Question

Discussion

1. Assume the market suddenly becomes more risk averse (think coronavirus, civil unrest, political unrest, etc.). What would be the effect on required rates of return and why? In turn, what would be the effect on NPV for the above projects? Explain.
2. How would a change in the required rate of return affect the project’s internal rate of return (IRR)? Explain. Would the accept/reject decision change using the IRR analysis method? Explain.
3. What are the reinvestment rate assumptions for NPV vs. IRR?

Answer 1

Answer a) If Market suddenly becomes more risk averse due to pandemic situation like coronavirus, Civil unrest, political unrest, etc.

1) The required rate of return for a given level of risk should be compensated. The market is so much volatile obviously investors will look for an investment to invest in company which gives safety to invested capital but investors will compromise & less importance about expectation about required rate of return.

2) During the above situations market exist so volatile hence investors prefers to invest in safety securities with the less return.

The above situations will definitely effect on NPV of projects

1) During the above situations prices will go up the project cost may tend go up. Hence cash outflows would go higher. when cost would go higher NPV either negative or lesser.

2) During the above situations the project cost would escalate due to shutdown pandemic situation.

3) Cash inflows are not sychronising with cash outflows

Over all NPV of the project either lesser or negative NPV due to escalation in cost.

Answer b)

The internal rate of return (IRR) rule is a guideline for deciding whether to proceed with a project or investment. The rule states that a project should be pursued if the internal rate of return is greater than the minimum required rate of return. That is, the project looks profitable.

On the other hand, if the IRR is lower than the cost of capital, the rule declares that the best course of action is to forego the project or investment.

Decision Rules for IRR

If the IRR of a project is greater than or equal to the project's cost of capital, accept the project. However, if the IRR is less than the project's cost of capital, reject the project. The rationale is that you never want to take on a project for your company that returns less money than you can pay to borrow money, that is, the company's cost of capital.

Just as with net present value, you have to consider whether you are looking at an independent or mutually exclusive project. For independent projects, if the IRR is greater than the cost of capital, then you accept as many projects as your budget allows. For mutually exclusive projects, if the IRR is greater than the cost of capital, you accept the project. If it is less than the cost of capital, then you reject the project.

Answer c) : The IRR is always expressed as a percentage. For a project to be acceptable under the IRR method, the discount rate must exceed the project’s cost of capital, otherwise known as the hurdle rate. An IRR less than the hurdle rate represents a cost to shareholders, while an IRR greater than the hurdle rate represents a return on investment, increasing shareholder wealth.

We must first analyze the reinvestment rate assumptions for each evaluation method. The NPV method assumes that cash flows will be reinvested near or at the project’s current cost of capital, while the IRR method assumes that the firm can reinvest cash flows at the project’s IRR. The assumption that the firm will reinvest its cash flows at the current cost of capital is more realistic than the assumption that cash flows can be reinvested at the projects IRR. This is because the IRR may not reflect the true rate at which cash flows can be reinvested. To correct this problem, a modified IRR (MIRR) is used that incorporates the cost of capital as the reinvestment rate; however, the NPV method still has the advantage when compared to the MIRR method (an example is when IRR and MIRR methods return conflicting results under certain project conditions).

The NPV and IRR methods will return conflicting results when mutually exclusive projects differ in size, or differences exist in the timing of cash flows. When mutually exclusive projects exhibit these attributes, their NPV profiles will cross when plotted on a graph. This point at which they cross is defined as the crossover rate, which happens because one project’s NPV is more sensitive to the discount rate caused by the differences in the timing of cash flows. In most cases, utilizing either the NPV or IRR method will lead to the same accept-or-reject decision. An exception exists when evaluating mutually exclusive projects with crossing NPV profiles and the cost of capital is less than the crossover rate. When these conditions are present, the NPV and IRR results will conflict in which project to accept or reject. Because the NPV method uses a reinvestment rate close to its current cost of capital, the reinvestment assumptions of the NPV method are more realistic than those associated with the IRR method.

NPV also has an advantage over IRR when a project has non-normal cash flows. Non-normal cash flows exist if there is a large cash outflow during or at the end of the project. The presence of non-normal cash flows will lead to multiple IRRs. Hence, the IRR method cannot be employed in the evaluation process. Mathematically, this problem will not occur if the NPV method is employed. The NPV method will always lead to a singular correct accept-or-reject decision.

In conclusion, NPV is a better method for evaluating mutually exclusive projects than the IRR method.   The NPV method employs more realistic reinvestment rate assumptions, is a better indicator of profitability and shareholder wealth, and mathematically will return the correct accept-or-reject decision regardless of whether the project experiences non-normal cash flows or if differences in project size or timing of cash flows exist.