Chapter 4: Net Present Value vs Internal Rate of Return

NPV vs IRR: Independent Projects NPV vs IRR: Dependent Projects Differences in the Scale of Investment Timing of the Cash flow Reinvestment Rates The Horizon Problem A Theoretical Justification for Net Present Value Capital Structure Irrelevancy Dividend Policy Irrelevancy Non-conventional Cash Flow Capital Rationing

4-1

NPV vs IRR: Independent Projects

If the discussion is limited to conventional projects which are economically independent of one another no problem arises. In this case, both the NPV and IRR rules lead to identical accept or reject decisions. The NPV and IRR rules with respect to conventional independent projects can readily be proven equivalence. The equivalence can be shown in the following graph:
4-2

NPV

Increase in productivity
NPV (K1)

0 NPV (K2)

R K1 Discount rate

K2

4-3

NPV vs IRR: Dependent Projects

There may be conflicting results in case of conventional projects which are economically dependent of one another. In this case, NPV and IRR rules lead to different accept or reject decisions. The NPV and IRR rules with respect to conventional dependent projects can readily be proven unequivalence. The unequivalence can be shown in the following graph:

4-4

NPV

2700 2000
Project B

Project A

1089 908

10%

K0

20% 28%

Discount rate

4-5

NPV vs IRR: Dependent Projects

Proje Initial Net cash IRR NPV ct investm inflow ent A 10000 12000 28% 908 B 15000 17700 20% 1089

Cost of capital

10%
10%

4-6

Conflictions between NPV & IRR

1. Differences in the Scale of Investment

Initial Proje Net cash investment inflow in ct year 1 M 1000000 1280000

IRR

NPV

Cost of capital 10%

10%

28% 163636
20% 454545

5000000

6000000

4-7

2. Timing of the Cash Flow

Proj Initial ect investment X Y 1000000 5000000 Net cash inflow in year 1 1280000 6000000 IRR NPV @ 10% CC Incremental () I0=4000000 CF1=4720000 IRR=18% NPV=290909

28% 163636 20% 454545

4-8

NPV 4000

Project B

515
Project A

15% 16.58%

17%

Discount rate

24%

4-9

Timing of the Cash Flow

Project Invest ment 100 100 0 Cash inflow Y=1 20 100 -80 Cash inflow Y=2 120 32 88 NPV @ 10% CC 17.30 16.70 0.60 IRR

A B A Minus B

20% 25% 10.9%

4-10

NPV 40

32 Project A

Project B

A minus B

0 10.9% Discount rate 20% 25%

4-11

3. Reinvestment Rate
The use of NPV method implicitly assumes that the opportunity rate at which cash flows generated by a project can be reinvested at the cost of capital, whereas use of IRR method implies that the firm has the opportunity to reinvest at the IRR. Thus NPV method evaluates the cash flows at the cost of capital, while the IRR method evaluates cash flows at the projects IRR.
4-12

Reinvestment Rate
Therefore, we simply must come to the conclusion that the correct reinvestment rate assumption is the cost of capital, which is implicit in the NPV method. This in turn, leads us to prefer the NPV method, at least firms willing and able to obtain capital at a cost reasonably close to their current cost of capital. In addition to this, in case of nonnormal cash flows, IRR is not usable because there is existence of multiple IRR.
4-13

4. Horizon Problem
Horizon problem arises when alternative investment projects have different lives. Example:
Project Invest ment CF1 CF2 CF3 CF4
NPV @ 10%

IRR

A B

100 100

120 -

174

9 19

20% 15%

4-14

Horizon Problem
Since project A earns its cash inflow of 120 at the end of the 1st year, while in project B the cash inflow of 174 at the end of 4th year, it has been argued that the appropriate comparison is with the cash flow of the earlier project repeated three more times. Denoting the repetitive project A*, cash flows can be rewritten as follows by assuming reinvestment of earlier years cash inflows:
4-15

Horizon Problem
Project Invest ment CF1 CF2 CF3 CF4 NPV @ 10 IRR

A*

100

100

120- 120- 120100= 100= 100= 20 20 20 -

120

31.7

20%

174

19.0

15%
4-16

A Theoretical Justification for Net Present Value

1. It maximizes investors utility by maximizing shareholders wealth. 2. It takes into account investment size. 3. It reinvest interim cash flows at the relevant rate. 4. It can be applied in case of both conventional and non-conventional cash flows.

