Chapter 5 - Comparison Methods Part 2

Question 1

What is the Internal Rate of Return?

Answer 1

Interest rate (i*) such that when all cash flows of the project are discounted at i*, the PW of cash inflows equals PW of cash outflows.

Interest rate at which a project breaks even.

PW(disbursements) = PW(receipts)

AW=AW

FW=FW

Question 2

For an independent project, when should a project be invested in? (regarding it’s IRR)

Answer 2

A project should be invest in if it has an IRR equal to or greater than the MARR.

Question 3

Why doesn’t IRR calculations alone work with Mutually Exclusive projects?

Answer 3

It does not take into consideraton magnitude. It overlooks projects where IRR > MARR.

Question 4

How do we compare Mutually Exclusive alternatives? (3 steps)

Answer 4

1. Sort projects from lowest first cost to the highest. The lowest first cost is now the current best option.
2. Challenge the current best with the next most expensive project. If the challenger is successful (ie. if the incremental investment has an IRR >= MARR) then make the challenger the current best.
3. Repeat step 2 until there are no further challengers.

Question 5

What is a rule of thumb for determining if there will be multiple IRRs?

Answer 5

Usually if there are 2+ sign changes, there will be multiple IRRs.

(usually its - - - - + + + + vs + + - - - - + + +)

Question 6

What is the External Rate of Return (ERR)?

Answer 6

The ERR, denoted by i_e*, is the rate of return where any “excess” cash earns interest at an explicit rate – usually the MARR.

Question 7

How do you compute an approximate ERR? (4 steps)

Answer 7

1. Take all net receipts forward at the MARR to the time of the last cash flow.
2. Take all net disbursements forward at the unknown rate i_ea* (approximate ERR) to the time of the last cash flow.
3. Set FW(receipts) = FW (disbursements) and solve for i_ea*
4. The value for i_ea* is the aproximate ERR for the project.

Question 8

When do you use the ERR method?

Answer 8

Whenever multiple IRRs are possible.

Question 9

What is a Simple Investment?

Answer 9

Characterized by one or more periods of cash outflows, followed by one or more periods of cash inflows.

Question 10

A comparison of Rate of Return and PW/AW methods leads to which three important conclusions?

Answer 10

1. The two sets of methods, when properly used, give the same conclusion.
2. Each set of methods has its own advantages and disadvantages.
3. If an independant project has a unique IRR, the IRR method and the PW method give the same decision.

Question 11

Name an important advantage of using the IRR.

Answer 11

It facilitates comparisons of projects of different sizes.

Question 12

What is an important disadvantage to the PW and AW methods of comparison?

Answer 12

It is difficult to compare projects of different sizes.

Question 13

What are some disadvantages to the Payback Period method?

Answer 13

1. It discriminates against long term projects (by ignoring benefits after the break even point)
2. Ignores the time value of money (interest assume 0)
3. Ignores the expected service life