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MODULE REVISION

Independent Versus Mutually Exclusive Investment Projects

that stands alone and can be undertaken

without influencing the acceptance or

rejection of any other project.

project from being accepted.

2

Evaluating Independent Investment Opportunities

method of evaluation (obviously).

• If the NPV method is used, the decision rule is as

follows:

• Decision rule: If NPV is positive, accept the

project. Otherwise, reject it.

• If the Profitability Index (PI) is used:

• Decision rule: If PI > 1, accept the project.

Otherwise, reject it.

3

Evaluating Mutually Exclusive Investment Opportunities

best project or set of projects from the set of

positive NPV investment opportunities.

• These are considered mutually exclusive

opportunities as the firm cannot undertake all

positive NPV projects.

4

Evaluating Mutually Exclusive Investment Opportunities (cont.)

faced with mutually exclusive projects:

1.Substitutes – Where firm is trying to pick

between alternatives that perform the same

function. For example, a new machinery for

the new project. While there might be many

good machines, the firm needs only one.

5

Evaluating Mutually Exclusive Investment Opportunities (cont.)

2. Firm Constraints –

Firm may face constraints such as limited

managerial time or limited financial capital

that may limit its ability to invest in all the

positive NPV opportunities.

6

Choosing Between Mutually Exclusive Investments

lives, we will calculate the NPVs and choose

the one with the higher NPV.

2. If mutually exclusive investments do not have

equal lives, we must calculate the Equivalent

Annual Cost (EAC), the cost per year. We will

then select the one that has a lower EAC.

7

Net Present Value

• Net present value (NPV) is the excess of the present value

(PV) of cash inflows generated by the project over the

amount of the initial outlay (IO):

the so-called cost of capital (or minimum required rate of

return) as the discount rate.

Decision rule: If NPV is positive, accept the project. Otherwise, reject it.

10

Q2:- NPV Calculation

You have been asked to consider the viability of the

following project

Estimated life 10 years

Annual cash inflows $3,000

Cost of capital

(minimum required rate of return) 12%

What are the advantages of this method?

Internal Rate of Return (IRR)

interest that equates the initial capital outlay (IO)

with the PV of future cash inflows.

IO = PV

or

NPV = 0

the cost of capital. Otherwise, reject it.

Internal Rate of Return (IRR)

Advantages

The advantage of using the IRR method is that it

does consider the time value of money

Disadvantages

The shortcomings of this method are:

• it is time-consuming to compute, especially when the cash inflows are

not even, although most business calculators and spreadsheet software

have a program to calculate IRR

• it fails to recognize the varying sizes of investment in competing

projects and their respective dollar profitabilities.

• it sometimes generate multiple IRRs

Advantages and Disadvantages of the NPV and IRR Methods

Advantages:

With the NPV method, the advantage is that it is a direct

measure of the dollar contribution to the stockholders.

With the IRR method, the advantage is that it shows the

return on the original money invested.

Disadvantages:

With the NPV method, the disadvantage is that the project

size is not measured.

With the IRR method, the disadvantage is that, at times, it

can give you conflicting answers when compared to NPV for

mutually exclusive projects. The 'multiple IRR problem' can

also be an issue, as discussed below.

Multiple Internal Rate of Return (IRR)

have one or more periods of cash

outflows (inflows) with periods of cash

inflows (outflows), there may be

multiple internal rates of return.

Q3: Multiple Internal Rate of Return (IRR)

Time 0 1 2

Cash flow -$60,000 155,000 -100,000

(a) 25%

(b) 33.33%.

Profitability Index PI

Profitability Index (Benefit/Cost Ratio)

cash inflows to the initial investment, that is, PV/I. This

index is used as a means of ranking projects in descending

order of attractiveness. If the profitability index is greater

than 1, then accept the project.

then accept the project.

Q4: Index PI

You have been asked to consider the viability of the

following project using the PI method.

Estimated life 10 years

Annual cash inflows $3,000

Cost of capital

(minimum required rate of return) 12%

What are the advantages of this method?

THE MODIFIED INTERNAL RATE OF RETURN (MIRR)

When the IRR and NPV methods produce a contradictory ranking for

mutual exclusive projects, the modified IRR, or MIRR, overcomes

the disadvantage of IRR

I = PV of terminal (future) value compounded at the cost of capital

The MIRR forces cash flow reinvestment at the cost of capital rather

than the project’s own IRR, which was the problem with the IRR.

differing sizes. NPV should again be used in such a case.

More Questions

Q5: THE MODIFIED INTERNAL RATE OF RETURN (MIRR)

returns of $400, $500, and $300 at the end of years one, two and

three respectively. The company’s cost of capital is 10%.

Q6: THE MODIFIED INTERNAL RATE OF RETURN (MIRR)

undertaking a $47,800 project that is expected to have an after-tax

cash flow of $14,200 for two years, $10,200 for the next two years,

and $8,300 for the fifth year? If the discount rate were 8% what

would your advice to the UWI be?

Q6: THE MODIFIED INTERNAL RATE OF RETURN (MIRR)

yield of one of its portfolios. The project promises the cash flows

shown below.

0 ($80,000)

1 ($65,000)

2 $45,000

3 $65,000

4 $110,000

the risk-free rate 3%, Calculate the MIRR.

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