Chapter 5 NPV vs' other Capital Budgeting Rules

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Chapter 5 NPV vs. other Capital Budgeting Rules

• Goals of Todays Lecture
• Drawbacks of IRR, Common Pitfalls

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Corporate Application of IRR

• A commonly accepted (but sometimes inaccurate)
  application of IRR is as a decision rule accept
  projects if IRR gt hurdle rate, reject otherwise.
• In certain situations, naïve application of this
  rule can lead to erroneous decisions.

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Pitfall 1 The Scale Problem

• Suppose I have an investment opportunity that I
  can undertake on a small scale or on a big
  scale small and big are mutually exclusive. The
  cost of capital is 15 either way.
• Small scale project invest 10mm now, get back
  15mm in one year. NPV 3.04mm.
• Big scale project invest 25mm now, get back
  35mm in one year. NPV 5.43mm.

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IRR Pitfall Scale Problem
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IRR Pitfall Timing

• When we calculate a PV, we implicitly assume that
  all cash flows are reinvested at the hurdle rate.
  This allows us to compare projects of different
  timing.
• The IRR calculation implicitly assumes that all
  cash flows are reinvested at the IRR. Suppose A
  and B are mutually exclusive. Which do we pick?

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IRR Pitfall Timing
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IRR Pitfall Multiple IRRs

• The IRR sets the NPV equal to zero. Sometimes
  there can be multiple solutions!
• This occurs when cash flows change signs, as
  sometimes happens in corporate settings.
• Make sure you havent just found one solution!

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IRR Pitfall Borrowing/Lending

• What is the IRR? Which is a better project?
• if your discount rate is 10? 20?

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Example 2

• Lets say our discount rate is 10. If we use
  the NPV rule, which projects do we take? IRR
  rule?
• What if we only have 5 million to invest? 10
  million? 15 million?

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A critique of the Scale Problem

• It is true that the IRR rule has the scale
  problem it tends to make little project with a
  high rate of return look better than big projects
  with a slightly lower return. However, we may
  still want to go with the small project (even if
  it has a lower NPV) because big projects tend to
  be riskier. We dont want to bet the farm if we
  dont have to.
• Agree or Disagree?

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A Venture Capital Problem

• A venture capitalist is considering purchasing a
  private held company for 10M. The company
  requires additional funding in years 1 and 2.
• There are two outcomes for the company in year 4.
  Either it goes public (VC gets 200M) or it
  fails (VC gets 0). The chance of success is 25.
• The VC uses the IRR rule with a hurdle rate of
  25. High can the annual funding be, so that the
  project is still profitable?