Question

12.  Explain the use of IRR and cash multiples as alternative valuation metrics, and discuss the drawbacks of those methods. In your answer, include how sensitivity analysis affects the evaluation process.

Answer 1

IRR is the Internal Rate of Return. It is a capital budgeting technique that is used when a firm wants to find out whether a project will be a good investment or not. It is calculated by discounting the cash flows and then finding out the rate at which the Net Present Value of the cash flows will be zero. It uses the time value of money concept.

Its drawbacks are:

It does not take into consideration the different time periods of different projects.

Sometimes there are more than one IRR for a project. Thus, creating confusion.

Sometimes the result obtained from NPV and IRR might be conflicting with each other.

Cash multiples is another valuation technique where the comparison between the different values of the company are compared. It helps in understanding the performance of a company and then deciding whether a company is performing good or not. It is a good method to evaluate but the only drawback is that it is based on historical prices which are irrelevant. The values that should be used for evaluation should be of present times and forward looking.

Sensitivity analysis is another technique to evaluate a project. It helpsin understanding the impact of different values of an independent variable on the dependent variable.