Ranking conflicts between NPV and IRR. The point
here is that occasionally the NPV rule will give
you one result and the IRR rule will tell you to do
something else. Whenever there is a conflict you
need to go with the higher NPV project. But let us
look at this material in more detail. If you have
a particular project with conventional cash flows
and if you recall conventional cash flow means that
there is only one change in sign then there would
be no conflict between NPV and IRR. In other words
if the NPV rule says that go for the project, the IRR
rule will always say the same thing. If you have two
projects which are independent and they have conventional
cash flows then again, there will be no conflict between
the NPV and IRR decision rules. We have a possible
issue if we have two projects which are mutually
exclusive. And this can happen even with conventional
cash flows. It is possible that there... that we can
have a conflict between the NPV and IRR rules and the conflicts
can arise because of two possible reasons. One: there
is a difference between the cash flow patterns and
two: there is a difference in the scale. Let's look at
these items in more detail. Ranking conflict due to
differing cash flow patterns. Consider two projects here,
X and Y. For project X, we have a fairly stable cash
flow over a four-year period whereas for project Y we have
the money coming up at the end. So clearly the cash
flow pattern is different. What I want you to do is
come up with the NPV and IRR for project X and then
the NPV and IRR for project Y. For NPV assume a discount
rate of 10% and then you need to decide which project
to select based on each rule and just to take this
to completion also show the NPV profile for both
projects. Here is what you should come up with. Based
on the NPV rule, it clearly makes sense to select
project Y because project Y has a higher NPV,
but based on the IRR rule it makes sense to select project
X because X has a higher, IRR and again when there
is a conflict the NPV rule is what you go with. Hopefully
you recognized that we had done the same example
before. When you come up with the NPV profile you
will notice that there is a crossover point and I
will not do that to you in detail because this has
been covered on an earlier slide. Ranking conflict
due to different project scale. Now we're looking
at projects C and D. Notice that project D is 4 times
bigger than project C and here again I want you to come
up with the NPV and IRR numbers for both projects
and I want you to come up with the NPV profile. Here
is what you should come up with and notice again that there
is a conflict between the NPV and IRR decision rules.
NPV says go with project D, IRR C's go with project
C. When there is a conflict you go with the NPV rule
and here is what the NPV profile looks like for both
the projects. Now, I want you to do this example. Notice
this is the same set of projects that we saw on the
previous slide. So here is the NPV profile for project D.
Here is the NPV profile for project C. We are effectively
being asked about the crossover point because that's
the point where both projects have the same IRR.
So at what rate do we have a crossover? You can look
at the two NPV profiles and it should be fairly obvious
based on looking at these two profiles that the crossover
point is somewhere between 10% and 25%. So the correct
answer is B. The multiple IRR problem and no IRR problem.
When you have non-conventional cash flows, such
as the numbers shown over here, where we have more
than one change in sign then it is possible that
a project has either multiple IRRs or there is no IRR.
What I want you to do now is come up with the NPV profile
for both these scenarios. Here is roughly what you
should come up with. For the first project notice
that initially the NPV is negative. It will rise
and notice also that we have two intercepts on the x-axis.
So this project really has two IRRs. This issue is called
the multiple IRR problem. With the second project
we do not have an intercept on the x-axis and this is the
no IRR problem. We can only have this issue when we have
non-conventional cash flows. Now that does not
mean that we have these problems for all non-conventional
cash flows. It only happens for some non conventional
cash flows. Here now is a quick comparison between
IRR and NPV. With NPV the advantages are as follows.
NPV is a direct measure of the expected increase in the
value of a firm. And theoretically, this is the best
approach. As I have said several times whenever there
is a conflict you go with what NPV says. The disadvantages
that the NPV does not consider the project size
and I go back to an example which I gave earlier, where
project A has an investment of 1 million and an NPV
of 0.1 million. Project B has an investment of 1 billion
and the NPV is 0.1 million. If A and B are mutually
exclusive then based on the higher NPV we would
pick project B but just looking at these two numbers
does not tell us anything about the size of the
project. With IRR we get a sense for the return on each
dollar invested or in other words, if we know that
the IRR on a project is 10% we know that roughly we
are getting a return of 10%. The IRR method allows
us to compare the return with the required rate. If
the required rate is 5% and the IRR 10% then this looks
very good. We can say that the project is fairly profitable.
