Discounted Cash Flow Analysis

Question 1

What is one common pitfall in capital budgeting?

Answer 1

A common pitfall in capital budgeting is the tendency to use the company’s current rate of return as the benchmark. This can lead to rejecting projects that should be accepted

Example: A firm’s current rate of return on all projects is 12%. Its shareholders’ opportunity cost of capital is 10%. The company incorrectly rejects a project earning 11%

Question 2

What is one pitfall of using internal rate of return (IRR) in capital budgeting decisions?

Answer 2

IRR used in isolation is seldom the best route to a sound capital budgeting decision

Direction of cash flows - when the direction of the cash flows changes, focusing simply on IRR can be misleading. The cash flow amounts on two different projects could be the same in absolute value, but the directions would differ. In choosing between the two, a decision maker might be tempted to select the project that has a cash inflow earlier and a cash outflow later

This effect is known as the multiple IRR problem. Essentially, there are as many solutions to the IRR formula as there are changes in the direction of the net cash flows

Question 3

What is one pitfall of using internal rate of return (IRR) in capital budgeting decisions?

Answer 3

Mutually exclusive projects - as with changing cash flow directions, focusing only on IRR when capital is limited can lead to unsound decisions

Question 4

What is one pitfall of using internal rate of return (IRR) in capital budgeting decisions?

Answer 4

Varying rates of return - a project’s NPV can easily be determined using different desired rates of return for different periods

The IRR is limited to a single summary rate for the entire project

Question 5

What is one pitfall of using internal rate of return (IRR) in capital budgeting decisions?

Answer 5

Multiple investments - NPV amounts from different projects can be added, but IRR rates cannot

The IRR for the whole is NOT the sum of the IRRs for the parts

Question 6

What does comparing two mutually exclusive projects entail?

Answer 6

Often a decision maker must choose between two mutually exclusive projects, one whose inflows are higher in the early years, but fall off drastically later and one whose inflows are steady throughout the project’s life

1. The higher a firm’s hurdle rate, the more quickly a project must pay off
2. Firms with low hurdle rates prefer a slow and steady payback

Question 7

How can a NPV profile be beneficial to a manager making investment decisions?

Answer 7

A graphical representation of the two projects at various discount rates helps to illustrate the factors a decision maker must consider in such a decision (x-axis: Discount rate %; y-axis: NPV in $)

The NPV profile can be of great practical use to managers trying to make investment decisions. It gives the manager a clear insight into the following questions:

1. How sensitive is a project’s profitability to changes in the discount rate?
2. At what discount rates is an investment project still a profitable opportunity?

Question 8

What are factors that must be considered when comparing net present value (NPV) and internal rate of return (IRR)?

(Comparing NPV and IRR)

Answer 8

The reinvestment rate becomes critical when choosing between the NPV and IRR methods. NPV assumes the cash flows from the investment can be reinvested at the project’s discount rate, that is, the desired rate of return

The NPV and IRR methods give the same accept/reject decision if projects are INDEPENDENT

Independent projects have unrelated cash flows. Hence, all acceptable independent projects can be undertaken

Question 9

How does the net present value (NPV) and internal rate of return (IRR) rate assess projects that are mutually exclusive?

(Comparing NPV and IRR)

Answer 9

If projects are mutually exclusive, NPV and IRR methods may rank them differently if:

1. The cost of one project is greater than the cost of another
2. The timing, amounts and directions of cash flows differ among projects
3. The projects have different useful lives
4. The cost of capital or desired rate of return varies over the life of a project. The NPV can easily be determined using different desired rates of return for different periods. The IRR determines one rate for the project
5. Multiple investments are involved in a project. NPV amounts are addable, but IRR rates are not. The IRR for the whole is NOT the sum of the IRRs for the parts

Question 10

What is the difference in the assumed reinvestment rate of cash flows between the internal rate of return (IRR) and net present value (NPV) method?

(Comparing NPV and IRR)

Answer 10

The IRR method assumes that the cash flows will be reinvested at the internal rate of return

If the project’s funds are NOT reinvested at the IRR, the ranking calculations obtained may be in error

The NPV method gives a better grasp of the problem in many decision situations because the reinvestment is assumed to be in the desired rate of return

Question 11

How would a decision maker decide on an investment decision if the net present value (NPV) and internal rate of return (IRR) method ranked the projects differently?

(Comparing NPV and IRR)

Answer 11

NPV and IRR are the soundest investment rules from a shareholder wealth maximization perspective. In some cases, NPV and IRR will rank projects differently

If one of two or more mutually exclusive projects is accepted, the other s must be rejected

Example: The decision to build a shopping mall on a piece of land eliminates placing an office building on the same land

When choosing between mutually exclusive projects, the ranking differences between NPV and IRR become very important

Overall, the manager concerned with shareholder wealth maximization should choose the project with the greatest NPV (not the largest IRR). IRR is a percentage measure of wealth, but NPV is an absolute measure. Shareholder well-being is also measured in absolute amounts