CHAPTER 6 : Some Alternative Investment Rules

1. INTERNAL RATE OF RETURN IRR!

IRR is the discount rate which makes NPV=0 IRR is the discount rate which makes NPV=0
0
) 1 ( ) 1 ( ) 1 (
2
2 1
0
=
+
+ +
+
+
+
+ =
T
T
IRR
C
IRR
C
IRR
C
C NPV
". NP# PROFILE
NPV Profile NPV Profile
C C
0 0 = - = -
C C
1 1 = !2 = !2
C C
2 2 = ! = !
"rial and #rror #stimation$ "rial and #rror #stimation$
If discount rate = 0%& then NPV =' If discount rate = 0%& then NPV ='
If discount rate = 2(% then NPV = ' If discount rate = 2(% then NPV = '
If discount rate = )0%& then NPV = ' If discount rate = )0%& then NPV = '
If discount rate = 2*%& then NPV = ' If discount rate = 2*%& then NPV = '
$. IRR RULE
+cce,t the ,ro-ect +cce,t the ,ro-ect
If IRR . /,,ortunit0 Cost of Ca,ital$ If IRR . /,,ortunit0 Cost of Ca,ital$
1ookin2 at the NPV ,rofile for a con3entional ,ro-ect& we will 4e acce,tin2 ,ro-ects with ,ositi3e NPV$ 1ookin2 at the NPV ,rofile for a con3entional ,ro-ect& we will 4e acce,tin2 ,ro-ects with ,ositi3e NPV$
%. &ULTIPLE IRRs
#5am,le #5am,le
6ear 6ear 0 0 1 1 2 2
C7 C7 -8 -8 82( 82( -82( -82(
"wo chan2es in si2n of cash flows$ "wo chan2es in si2n of cash flows$
- - 9enerates two IRRs : 2(% and 00% 9enerates two IRRs : 2(% and 00%
- - If r ; 2(%& NPV ; 0 If r ; 2(%& NPV ; 0
- - If 2(% ; r ; 00%& NPV . 0 If 2(% ; r ; 00%& NPV . 0
- - If r . 00& NPV ; 0$ If r . 00& NPV ; 0$
<ow does NPV ,rofile look like ' <ow does NPV ,rofile look like '
1
'. NO IRR E(ISTS
#5am,le #5am,le
6ear 6ear 0 0 1 1 2 2
C7 C7 81 81 -8) -8) 82$( 82$(
7or an0 r . 0& the PV of C7 a4o3e is ,ositi3e$ 7or an0 r . 0& the PV of C7 a4o3e is ,ositi3e$
"herefore& should I acce,t this ,ro-ect ' "herefore& should I acce,t this ,ro-ect '
Pro3e it for 0ourself$ Pro3e it for 0ourself$
6. CONFLICT )ET*EEN NP# AN+ IRR
IRR ma0 2i3e the wron2 decision with IRR ma0 2i3e the wron2 decision with mutually exclusive mutually exclusive ,ro-ects which differ in ,ro-ects which differ in
Scale and Pattern of Cash Flows Over Time Scale and Pattern of Cash Flows Over Time
Year 0 1 2 3 4 Year 0 1 2 3 4
Project G Project G -$9 $6 $5 $4 -$9 $6 $5 $4 $0 $0
Project H -$9 $1.8 every yr. forever
- - =hich ,ro-ect has hi2her IRR' =hich ,ro-ect has hi2her IRR'
- - =hich ,ro-ect has hi2her NPV& 2i3en r=10%' =hich ,ro-ect has hi2her NPV& 2i3en r=10%'
- - =hich ,ro-ect should I acce,t& if 4oth ,ro-ects are mutuall0 e5clusi3e ' =hich ,ro-ect should I acce,t& if 4oth ,ro-ects are mutuall0 e5clusi3e '
,. NP# PROFILES FOR )OTH PRO-ECTS
NP#
.6
Pro/e0t 1
"23 $$.$3 +is0ount Rate
4
Pro/e0t H
5. &UTUALL6 E(CLUSI#E PRO-ECTS
+nal0sis of Incremental Pro-ect > Pro-ect < - Pro-ect 9 ? +nal0sis of Incremental Pro-ect > Pro-ect < - Pro-ect 9 ?