On the other hand, if the required rate of return is
9.5% and the IRR is 10% then we know that this project
is only marginally profitable. Disadvantages,
and here is a big one from a testability perspective,
IRR incorrectly assumes that the money that is generated
during the project is reinvested at the IRR rate.
In other words, if we have a project where the required rate is 5%
and the IRR is 10% then any cash flows generated according
to the IRR calculation are assumed to be reinvested
at 10%. The theoretically correct assumption, however,
and one that is used by the NPV method is that intermediate
cash flows are reinvested at the required rate and
it is because of this that we have issues such as conflicts
between what iNPV says and what IRR says. And that's
the next point over here that an issue with IRR is
that at times it might conflict with NPV. The other
issue with IRR that we just talked about is that we
might have at times multiple IRRs or no IRRs, but this
will only happen if we have non-conventional cash
flows. Coming now to corporate usage of capital budgeting
methods. The various capital budgeting methods
that we've talked about such as NPV, IRR, the payback
method are all used at corporations, but analysts
and corporate managers should understand the logic
and the practicalities associated with the different
methods that we've talked about. If a corporate manager
is engaging in a project and the manager is focused
on shareholder value and stock price then the method
that links most closely with the stock price is
net present value and we'll discuss this in more detail
on the next slide. If a manager is concerned with
the return that might be expected from a given project
then the IRR method makes sense. If the manager is
concerned with how long it will take to recoup an
initial investment then the payback method is appropriate.
Having said that, a combination of these methods
can be used because they give different perspectives.
Typically in finance textbooks, the NPV method and IRR promoted and that's
because these make sense from a theoretical perspective.
Having said that the payback method is quite popular
in different parts of the world and in smaller private
companies, where the level of management sophistication
is relatively low, in such environments the payback
method is used quite frequently. Relationship
between NPV and stock price. NPV is a direct measure of
the expected change in a firm's value from undertaking
a capital project. NPV is the criterion most related
to stock prices. A positive NPV project should
cause a proportionate increase in a company's stock
value. These concepts are illustrated through
an example. Let's say a company is undertaking a project with
an expected NPV of 500 million. The company has a hundred
million shares outstanding and each share has a
price of $50. What is the likely impact of the project
on the stock price? If the project has an NPV of 500
million that means that by doing this project the
overall value of the firm will go up by 500 million.
Since there are a hundred million shares then on
a per-share basis the increase is going to be 500
million divided by 100 million which is equal to
5 and that means that if the share price is 50 before
doing this project then by doing this project the
value can go up by 5. So from 50, the share price is
likely to go up to 55. This is an extremely simplistic
example, but the point is to illustrate the fact
that positive NPV projects have a direct impact
on share price. That brings us to the end of the reading.
A summary of the main points: You need to understand
the capital budgeting process. We discussed this
briefly at the start where we need to come up with
ideas, identify projects, select the profitable projects,
and then consider the strategy of our company to identify
the particular projects that make sense. You need
to be on top of NPV calculation and NPV rule which
essentially says that you select positive NPV projects.
If you are selecting between projects, i.e. you have
mutually exclusive projects, then you select the
project with the highest NTV as long as the NPV is
positive. You need to know the IRR calculation and
actually when I say calculation over here, you need
to know the concept behind the calculation, but
you need to be able to do the work on a calculator.
Make sure you are an expert at using the calculator.
The IRR is that return which makes the NPV of a project equal
to zero, IRR rule is that you select projects with
the highest IRR as long as the IRR is greater than
the required return. We talked about several issues
with IRR. When you have mutually exclusive projects
then there are times where the IRR and the NPV rule will
give you different answers that can happen because
of differences in scale or differences in the cash
flow patterns. Whenever there is a conflict you go
with what the NPV rule says. We also have the issue
of multiple IRRs and the issue of no IRRs where there
are non-conventional cash flows. As a subtle point
you need to recognize that the conflicts between
IRR and NPV arise because IRR incorrectly assumes
that any intermediate cash flows are reinvested
at the IRR rate. The theoretically correct assumption
is that intermediate cash flows are invested or
reinvested at the required rate. You need to be comfortable
with the NPV profile recognizing that the y-axis
intercept is the undiscounted cash flows or it is
based on the undiscounted cash flows and the
x-axis intercept is the IRR. Do the summary as always,
review the learning objectives, do the examples,
the examples in this reading are short and quite helpful.
Practice problems are good. Make sure you do them
very carefully and as I keep saying practice questions
from other sources as well. That is it.