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

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? NPV & IRR Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014 1

IRR – Shortcomings Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014 IRR – Shortcomings  The IRR is plausible, intuitive, and widely used but … Javier Estrada IESE Business School Barcelona Spain Multiple IRRs MBA CorpFin No IRR Spring, 2014 2

IRR – Shortcomings  Which of these risk‐free options would you prefer? Javier Estrada  You give me $1 today, I give you back $2 next week IESE Business  You give me $1m today, I give you back $1.9m next week School Barcelona Spain 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 MBA CorpFin problem in mind Spring, 2014 Sensitivity Analysis Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014 3

The Discount Rate – One or More?  Which discount rate (DR) should be used? Javier Estrada  The company ‐ wide DR? IESE Business  Or a narrower DR? School • The DR for the relevant division or country Barcelona Spain  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 MBA CorpFin or countries Spring, 2014 The Discount Rate – One or More?  Which DR should be used? Javier Estrada  A constant DR over time? IESE Business  A time ‐ varying DR? School • The DR expected for each period Barcelona Spain  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 MBA CorpFin Spring, 2014 4

The Discount Rate – One or More? Javier Estrada IESE Business School Barcelona Spain MBA CorpFin Spring, 2014 The Discount Rate – One or More? Javier Estrada IESE Business School Barcelona Spain Taken from Best Practice EVA by Bennett Stewart, 2013 MBA CorpFin Spring, 2014 5

The Discount Rate – One or More? Javier Estrada IESE Business School Barcelona Spain Taken from Best Practice EVA by Bennett Stewart, 2013 MBA CorpFin Spring, 2014 The Discount Rate – One or More? Javier Estrada IESE Business School Barcelona Spain 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. MBA CorpFin Spring, 2014 6