CHAPTER 12 Capital investment 513Avalon’s CEO Damir Mujic considers IBM’s solution as the best one to fit their needs. IBM’s System X
server platform, along with IBM networking, provides a reliable, flexible and cost-effective IT infra-
structure that scales with growth and can handle diverse workloads. In addition, with IBM, it avoids
integration issues arising when dealing with different companies delivering different parts of an overall
solution. The declining PC market has severely hurt Hewlett Packard. The company’s future is in the
dark. The company is trying to add a few high margin services to its portfolio to drive growth.
HP is on a drive to strengthen its portfolio with security services for the web, mobile, and BYOD (bring
your own device) environments to boost its performance. The company released its TippingPoint next
generation firewall last year. Since cyber security and threats are becoming one of the major concerns
for corporate customers, so TippingPoint could benefit as it addresses this market. HP has two choices
to select from, either to market TippingPoint as an independent product or join hands with various
mobile companies, data centers, and app providers to boost its sales. Partnerships could help increase
the company sales.Conclusion
IBM is successfully transforming itself into a services company, but HP has just started following this
route. On the other hand, HP is running in losses and its CAGR for the next five years is low at 0.67%.
Hence, investors having a higher risk appetite could consider HP for their portfolio.
Source: ‘IBM and HP are looking at diversification, but where should you invest?’ 2014, GuroFocus, 28 April,
http://www.gurufocus.com/news/256982/ibm-and-hp-are-looking-at-diversification-but-where-should-you-invest.12.5 Internal rate of return
LEARNING OBJECTIVE 12.5 Discuss and calculate internal rates of return (IRR) and apply the
decision rule.
The IRR is the second of the discounted cash-flow techniques discussed in this chapter. It is
widely used by entities in their project appraisal work. The IRR is the rate of return that discounts
the cash flows of a project so that the PV of the cash inflows just equals the PV of the cash outflows.
The IRR thus gives managers a value for the projected return from any project and allows them to
compare the returns from various proposed projects. It also allows them to ascertain if the IRR is
higher than their hurdle required rate of return. If so, the decision rule would be to invest in the
project.
In many cases, the PV of the cash outflows will be just the initial investment, which often can be
assumed to occur at time zero or the present time. The equation used to find the IRR is similar to the
NPV equation, except that the left-hand side will equal zero when the IRR value is found.
0 = −INV + CF 1 /(1 + r) + CF 2 /(1 + r)^2 + CF 3 /(1 + r)^3 + ... + CFn/(1 + r)n
To find the IRR, we have to use the equation and solve for r. With a scientific calculator or the use of
discount tables, solving for r is a trial and error problem. On the other hand, with a financial calculator
or a computerised spreadsheet, the solution is more easily found!
Decision rule for IRR
The decision rule with IRR is to accept projects where the IRR exceeds the entity’s required rate of
return (RRR). Normally, that level would be the cost of capital, although some entities have arbitrary
RRRs that they have set for various reasons. The RRR may be less than 20 per cent for many enti-
ties. Accepting projects that have IRRs greater than the entity’s cost of capital means that the entity is
making investments that both return the cost of finance and make additional returns. Such entities are
thus enhancing the wealth of their owners.
The trial and error method of calculating IRR is examined in illustrative example 12.5.