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Dear Sir,
Please help on the following:
1. When calculating asset beta of comp. prodn, is the rationale is to use the proportion of equity and not the weighted average of the MV of both O. activities and comp. prodn?
2. As per the answer , process Zeta is chosen, why is this so?- the difference between both processes MIRR and IRR is minimal..
3. MIRR assumes that positive cash flows are reinvested at the cost of capital and here the MIRRs are both 22.7% and 23.3% and the cost of capital is 12.75%. What does the 22.7 or 22.3 mean if we have to explain it? Why is there such a large difference between MIRR and c.o.cap if the former assumes investment at c.o.cap??
Thank you.
1. Yes. Since it is the equity that carries the risk, it is the proportions of the equity invested in the two different activities that we need to use to get the asset beta of O activities.
2. The problem with IRR occurs when we are choosing between projects. For a simple accept/reject decision there is no problem – if IRR > cost of capital then we should accept, and the NPV would be positive, so again we should accept.
However, when comparing projects, it is not automatically valid to compare the IRR’s. For example if one project gave an IRR of 18% and lasted 5 years, and another gave an IRR of 19% for only 3 years you could not say that the second was automatically the best. (Unless you assumed that the inflows were to be always reinvested at the same IRR in which case no problem – the first would effectively be giving 18% for ever and the second would effectively be giving 19% for ever, and the second would then be best.)
Because the assumption about reinvesting at the IRR is unlikely to be valid, the MIRR is regarded as being better for this sort of decision – it assumes that the inflows are effectively reinvested at the cost of capital (or used to repay the borrowing, which is effectively assuming the same thing). Using MIRR also automatically means that we end up choosing the one with the highest NPV.
If a project is worthwhile, both its IRR and its MIRR will be higher than the cost of capital. The bigger the inflows the bigger the difference stands to be between them and the cost of capital – there is no significance really in the size of the difference.
Hope that helps 🙂
Sir,
I thought that when calculating for IRR, that value of one of the NPVs must be negative, Why is it that they used two positive NPVs?
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