4-17

Important Terms:
1. 2. 3. 4. 5. Investment schedule. The meaning of indifference curve. Optimal investment decisions The money market line. Separation of investment and financing decisions

4-18

Investment Opportunity Schedule

Second period cash flow

1,256 950

Project D

c
Project C

350

Project B

200
0

a
Project A W0= 1,000 First period cash flow

4-19

Investment Opportunity Schedule

Project Initial investment Rate of return Future cash (Io or Co) (IRR) inflow (I1 or C1) A 400000 15% 460000

B C D Total

300000 500000 800000 2000000

12% 10% 8%

336000 550000 864000 2210000

4-20

Indifference Curve

C1
I1 I

M1 M N b a

C0

4-21

Second period cash flow

d
C*

C1* I2 I1 I0 0
C0* W0
First period cash flow

4-22

Optimum Consumption Decision

Through consideration of investment opportunity schedule and indifference curve point where these two lines tangent each other i.e. slopes of these two lines are equal.

4-23

C1

C0

4-24

Optimum Investment Decision

1. Through consideration of investment opportunity
schedule and present value line point where these two lines tangent each other i.e. slopes of these two lines are equal.

2. Through consideration of investment opportunity

schedule and marginal cost of capital line point where these two lines intersect each other.

4-25

Capital Structure Irrelevancy

Capital structure refers to the proportion of debt and equity used by the firm in financing its investments. This capital structure is irrelevant for investment which means a firm can arbitrarily choose its capital structure. It means regardless of the firms financing mix, all investors will maximize their utility by borrowing and lending.
4-26

Dividend Policy Irrelevancy

Theoretically dividend policy is irrelevant for investment which means a firm can arbitrarily choose its dividend decision. It means regardless of the firms financing mix, the firm automatically decides its dividend policy. In practice, dividend is relevant since reality is uncertain and the economic content of dividends may be important i.e. dividend may have other uses such as signaling information to the market about the firms future earnings potential and stability.
4-27

Non-conventional cash flow

In case of conventional cash flows both NPV and IRR can be applied for making investment decision. Both the methods may provide same accept or reject decision or contradictory decisions. But in case of non-conventional cash flows IRR method can not applied for making investment decision because IRR does not exist. So NPV method can be applied for this project. For example, cash flows are (Tk.100), Tk.200 & (Tk.150) in years 0, 1 & 2 respectively. IRR is imaginary and NPV is calculable.
4-28

Non-conventional cash flow and Multiple IRR

In case of non-conventional cash flows IRR method can not applied for making investment decision because IRR does not exist. Sometimes it may be possible to calculate IRR, but there will be more than one rates that can not be compared with given cost of capital for making accept or reject decision. For example, cash flows are (Tk.16000), Tk.100000 & (Tk.100000) in years 0, 1 & 2 respectively. IRRs are 25% and 400% (by applying quadratic equation) and NPV @ 30% cost of capital is (Tk.1751).
4-29

Capital rationing
Firms commonly operate under capital rationing i.e. they have more acceptable independent projects than they can fund. Management internally imposes capital expenditure constraints to avoid what it deems to be excessive levels of new financing. The objective of capital rationing is to select the group of projects that provides the highest overall net present value and does not require more amount than are budgeted.
4-30

Capital rationing
As prerequisite to capital rationing, the best way to any mutually exclusive projects must be chosen and placed in the group of independent projects. It is occurred when the situation that exists if a firm has positive NPV projects but can not find the necessary financing.

4-31

Capital rationing: Fund available Tk.250000

Project s A Initial PV of IRR PI @ Selection investment Benefits @ (%) 10% IRR- B, C, E 10% CC CC 80000 12 1.40 X 112000

B
C

70000
100000

145000
119000

20
16

2.07 X Selection
1.19 X

D
E F

40000
60000 110000

100000 106500
60000

8
15 11

2.50 X
1.78 X 0.55 X

based on PI- D, B, E, A

4-32

Problems: 4.2, 4.3 & 4.5

4-33