Week 6 - Internal Rate of Return (IRR) and Payback Periods
IRR - Reasons
* Business people prefer rates of return. * IRR uses discounted cash flow methods.
The Payback Period - Disadvantages
* Does not use discounted cash flows. * Short-term focus. * Does not consider cash flows after the payback period. * Target payback periods are determined arbitrarily.
The Payback Period - Advantages
* Easy to calculate. * Uses cash flows. * Easy to interpret and apply decision rule. * Considers liquidity risk.
IRR - Problems
* Inconsistent with NPV rankings. * No adjustment for size differences. * Unconventional cash flow - unusable results.
IRR & NPV - Agree
* Independent projects. * Conventional cash flows.
The Payback Period - Needs
* Initial cost. * Future net cash flows. * Cut-off.
IRR & NPV - Disagree
* Mutually exclusive projects. * Unconventional cash flows.
The Payback Period - Decision Rules
* Payback period <= cut-off - accept. * Payback period > cut-off - reject.
IRR - Decision Rules - Multiple Projects
* Rank by IRR * Select highest first.
IRR - Purpose
* Rate of return. * Higher or lower.
IRR & NPV - Similarities
* Sophisticated. * Discounted net cash flows. * Decision rules.
IRR - Advantages
1. Easy to understand. 2. Discounted cash flow technique.
IRR - Disadvantages
1. Unusable with non-conventional cash flows. 2. Lower IRR better if inflow than outflow. 3. Mutually exclusive project - incorrect investment decision.
Unconventional Cash Flows - Definition
Cash flows change signs infrequently.
IRR - Decision Rules - Individual Projects
Compare IRR with required rate of return (k). * IRR > k - accept. * IRR < k - reject.
IRR - Definition
Discount rate that makes NPV zero.
IRR & NPV - Differences
IRR: * No adjustment for project size. * Cash inflows reinvested at IRR. NPV: * Cash inflows reinvested at cost of capital.
Conventional Cash Flows - Definition
Initial cash outflow followed by more cash inflows.
IRR - Approximating - Annuity
Need: * Initial cash flow. * Single - PVF. * Annuity - PVA. * Time period.
The Payback Period - Mixed Stream - Formula
PB = Full years until cost recover + (Remaining cost to recover / Cash flow during the year)
The Payback Period - Annuity - Formula
PB = Initial investment / Annual cash flow
IRR - Formula
PV(project's future cash flows) = PV(cost of the project)
Cut-Off - Definition
The longest acceptable payback period.
The Payback Period - Definition
The time required for a project to pay back its initial investment.