Why IRR Is Popular
Managers like the IRR method, since they consider it important to know the differential between the proposed investment’s IRR and the required return. This is a measure of safety that allows an evaluation of the investment’s return compared to its risk. If an investment has an IRR of 0.30 when the required return is 0.12, this is a large margin that allows for error. An NPV measure does not give the same type of information to management.
A Decision in Mexico
A major Mexican steel corporation had a major decision. It could stand relatively pat (a marginal investment of $50,000,000) with its present steel making facilities and earn indefinitely (after maintenance capital expenditures) $8,000,000 per year. This is an IRR of 0.16. The pesos have been translated to dollars.
The alternative is to invest $10,000,000,000 and earn $1,500,000,000 per year indefinitely, an IRR of 0.15.
What should the corporation do if it has a cost of capital of 0.10 for steel making facilities?
The solution is:
NPV (stand pat) = 8,000,000 ÷ 0.10 – 50,000,000 = 80,000,000 – 50,000,000 = $30,000,000
NPV (major investment) = 1,500,000,000 ÷ 0.10 – 10,000,000,000 = 15,000,000,000 – 10,000,000,000 = $5,000,000,000
IRR says stand pat (0.16 is larger than 0.15). NPV says rebuild ($5 billion is larger than $30 million).
An effective understanding of present value concepts is of great assistance in the understanding of a wide range of areas of business decision making. The concepts are especially important in managerial decision making, since many decisions made today affect the firm’s cash flows over future time periods.
It should be stressed that I have only discussed how to take the timing of the cash flows into consideration. Risk and tax considerations must still be explained before the real-world decision maker has a tool that can be effectively applied. In addition, there may be qualitative factors that management wants to consider before accepting or rejecting an investment.
It is sometimes stated that refinements in capital budgeting techniques are a waste of effort because the basic information being used is so unreliable. It is claimed that the estimates of cash proceeds are only guesses and that to use anything except the simplest capital budget procedures is as futile as using complicated formulas or observations of past market levels to determine which way the stock market is going to move next. For example, in 1974 K. Larry Hastie published his classic paper, “One Businessman’s View of Capital Budgeting.” His position is that firms should avoid excessively complex measurement techniques. He states: “Investment decision making could be improved significantly if the emphasis were placed on asking the appropriate strategic questions and providing better assumptions rather than on increasing the sophistication of measurement techniques” (1974, p. 36).
It is true that in many situations reliable estimates of cash proceeds are difficult to make. Fortunately, there are a large number of investment decisions in which cash proceeds can be predicted with a fair degree of certainty. But even with an accurate, reliable estimate of cash proceeds, the wrong decision is frequently made because incorrect methods are used in evaluating this information.
While it is not possible to make a single estimate of cash proceeds that is certain to occur, it does not follow that incorrect methods of analysis are justified. When all the calculations are completed, judgmental insights may be included in the analysis to decide whether to accept or reject a project.
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