Introduction to Corporate Finance

PART 3: CAPITAL BUDGETING

company’s hurdle rate, choosing the investment that maximises shareholder wealth involves more than

picking the highest IRR. For example, take another look at the investment opportunities faced by Global

Untethered, opportunities that vary dramatically in scale.

example

The Timing Problem

Managers of public corporations often receive criticism for neglecting long-term investment opportunities

for the sake of meeting short-term financial performance goals. We refrain from commenting on whether

corporate managers, as a rule, put too much emphasis on short-term performance. However, we do agree

with the proposition that a naive reliance on the IRR method can lead to investment decisions that

unduly favour investments with short-term payoffs over those that offer returns over a longer horizon.

The following example illustrates the problem we have in mind.

Here again are the NPV and IRR figures for the two

investment alternatives.

Project IRR NPV (@18%)

Western Europe 27.8% $75.3 million

South-eastern

Australia

36.7 25.7 million

If we had to choose just one project on the basis

of IRR, then we would (erroneously) choose to invest

in the South-eastern Australia project. But we have

also seen that the Western Europe project generates

a much higher NPV, meaning that it creates more

wealth for Global Untethered shareholders. Hence,

the NPV criterion tells us to expand in Western

Europe rather than in South-eastern Australia. Why

the conflict? It is because the scale of the Western

Europe expansion is roughly five times that of the

South-eastern Australia project. Even though the

South-eastern Australia project provides a higher

rate of return, the opportunity to make the much

larger Western Europe investment (which also offers

a return well above the company’s hurdle rate) is

more attractive.

example

A company wants to evaluate two investment

proposals. The first involves a major effort in new

product development. The initial cost is

$1 billion, and the company expects the project

to generate relatively meagre cash flows in the

first four years, followed by a big payoff in year 5.

The second investment is a significant marketing

campaign to attract new customers. It too has

an initial outlay of $1 billion, but it generates

significant cash flows almost immediately and

lower levels of cash in the later years. A financial

analyst prepares cash flow projections and

calculates each project’s IRR and NPV as shown

in the following table (the company uses 10% as

its hurdle rate):

Cash flow Product

development

($ in millions)

Marketing campaign

($ in millions)

Initial outlay –1,000 –1,000

Year 1 0 450

Year 2 50 350

Year 3 100 300

Year 4 200 200

Year 5 1,500 100

Technique

IRR 14.1% 15.9%

NPV (@10%) $ 184.44 $ 122.44

The analyst observes that the first project

generates a higher NPV, whereas the second offers

a higher IRR. Bewildered, he wonders which project

to recommend to senior management.