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11ComparisonMethods2PDF.pdf
11ComparisonMethods2PDF.pdf
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11ComparisonMethods2PDF.pdf-Centre for Management ...
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Page 26
26
When to Use ERR
•
ERR (approximate or precise) must be used when there
are mul8ple IRRs possible.
•
Usually, it is difficult to predict when mul8ple IRRs
occur
•
Fortunately, most real life projects are structured in a
way that prevents mul8ple IRRs
–
Simple Investments
typically consist of several in (out)
flows at the start and then several periods of out (in)
flows.
–
No IRR difficul8es for these projects
•
An approximate ERR will always provide a conserva8ve
answer because it is less than the real ERR and IRR
•
Nevertheless, it is desirable to compute the IRR
whenever possible and use an approximate ERR to
check the answer from a mul8ple root IRR calcula8on.
Page 27
27
Page 28
28
IRR Comparisons
•
We have two types of situa8ons where IRR will
be used to compare projects
•
INDEPENDENT projects are when a firm/
government has a number of projects which
could be acceptable at the same 8me, but,
BUDGETS and MARR limit which ones to accept,
and more than one may be accepted
•
MUTUALLY EXCLUSIVE projects are those when
only ONE project can be accepted.
•
Clearly, investments which do not produce at
least MARR or exceed the available budget for
capital projects are not acceptable
Page 29
29
"Finding" MARR using IRR for
Independent Projects & Budget
•
In many cases, especially in large firms, the MARR is set at
corporate offices and the budget may s8ll have cash leN aNer the
projects are selected
•
But equally, there may be projects leN aNer all the budget is used
up and this case, the last project accepted "defines" the de facto
MARR for the firm aNer all, any other project must be be\er than
the last one accepted
•
We assume investment, not loan cash flow pa\erns
–
rank the projects in their IRR order, but all must be >MARR (Corp)
–
calculate cumula8ve First Costs as projects are added to the list
–
keep comparing the above balance to the budget constraint
–
when you get to the end of the budget, you have found the MARR FOR
THAT SET OF PROJECTS ONLY.
–
Could use some op8misa8on technique (LP)
–
Major issue: all projects are not of the same risk!
•
Do not recommend this method!
Page 30
30
The Refinery Case of MARR Selec8on
•
Assume MARR = 15% and Budget = $1,000,000
•
The solu8on now as follows:
–
Start by adding the project with the largest IRR (Proj
A)
–
Con8nue un8l either MARR is reached or the last one
won't fit the budget (B,C,D, etc.)
–
Juggle projects with IRR>MARR to fit into money if any
leN over
–
Adjust scope of projects or budgets to fit
–
Add adjustable con8ngency amounts to projects to
use up cash
–
Use an LP solu8on aNer discarding the <MARR list
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