Year Year 0 1 2 3 4 0 1 2 3 4
H-G $0 -$4.2 -$3.2 -$2.2 $1.8 . . . H-G $0 -$4.2 -$3.2 -$2.2 $1.8 . . .
- - =hat is the IRR for Incremental Pro-ect >i$e$& <-9? ' =hat is the IRR for Incremental Pro-ect >i$e$& <-9? '
- - If cost of ca,ital . 1($@%& which ,ro-ect should I choose' If cost of ca,ital . 1($@%& which ,ro-ect should I choose'
- - If 1($@% ; c$o$c ; ))$) %& which ,ro-ect should I choose' If 1($@% ; c$o$c ; ))$) %& which ,ro-ect should I choose'
- - If c$o$c . ))$) %& which ,ro-ect should I choose' If c$o$c . ))$) %& which ,ro-ect should I choose'
2
7. CAPITAL RATIONIN1
- - Ased when limitations on the in3estment funds e5ist$ Ased when limitations on the in3estment funds e5ist$
in3estment initial
NPV
= PI$? >i$e$ index ity profitabil
Pro-ect Pro-ect In3estment In3estment NPV NPV Profit$ Inde5$ Profit$ Inde5$
+ + 10 10 21 21 2$1 2$1
B B ( ( 1@ 1@ )$2 )$2
C C ( ( 12 12 2$ 2$
Choose the ,ro-ect from hi2hest P$I until ca,ital e5hausted Choose the ,ro-ect from hi2hest P$I until ca,ital e5hausted
12. LI&ITATIONS IN USE OF P.I. &ETHO+
Ca,ital Constraints in more than one ,eriod Ca,ital Constraints in more than one ,eriod
Cu,,ose firm can raise 810 million in each of 0ear 0 and 1$ Cu,,ose firm can raise 810 million in each of 0ear 0 and 1$
0 0 1 1 2 2 NPVD10% NPVD10% P$I P$I
+ + -10 -10 !)0 !)0 !( !( 21 21 2$1 2$1
B B -( -( !( !( !20 !20 1@ 1@ )$2 )$2
C C -( -( !( !( !1( !1( 12 12 )$ )$
E E 0 0 -0 -0 !@0 !@0 1) 1) 0$ 0$
If we acce,t B and C 4ased on PI& we canFt acce,t E$ If we acce,t B and C 4ased on PI& we canFt acce,t E$
=hat if we take + and E' 9i3e hi2her total NPV$ =hat if we take + and E' 9i3e hi2her total NPV$
11. PA6)AC8 PERIO+
<ow lon2 will it take to reco3er the initial in3estment' >"he shorter& the 4etter? <ow lon2 will it take to reco3er the initial in3estment' >"he shorter& the 4etter?
Pro4lems Pro4lems
1$ 1$ Eoes not consider the timin2 of C7s >i$e$& i2nore the "VG? Eoes not consider the timin2 of C7s >i$e$& i2nore the "VG?
2$ 2$ Eoes not consider the C7s after the ,a04ack ,eriod$ Eoes not consider the C7s after the ,a04ack ,eriod$
)$ )$ +r4itrar0 standard for ,a04ack ,eriod$ +r4itrar0 standard for ,a04ack ,eriod$
1". +ISCOUNTE+ PA6)AC8 PERIO+
"o correct the Pro4lem 1 mentioned a4o3e$ "o correct the Pro4lem 1 mentioned a4o3e$
Pro4lem Pro4lem
1$ 1$ Eoes not consider the C7s after the ,a04ack ,eriod$ Eoes not consider the C7s after the ,a04ack ,eriod$
Solve all t9e :uestions an; Pro<lems in Te=t <oo> P? 1'6@162!
- E=0eAt 6.$ an; 6.% on P?. 1'6
- Pro<lem 6.15.
:t9e Bourt9 line s9oul; <e C Aro/e0te; to ?roD at 5 Aer0ent Aer Eear Bor 12 Eears after first year.F
)
CHAPTER ,. NP# an; CaAital )u;?etin?
*HAT TO +ISCOUNT
9eneral rules for discountin2 9eneral rules for discountin2
1$ /nl0 C7 is rele3ant 1$ /nl0 C7 is rele3ant
2$ +lwa0s estimate C7 on an incremental 4asis 2$ +lwa0s estimate C7 on an incremental 4asis
1$ Eo not confuse a3era2e with incremental ,a0offs 1$ Eo not confuse a3era2e with incremental ,a0offs
2$ Include all incidental effects and o,,ortunit0 2$ Include all incidental effects and o,,ortunit0
)$ Eo not for2et workin2 ca,ital reHuirements )$ Eo not for2et workin2 ca,ital reHuirements
$ 7or2et sunk costs$ $ 7or2et sunk costs$
($ Be ware of allocated o3erhead costs$ ($ Be ware of allocated o3erhead costs$
)$ Be consistent in the treatment of inflation )$ Be consistent in the treatment of inflation
Remem4er the relationshi, 4etween the nominal and real interest rate$ Remem4er the relationshi, 4etween the nominal and real interest rate$
CAPITAL )U+1ETIN1 PRO)LE&S
Ca,ital Bud2etin2 in3ol3es the anal0sis of costs and 4enefits that are s,read out o3er Ca,ital Bud2etin2 in3ol3es the anal0sis of costs and 4enefits that are s,read out o3er
se3eral time ,eriod$ se3eral time ,eriod$
- "his leads to a reHuirement that "VG 4e considered to e3aluate the alternati3e correctl0$ - "his leads to a reHuirement that "VG 4e considered to e3aluate the alternati3e correctl0$
NC7=(Re3-Cost-Ee,) (1-") ! Ee,$-Chan2e in N=C$ NC7=(Re3-Cost-Ee,) (1-") ! Ee,$-Chan2e in N=C$
NC7=(Re3-Cost) (1-") ! Ee,(") - Chan2e in N=C$ NC7=(Re3-Cost) (1-") ! Ee,(") - Chan2e in N=C$
- "his eHuation hi2hli2hts that fact that the hi2her the de,reciation e5,ense& the lar2er the NC7$ - "his eHuation hi2hli2hts that fact that the hi2her the de,reciation e5,ense& the lar2er the NC7$
"a5 Chield on Ee,$ = Ee,$ (") "a5 Chield on Ee,$ = Ee,$ (")
UNE:UAL ECON&IC LIFE
If we were choosin2 4etween two mutuall0 e5clusi3e ,ro-ects with different economic li3es& an ad-ustment would 4e necessar0$
=e discuss two ,rocedures
- Re,lacement Chain Gethod
- #Hui3alent +nnaul +nnuit0 Gethod >#++?
