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When NPV and IRR

do not agree
The Basics of Capital
Budgeting

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When NPV and IRR do not
agree
 If all acceptable investments can be
undertaken by the company, it makes no
difference whether the NPV or IRR
method is used.
 However, when all acceptable investments
cannot be undertaken by the company, it
does make a difference which method is
used.

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Two types of situation (conflict between
IRR and NPV)

 Mutually exclusive investment


 When the acceptance of one investment will
automatically imply rejection of another investment

 Capital Rationing
 when total Rupiah investment required by acceptable
projects (positive NPVs) is greater than the amount
management is willing or able to budget fro capital
expenditures.

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CAPITAL RATIONING
Independent Project Proposal Available
Project Cash Cash NPV IRR Rank Rank
Outlay flows @10% NPV IRR
F 10,000 12,000 908 20% 3 1

G 10,000 11,900 817 19% 4 2

H 10,000 11,600 544 16% 5 5

I 20,000 23,400 1,271 17% 2 4

J
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30,000 35,400 2,179 17% 1 3
Example
 Assume that management has limited the
total capital budget to Rp 30,000
 Examination of the IRRs is not very illuminating.
 18% return on J is nice, but is it as good as, say,
20% from F, coupled with 17% from I.
 Therefore, a much better approach is to
determine the NPV of all possible subsets of
proposals that will use up to the Rp30,000
available.

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All possible combinations can be grouped:

Acceptable Combined
Project Net Present Value
Combination
F, G, H 2,269
F, I 2,179
G, I 2,088
H, I 1,815
J 2,179
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Why conflict in Rankings Occurs?

1. Size Disparity Problem :


Consider the following projects

Projec Cash Cash NPV IRR Rank Rank


t Outlay flows NPV IRR
A 10,000 11,500 454 15% 2 1

B 22,000 24,860 598 13% 1 2

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 In comparison of Project A and B, note
that project B involves higher investment
outlays and higher net cash inflows that
does A.
 Think of Investment B as composite of two
investment: A and B-A, then break B up
into these two components;

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 The result of Splitting-up Investment B;

Investment Outlays Cash Flow IRR NPV


BA (10,000) 11,500 15.0% 454
BB-A (12,000) 13,360 11.3% 144
B (22,000) 24,860 13.3% 598

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Why conflict in Rankings Occurs?

2. Reinvestment Rate Problem :


The conflict arise simply due to a wide disparity
in the pattern of cashflows. Consider the
following projects

Project CF -0 CF - 1 CF - 2 CF - 3

D (10,000) 4,200 4,200 4,200

E (10,000) 7,000 4,000 1,000

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PV Profiles for Project D and E

Project D
Project E

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Investments with Unequal
Lives
 If a choice must be made between mutually
exclusive investments with unequal lives,
both the NPV and IRR methods can yield an
incorrect selection decision.

Investment CF-0 CF-1 CF-2 NPV@10%

A -1,000 130,000 0 18,170


B -1,000 70,000 70,000 21,520

Please note that based on NPV, B should be preferred, but A produces


more cash flows which can be reinvested to generate more PV in year 2.
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Replacement Chain Method
 Using this method, Investment A should be
converted to a two one-year investments.
Thus at the end of year one, it is assumed
that another investment A is undertaken.
Investment CF-0 CF-1 CF-2 NPV@10%

First A -100,000 130,000 0

Second A -100,000 130,000

Net CF -100,000 30,000 130,000 34,650

Now, Investment A, with replacement, can be compared with investment


B on NPV basis since they are both two-year investment 13
Equivalent Annual Annuity
(EAA) Method
 The EAA method distributes each
investment’s NPV over the number of years
needed to obtain it
 It is done by converting the investment’s NPV
into an annuity.
Invetsment NPV PVIFAk%,n EAA
A 18,170 0.909 19,989
B 21,520 1.736 12,396

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 Thus A actually produces more NPV per year than B
does.
 The EAA method gives the same result as the
replacement chain method without having to
determine the number of replacements required for
each.
Two year NPVA = EAAA(PVIFAk%,n)
= 19,989 (1.736) = 34,709
which, except for rounding, is equal to the NPV of
34,650 produced by replacement chain method.
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Multiple IRR
 A further problem with the IRR is that
investment have more than one IRR. This
situation can occur when the cash flows
being evaluated have more than one sign
reversal.
Investment CF-0 CF-1 CF-2

C -100,000 600,000 550,000

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NPV

0%
12.92%
50.00%
150.00%
225.00%
300.00%
387.08%
400.00%

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