Module 5: Comparison Methods ||

Question 1

Why do strategic and financial buyers use the internal rate of return (IRR)?

Answer 1

they use it as one of the primary measures to assess the attractiveness of an investment

Question 2

What is IRR expressed as? what type of measure is this?

Answer 2

expressed in percentage form, which is a relative measure

Question 3

What does IRR stand for?

Answer 3

Internal Rate of Return

Question 4

What is IRR?

Answer 4

it is the interest rate at which a project breaks even. Essentially benefits = costs

Question 5

What does the Rt stand for in the IRR formula?

Answer 5

receipt (aka benefit) in period t

Question 6

What does the Dt stand for in the IRR formula?

Answer 6

disbursement (cost) in period t

Question 7

For independent projects, if IRR > MARR, then project is…

Answer 7

accepted

Question 8

For independent projects, if IRR = MARR, then project is…

Answer 8

marginally accepted

Question 9

For independent projects, if IRR < MARR, then project is…

Answer 9

rejected

Question 10

What 2 conditions should be applied when dealing with IRR comparison of mutually exclusive projects?

Answer 10

1. Necessary condition
2. Sufficient condition

Question 11

What is the “Necessary Condition”?

Answer 11

one of the conditions that should be applied to IRR for mutually exclusive projects:

the project must have IRRi>MARR to be considered

Question 12

What is “Sufficient Condition”?

Answer 12

one of the conditions that should be applied to IRR for mutually exclusive projects:

the project with the highest incremental IRR should be selected

Question 13

why is IRR widely used?

Answer 13

b/c it is expresses return as a percentage, making it easy to compare across diff projects

Question 14

What’s a simple way of defining what IRR is?

Answer 14

IRR = the interest rate at which a project breaks even

Question 15

Can IRR be negative? When if so?

Answer 15

Yes, if a project is losing money

Question 16

when would a project have multiple IRRs? give example.

Answer 16

when cash flows change signs mutlitple times

EX:
Year 0: -$100
Year 1: +$200
Year 2: -$300

Question 17

What should you do when multiple IRRs occur within a project?

Answer 17

use the external rate of return (ERR)

Question 18

ERR is used when…

Answer 18

multiple IRRs exist

Question 19

What types of investments can have multiple internal rates of return (IRR)?

Answer 19

non-simple investments

Question 20

What does ERR assume?

Answer 20

it assumes that intermediate cash flows are reinvested at the MARR rather than the IRR

Question 21

Why is ERR sometimes considered a better measure of return than IRR?

Answer 21

b/c it is considered a more realistic assumption/method. it assumes that intermediate cash flows are reinvested at the MARR (an achievable rate, usually 5-15%), instead of the often-unrealistic IRR (anywhere from 10-40% typically). This makes ERR a more practical and reliable indicator of a project’s true return, especially when high reinvestment rates are not available.

Question 22

What are the steps for calculating ERR? 3 steps

Answer 22

“Bring inflows forward at MARR, outflows forward at MARR, then match”

1. Bring Inflows Forward at MARR
   → Take all cash inflows and calculate their future value using MARR.
2. Outflows Forward at ERR
   → Take all outflows and bring them to the same future point, but using an unknown ERR.
3. Then Match
   → Set the future worth of inflows equal to the future worth of outflows:

FW inflowsatMARR = FW outflowsatERR

Question 23

What assumption makes the approximate ERR method valid?

Answer 23

All receipts of a project are assumed to be invested at a minimum acceptable rate of return

Question 24

Computing a precise external rate of return can be a complex procedure because of…

Answer 24

the difficulty in determining exactly when the explicit interest rate should be applied

Question 25

What projects are called simple investments?

Answer 25

Projects that have one or more periods of cash outflows at the start, followed by one or more periods of cash inflows

Question 26

As a rule, the approximate ERR is between the _____ ______ and the _______

Answer 26

precise ERR; MARR

Question 27

If there are two mutually exclusive alternatives, then the best one is the one that...

Answer 27

has a higher minimum acceptable rate of return assuming the lives of the alternatives are the same.

Question 28

Unlike IRR-method, PW-method or AW-method does what?

Answer 28

gives a direct measure of the profit generated a project.

Question 29

What economic concept is used to introduce the external rate of return?

Answer 29

Opportunity cost

Question 30

What is the advantage of the internal rate of return method?

Answer 30

It characterizes projects in terms of productivity of their investments

Question 31

What is the major disadvantage of IRR?

Answer 31

it can produce more than one IRR

Question 32

What is the difference between IRR and ERR?

Answer 32

The IRR is earned by a project whereas the ERR is earned outside of it

Question 33

What alternative is the initial base for comparison of mutually exclusive projects?

Answer 33

the alt. with the smallest first cost

Question 34

When to know to use incremental IRR comparison?

Answer 34

- projects are mutually exclusive (choose only one) - you're given IRRs and Costs - you have a known MARR

Question 35

what are the steps for incremental IRR comparison method? (5 steps kinda)

Answer 35

1. sort projects by increasing cost 2. start with the cheapest project. accept it if IRR > MARR 3. do incremental comparison: compare the next more expensive project against the current one. 4. accept the new project if incremental IRR

Question 36

when do you use ERR vs IRR?

Answer 36

use ERR typically when there's more than one change of cash flow sign EX: - to + back to -, use ERR if there's only one change, like - to +, then use IRR