath Damodaran

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture