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Level I CFA: Capital Budgeting-Lecture 4 - YouTube
Channel: IFT
[6]
ranking conflicts between
[8]
npv and irr the point here is that
[12]
occasionally
[13]
the npv rule will give you one result
[17]
and the irr rule will tell you to do
[19]
something
[20]
else whenever there is a conflict you
[23]
need to go
[24]
with the higher npv project but let us
[27]
look at this material in more detail if
[30]
you have a particular
[31]
project with conventional cash flows and
[34]
if you recall conventional cash flow
[36]
means that there is only
[38]
one change in sign then there will be no
[41]
conflict between npv and irr
[44]
in other words if the npv rule says that
[47]
go for the project
[48]
the irr rule will always say the same
[51]
thing
[53]
if you have two projects which are
[56]
independent
[58]
and they have conventional cash flows
[61]
then again there will be no conflict
[64]
between the
[64]
npv and irr decision rules
[68]
we have a possible issue if we have two
[71]
projects which
[72]
are mutually exclusive
[75]
and this can happen even with
[78]
conventional
[79]
cash flows it is possible that there
[82]
that we can have a conflict between the
[85]
npv
[86]
and irr rules and the conflicts can
[89]
arise because of two possible reasons
[91]
one there is a difference between the
[94]
cash flow patterns
[95]
and two there is a difference in the
[99]
scale let's look at these items in more
[101]
detail
[103]
ranking conflict due to differing cash
[106]
flow
[107]
patterns consider two projects here
[110]
x and y for project
[113]
x we have a fairly stable cash flow over
[117]
a four year period whereas for project
[121]
y we have the money
[124]
coming up at the end so clearly the cash
[128]
flow pattern
[129]
is different what i want you to do
[133]
is come up with the npv
[137]
and irr for project x and then the npv
[140]
and irr for project y for
[143]
npv assume a discount rate of 10 percent
[147]
and then you need to decide which
[149]
project to select
[151]
based on each route and
[154]
just to take this to completion also
[157]
show the npv profile for both projects
[162]
here is what you should come up with
[165]
based on the
[166]
npv rule it clearly makes sense to
[169]
select
[170]
project y because project y has a
[174]
higher npv but based on the irr rule
[179]
it makes sense to select project
[182]
x because x has a higher irr
[186]
and again when there is a conflict the
[189]
npv rule is what you go with
[193]
hopefully you recognized that we had
[195]
done the same
[196]
example before when you come up with the
[200]
npv profile you will notice that there
[202]
is a
[204]
crossover point and i will not do that
[207]
here in detail because this has been
[209]
covered on a earlier slide
[213]
ranking conflict due to differing
[215]
project scale
[217]
now we are looking at projects c and d
[220]
notice that project d is four times
[223]
bigger than
[224]
project c and here again i want you to
[227]
come up
[228]
with the npv and irr numbers
[231]
for both projects and i want you to come
[234]
up with the
[235]
npv profile
[238]
here is what you should come up with and
[241]
notice again that
[243]
there is a conflict between the npv
[246]
and irr decision rules npv says
[249]
go with project d irr says
[253]
go with project c when there is a
[256]
conflict
[257]
you go with the npv role
[260]
and here is what the npv profile looks
[263]
like for both
[264]
the projects now i want you to do
[268]
this example
[272]
notice this is the same set of projects
[275]
that we saw
[275]
on the previous slide so here is the
[279]
npv profile for project d here is the
[281]
npv
[282]
profile for project c we are effectively
[286]
being asked
[287]
about the crossover point because that's
[289]
the point where both projects have the
[292]
same irr so at what rate
[295]
do we have a crossover you can look
[299]
at the two npv profiles and it should be
[302]
fairly obvious
[304]
based on looking at these two profiles
[307]
that the crossover point is somewhere
[309]
between 10 percent and 25
[313]
so the correct answer is
[316]
b
[319]
the multiple irr problem and no
[322]
irr problem
[325]
when you have non-conventional cash
[328]
flows such as
[329]
the numbers shown over here we where we
[332]
have more than one
[333]
change in sign then it is possible that
[337]
a project has either multiple irrs or
[341]
there is no irr what i want you to do
[345]
now
[345]
is come up with the npv profile for both
[348]
these scenarios
[353]
here is roughly what you should come up
[355]
with for the first project notice that
[358]
initially the
[359]
npv is negative it will
[362]
rise and notice also that we have two
[365]
intercepts on the x-axis
[368]
so this project really has two
[372]
irrs this issue is called the
[376]
multiple irr problem with the second
[379]
project
[380]
we do not have a intercept on the x-axis
[384]
and this is the no irr
[388]
problem we can only have this issue
[391]
when we have non-conventional cash flows
[394]
now that does not mean that we have
[396]
these problems for
[397]
all non-conventional cash flows it only
[400]
happens for
[401]
some non-conventional cash flows
[406]
here now is a quick comparison between
[409]
irr and npv
[413]
with npv the advantages are as follows
[417]
npv is a direct measure of the expected
[420]
increase
[420]
in the value of a firm and theoretically
[424]
this
[425]
is the best approach as i have said
[427]
several times whenever there is a
[429]
conflict
[429]
you go with what npv says
[433]
the disadvantage is that the npv does
[436]
not
[437]
consider the project size and i go back
[440]
to an example which i gave earlier
[442]
where project a has an investment of 1
[445]
million
[446]
and a npv of 0.1 million
[450]
project b has an investment of 1
[453]
billion and the npv
[456]
is 0.1 million if a and b
[459]
are mutually exclusive then based on the
[463]
higher npv we would pick project b
[467]
but just looking at these two numbers
[469]
does not tell us anything about the
[473]
the size of the project
[476]
with irr we get a sense
[479]
for the return on each dollar invested
[482]
or in other words if we know that the
[485]
irr on a project is 10
[487]
we know that roughly we are getting a
[490]
return of
[491]
10 the irr method allows us to compare
[495]
the return with the
[496]
required rate if the required rate is 5
[500]
and the irr is 10 then this looks
[503]
very good we can say that the project is
[506]
fairly profitable on the other hand if
[509]
the required rate of return is 9.5
[511]
percent
[512]
and the irr is 10 then we know that this
[516]
project is only
[517]
marginally profitable
[520]
disadvantages and here is a big one from
[522]
a testability
[524]
perspective irr incorrectly assumes
[527]
that the money that is generated during
[530]
the project
[530]
is reinvested at the irr
[534]
rate in other words if we have a project
[537]
where the
[537]
required rate is 5
[541]
and the irr is
[544]
10 then any cash flows generated
[548]
according to the irr calculation are
[551]
assumed
[551]
to be reinvested at 10 percent
[555]
the theoretically correct assumption
[557]
however and one that is used by the npv
[560]
method
[560]
is that intermediate cash flows are
[562]
reinvested
[563]
at the required rate and it
[567]
is because of this that we have issues
[570]
such as conflicts between what npv says
[574]
and what
[574]
irr says and that's the next point over
[578]
here
[578]
that an issue with irr is that at times
[582]
it might
[582]
conflict with npv the other
[586]
issue with irr that we just talked about
[588]
is that we might
[590]
have at times multiple irrs or no
[593]
irrs but this will only happen if we
[597]
have non-conventional cash flows
[600]
coming now to corporate usage of capital
[603]
budgeting
[604]
methods the various capital budgeting
[607]
methods that we've talked about such as
[609]
npv irr the payback method
[612]
are all used at corporations but
[615]
analysts and corporate managers should
[618]
understand the
[619]
logic and the practicalities associated
[622]
with the different methods that we've
[624]
talked about if a corporate manager
[626]
is engaging in a project and the manager
[629]
is focused on shareholder value and
[631]
stock
[632]
price then the method that links most
[634]
closely with
[635]
the stock price is net present value and
[638]
we'll discuss this in more detail on the
[640]
next slide
[641]
if a manager is concerned with the
[643]
return that
[644]
might be expected from a given project
[646]
then the irr
[647]
method makes sense if the manager is
[651]
concerned with
[651]
how long it will take to recoup an
[654]
initial investment
[655]
then the payback method is appropriate
[658]
having said that a combination of these
[661]
methods can be used because
[663]
they give different perspectives
[666]
typically in finance
[667]
textbooks the npr method and irr
[671]
are promoted and that's because these
