You are a financial analyst for Damon Electronics Company. The director of capit

Question

You are a financial analyst for Damon Electronics Company. The director of capital budgeting has asked you to analyze two proposed capital investments, Projects X and Y. Each project has a cost of $10,000, and the required rate of return for each project is 12 percent. The projects

Explanation / Answer

Using a financial calculator, we can determine the IRR for Projects X and Y as follow: Since the firm’s cost of capital is 12%, you should recommend Project X (because ) and not Project Y (because ). The relationship between NPV and IRR (the NPV profile) Based on our previous discussion, we know that there is a relationship between the NPV and IRR techniques. From the above equations, we know that when the internal rate of return (IRR) is identical to the firm’s cost of capital (r), the firm will break even, i.e. the project does not bring any value to the firm (NPV = 0). The IRR of a project is where the NPV profile intersects the x-axis (i.e. when the NPV = 0). From the graph below, we know that the project will bring a positive value to the firm (i.e. NPV > 0) if the cost of capital is below the IRR, it will bring a negative value (i.e. NPV < 0) if the cost of capital is above the IRR. Problems with the IRR technique Compare to the NPV technique, the IRR technique has 2 complications: (1) The IRR can only be computed with the help of a financial calculator or a computer for projects with uneven cash flows. However, this is not a major problem because most firms have that equipment readily available. (2) The examples we have discussed so far are normal projects, i.e. projects that generate only positive cash flows. There are nonnormal projects that have a mixture of positive and negative cash flows during the projects’ lifetime. As a result, it is possible to have more than solution for the IRR, i.e. multiple IRR. In this case, which one will be the right one? In situation like this, it is best for the firm to use the NPV technique. The multiple IRR problem affects both independent and mutually exclusive projects. What are independent and mutually exclusive projects? (i) An independent project is a project whose acceptance or rejection is not affected by the acceptance or rejection of other projects. For example, suppose Jewel is deciding whether it should have a store in Elmhurst and Lombard. In this case, the acceptance or rejection of the store in Elmhurst should have no impact on the acceptance or rejection of the store in Lombard. (ii) Mutually exclusive projects are projects that cannot coexist. In other words, the acceptance of one project will lead to the rejection of other projects. For example, a real estate company is deciding whether it should build a grocery store or a cinema theater on the corner of Fifth and Broadway. In this case, if the real estate company chooses to build the grocery store, it cannot build the cinema theater. 2. Conflicts between NPV and IRR rules We will now look at some of the problems that are associated with mutually exclusive projects. There are two major types of problems: (i) scale problem, and (ii) timing problem. We will show that these problems will lead to a conflict in recommendation for the NPV and IRR techniques. (i) Scale problem A firm will encounter this problem when it is comparing projects with very different cash flow sizes throughout the lifetime of the projects. It is easier to illustrate this problem with an example

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