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Capital Budgeting
Reinvestment rates are an embodied assumption in the NPV, IRR and MIRR methods because in each of those methods, the cost of capital for the company is typically used as the discount rate. The cost of capital for the company is going to be comprised of the different elements of the capital structure, but in each of those the reinvestment rate is a key factor. It is assumed that the cost of capital is the reinvestment rate under each of these methods, and this assumption introduces the potential for error.
The assumed reinvestment rate of MIRR is the cost of capital, but this is problematic for a couple of reasons. The first is that this does not take into account project-specific risk (Damodar, n.d.). Each project has its own risk. Thus, the reinvestment rate should not necessarily be the same rate that is used in an NPV, IRR or MIRR calculation. The reality is that the reinvestment rate of return could be quite different. The firm's cost of capital could change over time, or the project might vary substantially from the normal business that the firm conducts, and therefore have a significantly different risk characteristic.
The second reason why...
Once the capital is returned from the project, any reinvestment that is done would be subject to its own NPV, IRR, or MIRR calculation. Reinvestment should not be considered incremental to the project at hand, unless the funds are to be reinvested directly back into that project.
The assumed return under IRR, which is the IRR rate, is also problematic. NPV assumes return at the NPV rate. The problems are the same as above, however, in that there can be a discrepancy between this rate and the actual rate at which money is returned, and that discrepancy can skew a project's value when performing these calculations.
3. NPV is regarded as the most theoretically sound technique for a couple of reasons. The base calculation of NPV and IRR is the same one, the difference being that IRR is a percentage return, and NPV is the dollar value. The point at which the IRR becomes higher than the discount rate is also the point at which the NPV becomes positive. However, NPV takes into account the dollar value of the transaction. This is more robust because a company typically has…
References
"Chapter 10: Capital budgeting -- why it matters" (2014) Norwich University. In possession of the author.
Damodar, A. (no date) The components of risk. NYU Stern School of Business. Retrieved Jul 12, 2016 from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/invfables/riskcomponents.htm
NPV profiles for Franchises L. and S. At what discount rate do the profiles cross? NPV Due to the way that the revenues vary, they actually cross at a couple different points. Look at your NPV profile graph without referring to the actual NPVs and IRRs. Which franchise or franchises should be accepted if they are independent? Mutually exclusive? Explain. Are your answers correct at any cost of capital less than 23.6%? NPV IRR What
"MIRR: A better measure." Business Horizons. 51(4), 321-329. Cited in: http://econpapers.repec.org/article/eeebushor/v_3a51_3ay_3a2008_3ai_3a4_3ap_3a321-329.htm McClure, B. (n.d.). "Taking Stock of Discounted Cash Flow." Investopedia. Cited in: http://www.investopedia.com/articles/03/011403.asp?partner=answers "Modified Internal Rate of Return." (2009). Cited in: http://www.thinkanddone.com/finance/mirr.html Parrino, R, & D. Kidwell. (2009). Fundamentals of Corporate Finance. (Vol. 1, Ed.). Wiley Custom Solutions. Smart, S. And WL. Megginson. (2008). Corporate Finance. Thompson Learning. Sullivan, A. And S. Sheffrin. (2003). Economics: Principles in Action. Prentice-Hall. The IRR is the rate of return that makes the
1 0.107 0.107 1.788005 4.37% 7.24% D 20 Lev 1.2925 0.120475 0.11038 1.653411 4.05% 7.22% D 50 Lev 1.87 0.1609 0.16045 -0.1731 -0.44% 7.05% 5. The only project that is unacceptable is Project D. At the 50% leverage level. This has a negative NPV. The other projects at each leverage level all have positive net present values. The following graph shows the NPVs for the different projects: 6. My objective in making this decision is to maximize firm value. The projects are mutually exclusive. I would use NPV as the main
Capital Budgeting is a vital part of any business. Investment decisions, which need time to mature, must be based on the returns that they will make. If investment in a project is unprofitable in the long run, it would be unwise to invest in it. However, if the investment will be profitable, it is important to determine this early in the game. Because huge sums of money can be lost if
Approximately 19% of the short-term liabilities in the form of notes payable and other short-term debt. The long-term liabilities consist of long-term debt and other miscellaneous liabilities. The debt portion of this represents approximately 39% of the total long-term liabilities. Johnson & Johnson has issued notes onto the market that mature in 2017, comprising the bulk of the long-term debt. The calculate the market value capital structure of JNJ, we need
For company B, the risks associated with cash flows are higher than that for company A, and are in the order of 11%, but nevertheless, the IRR on the cash flows is higher than the minimum required rate of return of 11% making this investment also attractive. As these two projects are mutually exclusive, and considering only IRR investment selection criteria, purchase of company B. with IRR of 14,305%