#++>1? : Consider Costs /nl0
#++>2? : Consider Both Costs and Re3enue

REPLACE&ENT CHAIN &ETHO+

Cu,,ose A< com,an0 is ,lannin2 to moderniIe its ,roduction facilities$ 7ollowin2 are the cash flows for Cu,,ose A< com,an0 is ,lannin2 to moderniIe its ,roduction facilities$ 7ollowin2 are the cash flows for
each machine$ each machine$
6R 6R tJ0 tJ0 tJ1 tJ1 tJ2 tJ2 tJ) tJ) tJ tJ tJ( tJ( tJ@ tJ@ NPVD12% NPVD12%
Pro-ect C Pro-ect C -80 -80 8* 8* 81 81 81) 81) 812 812 811 811 810 810 ' '
Pro-ect 7 Pro-ect 7 -820 -820 8K 8K 81) 81) 812 812 ' '
=hich one 2i3es hi2her NPV' Chould we choose Pro-ect C' =hich one 2i3es hi2her NPV' Chould we choose Pro-ect C'
"o make a ,ro,er com,arison& we could a,,l0 the re,lacement chain method: that is we could find the "o make a ,ro,er com,arison& we could a,,l0 the re,lacement chain method: that is we could find the
NPV of ,ro-ect 7 o3er @-0ear ,eriod and then com,are this with NPV of Pro-ect C o3er the same @ 0ears$ NPV of ,ro-ect 7 o3er @-0ear ,eriod and then com,are this with NPV of Pro-ect C o3er the same @ 0ears$
REPLACE&ENT CHAIN &ETHO+GContinue;H
6R 6R tJ0 tJ0 tJ1 tJ1 tJ2 tJ2 tJ) tJ) tJ tJ tJ( tJ( tJ@ tJ@ NPVD12% NPVD12%
Pro-ect C Pro-ect C -80 -80 8* 8* 81 81 81) 81) 812 812 811 811 810 810 ' '
Pro-ect 7 Pro-ect 7 -820 -820 8K 8K 81) 81) 812 812
-820 -820 8K 8K 81) 81) 812 812
Pro-ect 7J#5t$ Pro-ect 7J#5t$ -$20 -$20 $7 $7 $13 $13 $8 $8 $7 $7 $13 $13 $12 $12 ? ?
Now we can directl0 com,are Pro-ect C with Pro-ect 7J#5t$ Now we can directl0 com,are Pro-ect C with Pro-ect 7J#5t$
=hich one 2i3es 0ou hi2her NPV at 12% interest rate (or cost of ca,ital)' =hich one 2i3es 0ou hi2her NPV at 12% interest rate (or cost of ca,ital)'
+ssum,tion a,,lied here$ +ssum,tion a,,lied here$
1$ "he ,ro-ect 7Fs cost and C7 will not chan2e o3er e5tended ,eriod$ 1$ "he ,ro-ect 7Fs cost and C7 will not chan2e o3er e5tended ,eriod$
2$ "he interest rate (or cost of ca,ital) will remain at 12% 2$ "he interest rate (or cost of ca,ital) will remain at 12%
Pro4lems : +rithmetic is more com,le5 (@ 6r VC$ K 6r life) Pro4lems : +rithmetic is more com,le5 (@ 6r VC$ K 6r life)
(
EAA1! : Consi;er Costs onlE
"his method i2nores "his method i2nores the revenue side the revenue side$ $
G+C<IN# G+C<IN# CJ0 CJ0 CJ1 CJ1 CJ2 CJ2 CJ) CJ) PVD@% PVD@%
+ + 1( 1( ( ( ( ( ( ( 2*$)K 2*$)K
B B 10 10 @ @ @ @ 21$00 21$00
Chould we take machine B& the one with the lower PV$ of cost' Chould we take machine B& the one with the lower PV$ of cost'
1$ Not necessaril0& 4ecause B will ha3e to 4e re,laced a 0ear earlier than +$ 1$ Not necessaril0& 4ecause B will ha3e to 4e re,laced a 0ear earlier than +$
2$ "imin2 of a future in3$ decision is contin2ent on "oda0Fs choice& + or B$ 2$ "imin2 of a future in3$ decision is contin2ent on "oda0Fs choice& + or B$
)$ Co a machine with PV(costs) of 821&000 s,read o3er ) 0ears is not necessaril0 4etter than a )$ Co a machine with PV(costs) of 821&000 s,read o3er ) 0ears is not necessaril0 4etter than a
com,etin2 machine with PV(costs) of 82(&@L0 s,read o3er 0ears$ com,etin2 machine with PV(costs) of 82(&@L0 s,read o3er 0ears$
=e ha3e to con3ert total PV(costs) to a cost =e ha3e to con3ert total PV(costs) to a cost per year per year$ $
CJ0 CJ0 CJ1 CJ1 CJ2 CJ2 CJ) CJ) PVD@% PVD@%
Gachine + Gachine + 1( 1( ( ( ( ( ( ( 2*$)K 2*$)K
#Hui$ +nn$ Cost #Hui$ +nn$ Cost 10.1 10.1 10.1 10.1 10.1 10.1 2*$)K 2*$)K
<ow do we 2et 810$@1' <ow do we 2et 810$@1'
PV=2*$)K PV=2*$)K N=) N=) 7V=0 7V=0 I=@ I=@ PG"=' PG"='
Cimilarl0& 0ou can 2et Cimilarl0& 0ou can 2et
CJ0 CJ0 CJ1 CJ1 CJ2 CJ2 PVD@% PVD@%
Gachine + Gachine + 10 10 @ @ @ @ 21$00 21$00
#Hui$ +nn$ Cost #Hui$ +nn$ Cost 11.!" 11.!" 11.!" 11.!" 21$00 21$00
=e see that Gachine + is 4etter& 4ecause its eHui3alent annual costs is less (810$@1 3s$ 811$( for =e see that Gachine + is 4etter& 4ecause its eHui3alent annual costs is less (810$@1 3s$ 811$( for
Gachine B)$ Gachine B)$
Rule : Celect the machine that has the lowest #Hui3alent +nnual Cost >#+C? Rule : Celect the machine that has the lowest #Hui3alent +nnual Cost >#+C?
@
EAA"! : Consi;er Costs an; Revenue
Consider the Pro-ect C and 7 Consider the Pro-ect C and 7
6R 6R tJ0 tJ0 tJ1 tJ1 tJ2 tJ2 tJ) tJ) tJ tJ tJ( tJ( tJ@ tJ@ NPVD12% NPVD12%
Pro-ect C Pro-ect C -80 -80 8* 8* 81 81 81) 81) 812 812 811 811 810 810 8@$L1 8@$L1
Pro-ect 7 Pro-ect 7 -820 -820 8K 8K 81) 81) 812 812 8($1(( 8($1((
Chould we choose Pro-ect C& which 2i3es the hi2her NPV' Chould we choose Pro-ect C& which 2i3es the hi2her NPV'
If not& how can we e3aluate these two ,ro-ects' If not& how can we e3aluate these two ,ro-ects'
1$ Anlike the #+C case& here we consider cost and re3enue$ 1$ Anlike the #+C case& here we consider cost and re3enue$
2$ =hen com,arin2 ,ro-ects of uneHual li3es& the one with the hi2her eHui3alent annual annuit0 2$ =hen com,arin2 ,ro-ects of uneHual li3es& the one with the hi2her eHui3alent annual annuit0
should 4e chosen$ should 4e chosen$
Procedures Procedures
1$ 7ind each ,ro-ectFs NPV o3er its 1$ 7ind each ,ro-ectFs NPV o3er its initial initial life$ life$
2$ "here is some constant annuit0 cash flow >I$e$& #++? 2$ "here is some constant annuit0 cash flow >I$e$& #++?
- - "o find #++ for ,ro-ect 7& enter N=)& I=12& PV=-(1((& and 7V=0 and sol3e for PG"$ "o find #++ for ,ro-ect 7& enter N=)& I=12& PV=-(1((& and 7V=0 and sol3e for PG"$
- - Cimilarl0 0ou can find #++ for ,ro-ect C$ Cimilarl0 0ou can find #++ for ,ro-ect C$
)$ "he ,ro-ect with the hi2her #++ will alwa0s ha3e the hi2her NPV when e5tended out )$ "he ,ro-ect with the hi2her #++ will alwa0s ha3e the hi2her NPV when e5tended out
to an0 common life$ to an0 common life$
"herefore choose the ,ro-ect with hi2her #++$ >#++ for C=81$(KL& #++ for 7=82$1@? "herefore choose the ,ro-ect with hi2her #++$ >#++ for C=81$(KL& #++ for 7=82$1@?
#++ method is easier to a,,l0& 4ut chain method is easier to understand$ #++ method is easier to a,,l0& 4ut chain method is easier to understand$
Solve t9e BolloDin? :uestions an; Pro<lems in Te=t <oo>
- Pro<lem ,.1 I ,.11 an; ,."2 I ,.""
K