# Term Paper: Capital Budgeting

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[. . .]
IRR method is easy and understandable, yet it does not have the drawbacks of the ARR and the payback period, both of which do not take into account the time value of money. Most of the time, the IRR method will provide a correct recommendation and the IRR will be greater than the opportunity cost of capital when the NPV is positive, and vice versa. (Ross)

Problems

Still, the IRR has its own problems. It tends to give unrealistic rates of return. If the cutoff rate is fifteen percent and the IRR is calculated as thirty percent, an analyst should avoid accepting the project because its IRR is thirty percent, because an IRR of thirty percent assumes that a firm has the opportunity to reinvest future cash flows at thirty percent. If past experience and the economy indicate that thirty percent is an unrealistic rate for future reinvestments, the IRR is suspicious. Therefore, unless the calculated IRR is a reasonable rate for reinvestment of future cash flows, it should not be used as a key factor to accept or reject a project. (Brealey)

The IRR technique may also give different rates of return. If two discount rates that make the present value equal to the initial investment are present, this can create additional problems.

If an analyst compares two projects using the NPV and IRR methods, he/she will often get different results. The use of the IRR always leads to the selection of the same project, whereas project selection using the NPV method depends on the discount rate chosen. (Ross)

For instance, Project One and Project Two both call for initial investments of $2,500. Project One will provide annual cash flows of $100 for the next 10 years. Project Two has annual cash flows of $100, $200, $300, $400, $500, $600, $700, $800, $900, and $1,000 in the same period. The analyst finds that the IRR of Project One is 17% and the IRR of Project Two is around 13%.

However, if the NPV method is used, the analyst's decision will change depending on the discount rate used. At a 5% discount rate, Project Two has a higher NPV than Project One does. But at a discount rate of 8%, Project One is preferred because of a higher NPV.

The disadvantages of using the NPV technique are that it requires an estimate of the cost of capital in order to calculate the net present value and it is often expressed in terms of dollars, not as a percentage.

Reliable Tools

Both techniques can be reliable tools in capital budgeting. If projects are compared using the NPV, a discount rate that fairly reflects the risk of each project must be chosen. There is no problem if two projects are discounted at two different rates because one project is riskier than the other. The result of the NPV is as reliable as the discount rate that is chosen. If the discount rate is unrealistic, the decision to accept or reject the project is baseless and unreliable.

If the IRR technique is used, the project must not be accepted only because its IRR is very high. Analysts must assess whether such a high IRR is possible to maintain. The analyst should look into past records, and existing and future business, to see whether an opportunity to reinvest cash flows at such a high IRR really exists. If the firm is convinced that such an IRR is realistic, the project is acceptable. Otherwise, the project must be reevaluated by the NPV method, using a more realistic discount rate.

The Modified IRR (MIRR) is similar to the IRR, but is an improved method, as it overcomes three weaknesses of the IRR: lending vs. borrowing, multiple IRRs, and timing differences. This technique assumes that project cash inflows are reinvested or discounted at the opportunity cost of capital. It keeps the desirable characteristics of the IRR technique but fixes its shortcomings, making it a preferred method over both the NPV and IRR methods.

Bibliography

Bodie, Z., and R. Merton (1998) Finance, Upper Saddle River, N.J.: Prentice Hall.

Brealey, R. And S. Myers (1996) Principles of Corporate Finance, 5th ed., New York: Irwin McGraw-Hill.…
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