Aswath damodaran 288 assume that you can pick only

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?

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.

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

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.

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

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.

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.