Presentation on theme: "Capital Budgeting Plus some stocks and bonds Review question A bond has a coupon rate of 8%. It sells today at par, that is, for $1000. What is."— Presentation transcript:
Payback defects No market response. When r is high, the satisfactory payback period should be shorter. Subtracts time-t dollars from time-0 dollars, a cardinal sin. Ignores cash flow after payback. Ignores timing during payback.
Defects are not necessarily fatal Repeated, similar investments. Stable financial conditions.
The well-informed capital budgeter knows When to accept payback period as a measure. When it is likely to fail.
Accounting rate of return Doesn’t value cash flows No market response Ignores market values Scaling problems: melons or malls
Merits of accounting r.o.r. Easily understood. Sometimes okay in stable markets. Smart application can overcome defects.
Internal rate of return Definition: IRR is the discount rate that makes NPV = 0 That is, IRR is the r such that
Internal rate of return Definition: IRR is the discount rate that makes NPV(r) = 0. NPV(r) is a function. RWJ Figures 6.4 and 6.5.
IRR is almost the same as bond yield Bond yield is r such that
Applications of IRR measure Hurdle rate = market rate Project acceptance: Accept a project if IRR > hurdle rate. Mutually exclusive projects: Take the one with the highest IRR (> hurdle rate)????? Don’t rely on it.
Project acceptance: NPV and IRR give the same conclusion when... Cash flows have one sign change. In the example: IRR = 23.37% > hurdle = 10% for an investment project. IRR = 23.37% < hurdle rate = 30% for a financing or “borrowing from nature” project.
Merits Uses cash flows. Responds to the market when the hurdle rate changes
Objective Learn to recognize the times when NPV and IRR are the same. and also the problems with IRR
Defects of IRR -- project acceptance Lending to nature or borrowing from her? Multiple IRR's may occur.
Financing (borrowing from nature) Seek IRR < hurdle rate Same as NPV > 0
Descartes’ Rule The number of internal rates of return is no more than the number of sign changes. The number of positive roots of a polynomial with real coefficients is at most equal to the number of sign changes in the coefficients. Interest rates are more than -100%
Defects of IRR -- mutually exclusive projects Ignores market values. Scale problems -- melons or malls.
Typical hour exam question What is the scale problem in using IRR to choose between mutually exclusive projects?
Sketch of answer The smaller dam has the higher IRR. The big dam has higher value. The big dam extends consumption possibility of owners more than the little dam does. It is wrong to take the higher IRR in this case.
Capital Budgeting Jiu Jitsu Consider the project of replacing the little dam by the big dam. Cash flows are -900, +1300. IRR of the project is 4/9 =.4444 >.1 NPV is 281.8181… So replace the little dam. Capital budgeting jiu jitsu.