Introduction to Corporate Finance

9: Capital Budgeting Process and Decision Criteria

example

When we first looked at the Global Untethered Western Europe expansion project, we examined cash flows

over a five-year project life. Let’s modify the example a little. Suppose that the project life is six years rather

than five, and that in the sixth year the company must incur a large negative cash outflow. The modified cash

flow projections look like this:

Year Western Europe

project ($ in millions)

0 –250

1 35

2 80

3 130

4 160

5 175

6 –355

When we attempt to calculate the IRR for this stream of cash flows, we find that our financial calculator (or Excel)

returns an error code. The problem is that for this stream of cash flows there is no real solution to the IRR equation.

That is, there is no (real) interest rate at which the present value of cash flows equals zero. If we cannot determine

the IRR of this project, how can we determine whether the project meets the company’s hurdle rate of 18%?

The last three examples illustrate problems that analysts may encounter when using the IRR decision

rule. In practice, these problems arise infrequently, because most investments generate cash outflows up

front and cash inflows later on. Hence, most investments have a unique IRR. However, two additional

problems may arise when analysts use the IRR method to prioritise projects or to choose between

mutually exclusive projects. We examine these problems in the next section.

9-5d IRR, NPV AND MUTUALLY EXCLUSIVE PROJECTS

In this section, we differentiate between the NPV and IRR techniques by focusing on the scale and

timing problems associated with mutually exclusive capital budgeting projects.

The Scale Problem

Suppose a friend promises to pay you $2 tomorrow if you lend him $1 today. If you make the loan and

your friend fulfils his end of the bargain, then you will have made an investment with a 100% IRR.^7 Now

consider a different case. Your friend asks you to lend him $100 today in exchange for $150 tomorrow.

The IRR on that investment is 50%, exactly half the IRR of the first example. Both of these loans offer

very high rates of return. Assuming that you trust the friend to repay you in either case, which investment

would you choose if you could choose only one? The first investment increases your wealth by $1, and the

second increases your wealth by $50. Even though the rate of return is lower on the second investment,

most people would prefer to lend the larger amount because of its substantially greater monetary payoff.

The point of these examples is to illustrate the scale problem inherent in IRR analysis. When choosing

between mutually exclusive investments, we cannot conclude that the one offering the highest IRR

will necessarily create the most wealth. When several alternative investments offer IRRs that exceed a

LO9.5

7 The IRR is 100% per day in this example, which is not a bad return if you annualise it.