Lecture-3 - Corporate Finance PDF

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CORPORATE FINANCE - LECTURE 3 : THE INTERNAL RATE OF RETURN

HOW IS INTERNAL RATE OF RETURN DETERMINED ? The net present value: difference between the market value and the Somme of the future cash flows related by the investment project. It is universally proportional to the discount rate. If the net present value is universally proportional to the discount it means

IRR also called discounted cash rate of return (DCF). The internal rate of return (IRR – taux de rendement interne) is the rate of discount which makes NPV=0.

Discounting rate: taux d’actualisation THE DECISION MAKING RULE :

- The IRR decision making rule is very simple: if an investment’s IRR is higher than the investor’s required return, he will make the investment or buy the security (titre).

- The major idea is: “if you want to undertake an investment, the IRR’s investment must be sufficient to pay the required return by investors”.

Graph: point where the present value is = 0, it’s the internal rate of return. Since it is a breaking point, on the left side, each discount rate gives a positive NPV. If you go above this point (on the right), you get a negative NPV. The internal rate of return can be used as another decision rule. The discount rate is the cost of resources. The idea: if the resources have a lower cost than the investment cost then investment is possible. 30% sur le graphe: Seuil au delà duquel on n’investit plus cest le cout interne de rentabilité (seuil de rentabilité – le point à partir duquel on passe de positif à negatif). The internal rate of return is used by managers to assess if the investment is worth to be taken or not.

THE LIMITS OF THE INTERNAL RATE OF RETURN :

- Sometimes, it is impossible to compare IRR from two investments, because the investment’s maturity are different. In this case, we should use the modified IRR (pas au programme)

- We can face a problem of multiple IRR or no IRR - NPV and IRR can be linked positively - The discount rates should change through time. we can in a situation where the discount rate should not be fixed/constant because the risk in the market is changing. We have to keep the internal rate constant

- When a firm suffers from capital rationing, mutually exclusive projects can generate a dilemma between NPV and IRR.

At least, 2 solutions. 20% and 500%. Which one is the good one? In this case, cannot use the internal rate criteria. There is no theoretical basis to decide if it is the second one or the first one.

In this case, we cannot use the criteria of internal rate of return. Here we have just positive NPV. The NPV is very small, the company can decide to not take the project. Investing or financing:

- The company in this case is about contracting debt. When the first cash flow is positive and the next cash flows are negative, we are not in an investment case but rather in a financing case (take the money now and give it back after). In these cases, NPV is positively related to the IRR.

- The IRR doesn’t help us to choose the project. It’s about financing a project. Here it’s an investment project. What’s the rule if we apply the IRR?

- The rule is the opposite of the traditional investment project (we have to undertake the project). If the IRR is lower than the discount rate in this case we have to undertake the financing project. We should not undertake the project. Changing discount rates :

- One of the factor determining is the interest rate and also the risk of the investment. If the risk of cash flows is changing, if the company loosing shares, the future cash flows will be more risky and we should revise the internal rate. We have to determine only one internal rate of return.

The internal rate of return criteria and the NPV criteria have different decisions. We need an incremental IRR. Incremental IRR: several steps. The first one: identify which project can be considered as a high level project. If the incremental internal rate of return is higher than the discount rate (the cost of capital) then you must invest in the highest scale project. Incremental NPV= (NPVH – NPVL) = 0.

If the Incremental IRR > r High If the incremental IRR < r Low.

Les deux critères valeur actuelle nette et taux interne de rentabilité ne conduisent pas au meme choix. On va créer un projet virtuel. On retient le projet à la plus grande profitabilité. Entre le taux de rentabilité et le benefice = l’un est normé par rapport aux ressources injectées. Distinguer le taux d’intérêt nominal des taux d’intérêts proportionnels ou effectifs : la notion de temps est différente. NOMINAL EFFECTIVE AND PROPORTIONAL RATES :

QUESTIONS

1. DOES'THE'IRR'DEPEND'ON'WHEN'CASH'FLOWS'OCCUR'?''

Yes,%IRR%depends%on%when%cash%flows%occur%because%if%cash%flows%are%pro%pond% in%6me,%interest%rate%decreases.%

2.'WHAT'ARE'PROPORTIONAL'RATES'USED'FOR'?'AND'IRR'?'...