Finance Lecture 6.ppt

Finance Lecture 6 Outline Lecture 6 The Internal Rate Of Return IsThe Interest Rate At Which PV = 0 Or, More Formally, SolveFor IRR In This Equation Typically, NPV And IRR AnalysesWill Give The Same Answer IRR And NPV Can ConflictOn Mutually Exclusive Projects IRR Likes Small, High Rate Projects Primarily Use NPV In Decisionmaking Outline Lecture 6 Mutually Exclusive Projects With UnequalLengths Pose An Analytical Challenge Replacement Chain Assumes YouReplace Each Project With Copy Replacement Chain Example:NPV Is Not Enough Equivalent Annuity TranslatesUneven Flows Into One Annual Value Replacement Chains And EquivalentAnnuity Will Give Same Results With Capital Rationing,Capital Budget Is Capped Capital Rationing Creates AConstrained Maximization Problem Keating FA 6-* Spring 2008 NPV’s Tempting Cousin, IRR Assorted Insights on Capital Budgeting Can be hard to solve by hand, but easy for a computer to solve numerically If NPV of a prospective project is positive, do it If prospective project’s IRR is greater than firm’s cost of capital (e.g., interest rate), do it For many scenarios, NPV and IRR analyses agree with one another Plus IRR additionally provides information on how high interest rates can be with a project remaining desirable Unfortunately, there are certain pathological cases where IRR gives the wrong answer Project A: Spend $1 now, get $2 next year Project B: Spend $1000 now, get $1500 next year IRR(A)=100% IRR(B)=50% But if i=15%, NPV(A)= $0.74 NPV(B)=$304.35 NPV is contribution to shareholder wealth IRR falsely assumes unused capital (in small/large case) is reinvested at IRR IRR-based decisionmaking is OK if projects are independent (e.g., both A and B are good projects if you can do both) IRR does give intuition on safety margin NPV’s Tempting Cousin, IRR Assorted Insights on Capital Budgeting NPV alone may be insufficient What will happen when shorter project ends? Two technique