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.