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Incremental Cash Flow Analysis Lecture Notes

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*Incremental cash-flow analysis   It's a technique that can be used whenever attempting to choose among Investments on the basis of their IRRs. Steps to take is called an algorithm: 1. Think of them as in a pot, and pick any two from the pot. 2. Find the highest net positive cash-flow total (sum of its all cfs) so called ‘defender’, and the other one the ‘challenger’. 3. Ssubtract the cash flows of the challenger from those of the defender, the resulting stream the' incremental cash flows’. 4. Find the IRR of the incremental cash flows. 5. If the IRR of the incremental cash flows is greater than hurdle rate, keep the defender, and throw out the challenger. If the IRR of the incremental cash flows is less than the hurdle rate, keep the challenger, and throw out the defender. 6. Keep the survivor and return to the pot, pick another investment, and begin the algorithm at step 2. When all available projects have been tested, you will have a single survivor 'winner’. 7. Calculate the IRR of the winner. If it exceeds the hurdle rate, accept the winner; if the winner’s IRR is lower than the hurdle rate, reject the winner and all other projects that were in the pot. (‘Crossover rate’) is the IRR of the incremental cash flows & the rate at which the NPVs of defender and challenger is equal to zero.  Drawback of incremental cash-flow method: 1. When the incremental cash flows that you calculate have more than one change of sign across time. The algorithm d ...
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