We will be solving practical challenges through MBA concepts. No theory only applications!
This particular lesson builds upon my previous finance lesson on NPV and valuations of deals from an investment standpoint. In this lesson, we cover two topics-
a) What are the certain types of risks one needs to be mindful of while investing in an asset ?
b) What is the IRR method of taking investment decisions and why do we still prefer the NPV method ?
This lesson is high on equations and numbers so keep your seat belt tight as we navigate the finance takeaways together.
A- Risks associated while investing in an asset
The below graph is a good starting point to broadly understand the 2 major categories of risks that exist when you invest in an asset. It signifies there is an inherent systemic/market/industry risk associated with the asset and there is another idiosyncratic (firm-level) risk associated with the asset.
Total Risk= Market Risk (eg- interest rates, GDP changes etc.) + Unique Deal Risk (eg- success of r&d, labour strike etc.)
The famous Capital Asset Pricing Model (CAPM) aims to compensate for this measure of risk. It says-
Required Return=Risk Free Rate + Beta*Market Risk Premium
where, Beta= Measure of Systemic Risk and
Market Risk Premium= Expected return on market portfolio- Risk Free Rate(market interest rate)
ERi = Rf + B i [ERm Rf ]; where B i =Covariance(ri ; rm)/Variance (rm)
Now, intuitively and mathematically, High beta assets have high expected returns- High return in good times (when the market portfolio is doing well) and low return in bad times.
One of the other key takeaways is also -since Beta is the only relevant measure of risk in determining the opportunity cost of capital, we only need to price a comparable portfolio that has the same Beta to value the project
A- Now what is IRR and why are we calling it BAD !
There are several methods to evaluate the investment opportunity. Survey of CFOs fi nds 75% use NPV, 76% use IRR, 57% payback period in analyzing investment decisions. [ Source: Graham and Harvey, The Theory and Practice of Finance: Evidence from the Field, Journal of Financial Economics 61 (2001), pp.187-243 ]
Talking about IRR, Internal rate of return (IRR) is the rate r that makes Net Present value(FCF) = 0
In case you are new to my blog, I'd advise to read through Lesson 25 for understanding basics of FCF and valuations.
The intuition behind the IRR method is What rate of return am I earning on the project given its
cash flows?
An IRR greater than the cost of capital (interest rate) indicates a wealth increase, hence such a project must be accepted; conversely, a project with an IRR less than the cost of capital must be rejected.
To understand why IRR is not the best method, let's quickly look at the NPV profiles of 2 assets via graph below.
1. IRRs can be read o n the graph as points where the NPV profi les intersect the horizontal axis i.e. 14% for project S and 12% for project L.
2. The cross-over rate is the rate where the NPV pro files intersect.
In this example, it is 7.2%. At costs of capital below 7.2%, project L has the higher NPV and must be the only one selected. Between 7.2% and 14.49%, project S has a higher NPV and must be the only one selected, and lastly above 14.49%, both projects have negative NPVs and hence both should be rejected !
One of the main problems with IRR method is IRR says at all costs of capital below 14.49%, project S is preferred over project L ! Moreover, there is conflict in the region when the cost of capital is less than 7.2%! Lastly, IRR doesn't also account for the scale/size of the deals when evaluating comparative answers. There are multiple other challenges with IRR but to maintain simplicity, I'd land 20% of the reasons solving 80% of the issues.
Hence, typically smart investors favor along with NPV method more than IRR because NPV allows for a deep dive than throw global answers because there is always an opportunity cost when evaluating assets. I'd now strongly urge you to start evaluating stock/bond opportunities via this lesson takeaways and you'd be surprised how sound and more data-backed investment strategies will come to you even with associated risks :)
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