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Although the net present value technique is subject to a number of assumptions about the perfection and efficiency of the capital market it does generate an absolute measure of increase in shareholder value ***and as such avoids scale and other effects associated with percentage performance measures.*** Given the magnitude of the net present value of the project it is safe to assume that it is value-adding assuming that the underlying cash projections can be relied upon.
However, in certain circumstances it can be useful ***to have a ‘headroom’ percentage which reliably measures the rate of return on an investment such as this.*** In this case the modified internal rate of return of 20.2% is much greater than the firm’s cost of capital of 9.2%. MIRR measures the economic yield of the investment (i.e. the discount rate which delivers a zero net present value) under the assumption that any cash surpluses are reinvested at the firm’s current cost of capital. The standard IRR assumes that reinvestment will occur at the IRR which may not, in practice, be achievable.
Although MIRR, like IRR, cannot replace net present value as the principle evaluation technique it does give a measure of the maximum cost of finance that the firm could sustain and allow the project to remain worthwhile. ***For this reason it gives a useful insight into the margin of error, or room for negotiation, ***when considering the financing of particular investment projects.
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My question is I am not sure about the meaning of
1. and as such avoids scale and other effects associated with percentage performance measures.
2.to have a ‘headroom’ percentage which reliably measures the rate of return on an investment such as this.
3.For this reason it gives a useful insight into the margin of error, or room for negotiation,Could you please elaborate these 3 sentences? Thank you very much.
1. This relates to the NPV which, as the question states, gives the increase in shareholder value in $’s. Suppose one investment gives a return of 10% and another gives a return of 12% – we cannot automatically say that the one giving 12% is preferable. It could be that we can invest 100,000 in the first investment but only 1,000 in the second. In that case it would be better to choose the first investment because the return in $’s will be much higher.
2 & 3 The cost of capital is always only an estimate – it can never be calculated precisely. Here, we think it is 9.2%, but what happens if it turns out to be 10% or 11% etc.? Obviously if it turns out to be higher than 9.2% then the NPV will be lower. However the NPV will still be positive (and therefore the investment will still be worthwhile) provided that the cost of capital is lower than 20.2%. So we know by how much we can afford the cost of capital to be wrong. If the return was only 10% then it would be very risky accepting the investment, but with a return of 20.2% there is not the same risk because the chance of the cost of capital being that high is very remote.
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