When is the irr rule unreliable

The Dilemma at Day-Pro

Comparison of Capital Budgeting Techniques

The Day-Pro Chemical Company, established in 1995, has managed to earn

a consistently high rate of return on its investments. The secret of its success has

been the strategic and timely development, manufacturing, and marketing of

innovative chemical products that have been used in various industries. Currently,

the management of the company is considering the manufacture of a thermosetting

resin as packaging material for electronic products. The Company’s Research and

Development teams have come up with two alternatives: an epoxy resin, which

would have a lower startup cost, and a synthetic resin, which would cost more to

produce initially but would have greater economies of scale. At the initial

presentation, the project leaders of both teams presented their cash flow projections

and provided sufficient documentation in support of their proposals. However,

since the products are mutually exclusive, the firm can only fund one proposal.

In order to resolve this dilemma, Tim Palmer, the Assistant Treasurer and a

recent MBA from Drexel University, has been assigned the task of analyzing the

costs and benefits of the two proposals and presenting his findings to the board of

directors. Tim knows that this will be an uphill task, since the board members are

not all on the same page when it comes to financial concepts. The Board has

historically had a strong preference for using rates of return as its decision criteria.

On occasions it has also used the payback period approach to decide between

competing projects. However, Tim is convinced that the net present value (NPV)

method is least flawed and when used correctly will always add the most value to a

company’s wealth.

After obtaining the cash flow projections for each project (see Tables 1 & 2),

and crunching out the numbers, Tim realizes that the hill is going to be steeper than

he thought. The various capital budgeting techniques, when applied to the two

series of cash flows, provide inconsistent results. The project with the higher NPV

has a longer payback period as well as a lower Accounting Rate of Return (ARR)

and Internal Rate of Return (IRR). Tim scratches his head, wondering how he can

convince the Board that the IRR, ARR and Payback Period can often lead to

incorrect decisions.

Table 1. Synthetic Resin Cash Flows

Synthetic Resin

Year 0 1 2 3 4 5

Net Income

$150,000

$200,000

$300,000

$450,000

$500,000

Depreciation

$200,000

$200,000

$200,000

$200,000

$200,000

Net Cash Flow $(1,000,000)

$350,000

$400,000

$500,000

$650,000

$700,000

Table 2. Epoxy Resin Cash Flows

Epoxy Resin

Year 0 1 2 3 4 5

Net Income

$440,000

$240,000

$140,000 $ 40,000 $ 40,000

Depreciation

$160,000

$160,000

$160,000

$160,000

$160,000

Net Cash Flow $(800,000)

$600,000

$400,000

$300,000

$200,000

$200,000

Questions:

1. Calculate the Payback Period of each project. Explain what arguments Tim

should make to show that the Payback is not appropriate in this case.

2. Calculate the Discounted Payback Period (DPP) using 10% as the discount

rate (required rate of return). How is the DPP an improvement over the

regular Payback Period? Should Tim ask the Board to use the DPP as the

deciding factor? Explain.

3. The Accounting Rate of Return (ARR), also called the Book Rate of Return,

is calculated as the project’s average net income divided by average book

value over the project’s economic life. When choosing among mutually

exclusive alternatives, the ARR rule would pick the project with the highest

ARR among projects exceeding the hurdle rate. If management sets a hurdle

for the accounting rate of return of 40% accounting rate of return, which

project would be accepted? What is wrong with the ARR and this decision?

4. Calculate the IRR for each project. Tim wants to convince the Board that the

IRR measure can be misleading when choosing between mutually exclusive

alternatives. Why is the IRR decision rule unreliable in making the correct

choice between the two projects? Tim’s presentation should inform the

board on the different reinvestment assumptions underlying IRR and NPV

and how that relates to the reliability of the IRR decision rule.

5. An NPV profile graphs the relationship between a projects’s NPV and the

discount rate (see Figure 5.6 in Chapter 5). The NPV profiles of mutually

exclusive projects highlight the possible conflict in the decisions made by

NPV and IRR and the importance of the crossover point. Construct the NPV

profiles for the two projects. Identify the IRR for both projects on the graph

and explain the relevance of the crossover point. At the cost of capital,

which projects would the NPV and IRR decision rules accept? Tim wants to

point out to the board that NPV is an absolute measure of the monetary

impact of a project on shareholder value and IRR is a relative value that

evaluates the project’s return per dollar invested. What argument can Tim

advance to convince the Board that the NPV decisions are always consistent

with maximizing shareholder value?

6. Given the problem of the IRR rule in evaluating mutually exclusive projects,

an Incremental Internal Rate of Return is used as an alternative. Which

project would the Incremental IRR accept? Although not a problem here,

there could be cases in which there are multiple IRRs. In such a case, the

IRR method would be inoperable as there would be no unique IRR. When

would this be the case?

7. Calculate the Profitability Index for each proposal. How does the

Profitability Index relate to NPV? Do the synthetic resin and epoxy resin

projects significantly differ in scale? Can the Profitability Index rule be

applied here? Explain?

8. In looking over the documentation prepared by the two project teams, it

appears to you that the synthetic resin team has been somewhat more

conservative in its revenue projections than the epoxy resin team. What

impact might this have on the Payback Period, NPV, and IRR calculations

for the synthetic resin project? How does this complicate comparing the

synthetic resin and epoxy resin projects? Is being conservative in revenue

projections a good practice? What adjustments might be made?

9. In looking over the documentation prepared by the two project teams, it

appears to you that the synthetic resin technology would require extensive

development before it could be implemented whereas the epoxy resin

technology is available “off-the-shelf.” What impact might this have on your

analysis?