Topic 2 - special situations in capital budgeting

Question 1

According to the Descartes “Rule of signs”

Answer 1

there could be (maximum) as many positive solutions as the number of changes in the sign of the coefficients (cash flows)

If there is two changes in sign, there can be up to two positive IRRs

Question 2

We classify projects as

Answer 2

• Simple: only one negative cash flow at the beginning
• Non-simple: more than one negative cash-flow

In simple, IRR is always consistent, in non-simple - consistent or not

Question 3

When is the IRR consistent?

(try using no formula)

Answer 3

When there is only one change in sign, the IRR is consistent (maximum one positive IRR)

Question 4

Advantages of using the MIRR

Answer 4

• easy to compute
• less optimistic than the IRR (investment rates are more realistic)
• gives a unique valid answer

Question 5

Investments with unequal lives

Can you use the NPV?

Answer 5

No, because you cannot compare the absolute number from two projects when the number of discounted added cash flows is different.

Solution: Compute the NPV for both projects and then compute a constant annual cash flow that would lead to the creation of the same present value.

Project with lowest annual equivalent cost should be chosen