Beruflich Dokumente
Kultur Dokumente
do not agree
The Basics of Capital
Budgeting
1
When NPV and IRR do not
agree
If all acceptable investments can be
undertaken by the company, it makes no
difference whether the NPV or IRR
method is used.
However, when all acceptable investments
cannot be undertaken by the company, it
does make a difference which method is
used.
2
Two types of situation (conflict between
IRR and NPV)
Capital Rationing
when total Rupiah investment required by acceptable
projects (positive NPVs) is greater than the amount
management is willing or able to budget fro capital
expenditures.
3
CAPITAL RATIONING
Independent Project Proposal Available
Project Cash Cash NPV IRR Rank Rank
Outlay flows @10% NPV IRR
F 10,000 12,000 908 20% 3 1
J
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30,000 35,400 2,179 17% 1 3
Example
Assume that management has limited the
total capital budget to Rp 30,000
Examination of the IRRs is not very illuminating.
18% return on J is nice, but is it as good as, say,
20% from F, coupled with 17% from I.
Therefore, a much better approach is to
determine the NPV of all possible subsets of
proposals that will use up to the Rp30,000
available.
5
All possible combinations can be grouped:
Acceptable Combined
Project Net Present Value
Combination
F, G, H 2,269
F, I 2,179
G, I 2,088
H, I 1,815
J 2,179
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Why conflict in Rankings Occurs?
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In comparison of Project A and B, note
that project B involves higher investment
outlays and higher net cash inflows that
does A.
Think of Investment B as composite of two
investment: A and B-A, then break B up
into these two components;
8
The result of Splitting-up Investment B;
9
Why conflict in Rankings Occurs?
Project CF -0 CF - 1 CF - 2 CF - 3
10
PV Profiles for Project D and E
Project D
Project E
11
Investments with Unequal
Lives
If a choice must be made between mutually
exclusive investments with unequal lives,
both the NPV and IRR methods can yield an
incorrect selection decision.
14
Thus A actually produces more NPV per year than B
does.
The EAA method gives the same result as the
replacement chain method without having to
determine the number of replacements required for
each.
Two year NPVA = EAAA(PVIFAk%,n)
= 19,989 (1.736) = 34,709
which, except for rounding, is equal to the NPV of
34,650 produced by replacement chain method.
15
Multiple IRR
A further problem with the IRR is that
investment have more than one IRR. This
situation can occur when the cash flows
being evaluated have more than one sign
reversal.
Investment CF-0 CF-1 CF-2
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NPV
0%
12.92%
50.00%
150.00%
225.00%
300.00%
387.08%
400.00%
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