Assuming CFs are reinvested at the opportunity cost of capital (i.e., prevailing market interest rate or WACC) is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects.The IRR approach will have to be modified to take into account the fact that capital reinvestment is done at the prevailing market interest rate (or WACC).
11-24Project P has cash flows (in 000s): CF0 = -$0.8 million, CF1 = $5 million, and CF2 = -$5 million. Find Project P’s NPV and IRR.Enter CFs into calculator CFLO register.Enter I/YR = 10.NPV = -$386.78.IRR = ERROR Why?-800 5,000 -5,0000 1 2WACC = 10%
11-25Multiple IRRs450-8000400100IRR2= 400%IRR1= 25%WACCNPV
11-26Why Are There Multiple IRRs?At very low discount rates, the PV of CF2 is large & negative, so NPV < 0.At very high discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV < 0.In between, the discount rate hits CF2 harder than CF1, so NPV > 0.Result: 2 IRRs.
11-27Since managers prefer the IRR to the NPV method, is there a better IRR measure?Yes, MIRR is the discount rate that causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC.MIRR assumes cash flows are reinvested at the prevailing market rate or WACC.
11-28Calculating MIRR66.012.110%10%-100.0 10.0 60.0 80.00 1 2 310%PV outflows-100.0$100MIRR = 16.5%158.1TV inflowsMIRRA= 16.5%$158.1(1 + MIRRA)3=
11-29Steps for Computing the MIRR1. Compound all cash inflows to time T (end of the investment project) with the prevailing market rate or WACC. Adding them up to become a single sum future value at time T;2. Discount the future value single sum back to t=0;3. Find the discount rate that will make the present value of the future value single sum equal to the initial cash outflow at t=0. The discount rate this derived is the MIRR of the project.
11-30Why use MIRR versus IRR?MIRR assumes reinvestment at the opportunity cost = WACC. MIRR also avoids the multiple IRR problem.Managers like rate of return comparisons, and MIRR is better for this than IRR.
11-31What is the payback period?The number of years required to recover a project’s cost, or “How long does it take to get our money back?”Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive.
11-32Calculating paybackPaybackA= 2 + / = 2.375 yearsCFt-100 10 60Cumulative -100 -90 500123=308080-30Project A’s Payback CalculationPaybackA= 2.375 yearsPaybackB= 1.600 years
11-33Strengths and weaknesses of paybackStrengthsProvides an indication of a project’s risk and liquidity.