[674]
make sense
[674]
from a theoretical perspective having
[677]
said that
[678]
the payback method is quite popular in
[680]
different parts of the world
[682]
and in smaller private companies where
[685]
the level of management sophistication
[687]
is relatively low
[688]
in such environments the payback method
[691]
is used
[691]
quite frequently relationship between
[696]
npv
[696]
and stock price npv is a direct measure
[699]
of the expected
[700]
change in a firm's value from
[703]
undertaking a capital project
[706]
npv is the criteria most related to
[710]
stock prices a positive npv project
[713]
should cause
[714]
a proportionate increase in a company's
[717]
stock value these concepts
[720]
are illustrated through an example
[724]
let's say a company is undertaking a
[726]
project
[727]
with a expected npv of 500 million
[731]
the company has 100 million shares
[733]
outstanding and each
[735]
share has a price of 50 what is the
[738]
likely
[739]
impact of the project on the stock price
[743]
if the project has a npv of 500 million
[746]
that means
[748]
that by doing this project the overall
[750]
value of the firm
[752]
will go up by 500 million
[757]
since there are a hundred million shares
[760]
then on a per share basis the increase
[764]
is going to be 500 million divided by
[766]
100 million
[767]
which is equal to five and that means
[770]
that if the share price
[772]
is 50 before doing this project
[775]
then by doing this project the value can
[778]
go up by
[779]
five so from 50 the share price is
[782]
likely to go up
[783]
to 55. this is a extremely
[787]
simplistic example but the point is to
[790]
illustrate the fact that
[792]
positive npv projects have a direct
[795]
impact on share price
[799]
that brings us to the end of the reading
[801]
a summary of the main points
[803]
you need to understand the capital
[806]
budgeting process
[807]
we discussed this briefly at the start
[810]
where we
[811]
need to come up with ideas identify
[813]
projects
[814]
select the profitable projects and then
[817]
consider the strategy
[818]
of our company to identify the
[820]
particular projects that make sense
[823]
you need to be on top of npv calculation
[826]
and npv rule which essentially says that
[829]
you select positive npv projects
[832]
if you are selecting between projects
[834]
i.e you have mutually exclusive
[836]
projects then you select the project
[839]
with the highest
[840]
npv as long as the npv is positive
[843]
you need to know the irr calculation and
[846]
actually when i say calculation over
[848]
here
[848]
you need to know the concepts behind the
[851]
calculation
[852]
but you need to be able to do the work
[854]
on a calculator
[856]
make sure you are an expert at using the
[858]
calculator
[860]
the irr is that return which makes the
[863]
npv of a project equal to zero
[866]
irr rule is that you select projects
[869]
with the highest
[870]
irr as long as the irr is greater than
[873]
the
[874]
required return we talked about several
[877]
issues with
[878]
irr when you have mutually exclusive
[882]
projects then there are times where the
[885]
irr
[886]
and the npv rule will give you different
[889]
answers that can happen because of
[891]
differences in scale
[893]
or differences in the cash flow patterns
[896]
whenever there is a conflict you go with
[899]
what
[899]
the npv rule says we also have the issue
[903]
of multiple irrs and the issue of
[907]
no irrs where there are non-conventional
[911]
cash flows as a subtle point
[914]
you need to recognize that the conflicts
[916]
between irr and npv arise
[919]
because irr incorrectly assumes that any
[922]
intermediate cash flows are reinvested
[925]
at the irr rate
[926]
the theoretically correct assumption is
[928]
that intermediate cash flows are
[931]
invested
[932]
or reinvested at the required rate
[935]
you need to be comfortable with the npv
[937]
profile
[938]
recognizing that the y-axis intercept
[941]
is the undiscounted cash flows or it is
[944]
based on the undiscounted cash flows
[947]
and the x-axis intercept is the irr
[952]
do the summary as always review the
[955]
learning objectives do the examples
[959]
the examples in this reading are short
[961]
and
[962]
quite helpful practice problems are good
[966]
make sure you do them very carefully and
[968]
as i keep saying
[969]
practice questions from other sources as
[971]
well
[972]
that is it
[982]
you
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