NPV & IRR Javier Estrada IESE Business School Barcelona - - PDF document

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Corporate Finance

Project Evaluation

Javier Estrada Spring, 2014

• 1. Tools
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Shortcomings of the IRR
• 2. Further Analysis
• Sensitivity analysis
• One or more discount rates?

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

NPV & IRR

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

IRR – Shortcomings

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

IRR – Shortcomings

• The IRR is plausible, intuitive, and widely used but …

Multiple IRRs No IRR

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

IRR – Shortcomings

• Which of these risk‐free options would you prefer?
• You give me $1 today, I give you back $2 next week
• You give me $1m today, I give you back $1.9m next week

Scale Problem

• Executive takeaway
• The IRR is plausible, intuitive, useful, and widely

used, but tricky

• Therefore, when discussing a project’s IRR …

 think whether there will be negative CFs along the way  if you are considering competing projects, keep the scale problem in mind

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

Sensitivity Analysis

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

The Discount Rate – One or More?

• Which discount rate (DR) should be used?
• The company‐wide DR?
• Or a narrower DR?
• The DR for the relevant division or country
• In theory, each project should have its own DR
• If not, overinvestment in ‘risky’ projects and

underinvestment in ‘conservative’ projects

• BUT, the narrower the DR, the more difficult and

inaccurate is its estimation

• Then the relevant question becomes: Are the projects,

divisions, or countries ‘substantially’ different?

 If not, then use the same, company‐wide DR  If yes, then estimate different DRs for different divisions

• r countries

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

The Discount Rate – One or More?

• Which DR should be used?
• A constant DR over time?
• A time‐varying DR?
• The DR expected for each period
• In theory, each period should have its own DR,

but …

• time‐varying DRs …
• complicate the NPV calculation substantially
• render the IRR approach useless
• can you really foresee every and each period’s DR?
• remember, a constant DR simply means that we get

the average DR right

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

The Discount Rate – One or More?

Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

The Discount Rate – One or More?

Taken from Best Practice EVA by Bennett Stewart, 2013

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Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

The Discount Rate – One or More?

Taken from Best Practice EVA by Bennett Stewart, 2013 Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014

The Discount Rate – One or More?

Adapted from “Best Practices in Estimating the Cost of Capital: An Update” by Todd Brotherson, Kenneth Eades, Robert Harris, and Robert Higgins. Journal of Applied Corporate Finance, 2013.