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Budgeting (FM-II)
April 7, 2016
Introduction 1
Introduction 2
But we did not probe whether the choice of NPV versus IRR
(as decision rule/criterion) depends on
Firm characteristics, or
Project settings (e.g., size, life, risk, etc.)
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Introduction 3
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Capital Rationing 1
Capital Rationing 2
That the projects will create value (on the top of the firms
own perceived indecisiveness about its own estimation of
NPV)
3) Market Efficiency: Markets may remain (excessively)
optimistic (over-valued) or (extremely) pessimistic (undervalued) for a considerable period of time
That is, markets are not efficient since value is not equal
to price at all the times
Managers know the value better than anybody else
credibility of communication (or information asymmetry) is
another issue
When markets are undervalued (in times of recession, as in
2012/13 in India), stock prices continue to be depressed
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Capital Rationing 3
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Capital Rationing 4
4) Floatation Costs:
Direct (fees to investment bankers, bankers, legal experts, costs
of complaince, distribution costs, etc.) and
Indirect (under-pricing or selling at market price below true
value for IPOs & FPOs, negative announcement effect for FPOs)
We know that conflict may arise (between NPV rule & IRR
rule) in all situations except for
YES-NO decision (firm has only one investment opportunity),
AND
Conventional project
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While a smaller rate (of COC than IRR in either case) at the
denominator makes NPV larger, the IRR is not dependent on
the COC
The result is: while NPV tends to favour larger projects, IRR is
invariant to scale and COC
So long as both have positive NPV and IRR>COC(of A &/or B)
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of
Timing of cash flows may also be responsible for the NPVIRR conflict
It appears from Ex-2A that IRR does a better job in taking
into account the timing of cash flows
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This is how:
If the firm has easy access to capital markets, and/or if the
extent of information asymmetry faced by the firm is low,
Leading to the difference in cost of external and internal finance
low,
It can select both projects
Since both yield positive NPV as well as high IRR (above cost
of capital even beyond WACC of 19.35%)
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Note: Another version defines the PI ratio as PV of all CFinflows to PV of all CF-outflows during the life of the
project
The resulting ranking will be the same by PI as defined before
See Example 3A
There are several limitations of the PI-based Ranking
A.i) It concentrates on the current period only but capital
rationing constraint is usually spread over more than one
period
Projects chosen this year (using PI) may limit the firms ability
to investment in more profitable future projects
See Example-4
Many believe that MIRR is a mix of the NPV and IRR rules
Not without reason
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Maximize
X
j 1
NPV j
X
j 1
INV j ,1 1,000
X
j 1
X
j 1
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INV j , 2 1,200
INV j ,3 1,400
Project Dependence
Even in the absence of CR, selection of one project may
lead to rejection of another
For example, an information technology product to do a
particular job, or product distribution service
See Examlpe-5.
Problem arises when two mutually exclusive projects have
unequal lives
Projects with Unequal Lives
Consider a 5-year and a 10-year project
The 5-year project may be replicated for another 5 years
And now the 10-year project can be compared with
replicated two 5-year projects
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r
Equivalent _ Annuity NPV *
n
1 1 r
Where
r: project discount rate
n: project lifetime
See Example-6.
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What are options? What are financial options? What are real
options? How are they (financial and real options) different?
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Readings
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