Description
DCF vs Other Methods
Bottom of Form
We've discussed the power of the discounted cash flow methodology for evaluating investment decisions. In this segment we'll discuss other methods you may encounter, such as the payback criterion and the IRR rule, and how they compare with the DCF approach. We'll see when it is appropriate to use IRR and the potential problems that arise due to ranking projects by IRR.
This next exercise reinforces the concept of the internal rate of return (IRR) and will help you solidify your understanding of how market penetration impacts IRR and when you can apply the IRR rule.
Top of FormInternal Rate of Return (IRR)
Bottom of Form Top of FormThis exercise reinforces the concept of the internal rate of return (IRR) and will help you solidify your understanding of how market penetration impacts IRR and when you can apply the IRR rule.
Read the question and answer from the chooses below:
1-For the base case 20% sales penetration rate, the NetPhone project had a 32.1% IRR. What would its internal rate of return be if the expected penetration rate were only 15%?
20.5%
18.3%
15%
6%
2.5%
2-What would the NetPhone project's internal rate of return be if the expected penetration rate were only 10%?
6%
2.5%
20.5%
18.3%
15%
3-For which of the projects below can you be certain the IRR rule will be reliable?
Project | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 |
A | (60.0) | 60.0 | 120.0 | 60.0 | (200.0) |
B | (60.0) | (200.0) | 120.0 | 60.0 | 60.0 |
C | (60.0) | 60.0 | 120.0 | (200.0) | 60.0 |
Project A
Project B
Project C
Questions #4 and #5 refer to the scenario below.
Your firm is planning to redesign its production plant. Three engineering firms have provided the following bids ($m):
Bid | Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | IRR |
I | (60.0) | 10.0 | 10.0 | 10.0 | 80.0 | 19.8% |
II | (60.0) | 30.0 | 30.0 | 20.0 | 10.0 | 22.3% |
III | (40.0) | 25.0 | 15.0 | 15.0 | 15.0 | 30.3% |
Your firm's cost of capital is 8%.
4-Which of the redesign plans above would create value? How can you tell?
5-Is Bid III necessarily the best choice, given that it has the highest IRR?
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Explanation & Answer
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DCF vs Other Methods
We've discussed the power of the discounted cash flow methodology for evaluating investment
decisions. In this segment we'll discuss other methods you may encounter, such as the payback
criterion and the IRR rule, and how they compare with the DCF approach. We'll see when it is
appropriate to use IRR and the potential problems that arise due to ranking projects by IRR.
This next exercise reinforces the concept of t...