Exam 3 essays
Under what circumstances will the IRR and NPV rules lead to the same accept-reject decisions? When might they conflict?
Using the IRR and NPV rules will always yield the same decision as long as two conditions are met: the project or investment’s cash flows are conventional and the project or investment is independent. If the initial cash flow is negative and all the subsequent cash flows are positive, the cash flows are said to be conventional. If at any point any of the 2nd or later cash flows are negative, meaning we have a cash outflow, the IRR will provide multiple rates of return which can make the decision of whether or not to choose a particular investment very difficult since the required rate must be within a specified range instead of just needing to be above the IRR. There do exist ways of calculating a modified IRR or MIRR, that attempt to take cash outflows into perspective to standardize the resulting IRR making it more useful by providing one number instead of multiple. The Discounting Approach discounts all negative cash flows back to the present while the Reinvestment Approach compounds all cash flows to the end of the project. The third type of MIRR, the combined approach, mixes the Discounting and Reinvestment approach to come up with another MIRR. These methods usually provide three different required rates which can further convolute the decision making process with potential projects.
Also, when comparing two mutually exclusive, or dependent investments, the IRR is not helpful in deciding which one is best. When only one of the possible projects can be done, projects are said to be mutually exclusive. In these cases, we must use the NPV to decide which project is the best investment: the one with the highest NPV. If one or both conditions are not met, it is not feasible to use the IRR to determine whether a project will be profitable and one should take the NPV of the project into account.
What is capital rationing? What types are
Using the IRR and NPV rules will always yield the same decision as long as two conditions are met: the project or investment’s cash flows are conventional and the project or investment is independent. If the initial cash flow is negative and all the subsequent cash flows are positive, the cash flows are said to be conventional. If at any point any of the 2nd or later cash flows are negative, meaning we have a cash outflow, the IRR will provide multiple rates of return which can make the decision of whether or not to choose a particular investment very difficult since the required rate must be within a specified range instead of just needing to be above the IRR. There do exist ways of calculating a modified IRR or MIRR, that attempt to take cash outflows into perspective to standardize the resulting IRR making it more useful by providing one number instead of multiple. The Discounting Approach discounts all negative cash flows back to the present while the Reinvestment Approach compounds all cash flows to the end of the project. The third type of MIRR, the combined approach, mixes the Discounting and Reinvestment approach to come up with another MIRR. These methods usually provide three different required rates which can further convolute the decision making process with potential projects.
Also, when comparing two mutually exclusive, or dependent investments, the IRR is not helpful in deciding which one is best. When only one of the possible projects can be done, projects are said to be mutually exclusive. In these cases, we must use the NPV to decide which project is the best investment: the one with the highest NPV. If one or both conditions are not met, it is not feasible to use the IRR to determine whether a project will be profitable and one should take the NPV of the project into account.
What is capital rationing? What types are