GSFM 7514 – ACCOUNTING AND FINANCE DECISION MAKING

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ACCOUNTING AND FINANCE FOR

DECISION MAKING

(GSFM 7514)

REFLECTIVE TASK 02

Suppose that your company’s weighted-average cost of capital is 9 percent. Your

company is planning to undertake a project with an internal rate of return of 12%, but
you believe that this project is not a good investment for the firm. What logical
arguments might you use to convince your boss to forego the project despite its high
rate of return? Is it possible that making investments with expected returns higher than
your company’s cost of capital will destroy value? If so, how?

PREPARED BY
LAVANNYA MOORTHY
(MC191010006 - ONLINE)

SUBMITTED TO
EN ROSLAN BIN HJ MOHD ROSE
(FACULTY OF BUSINESS AND TECHNOLOGY)

Table of Contents
1.0 INTERNAL RATE OF RETURN (IRR).....................................................................................3

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1.0.1 WHAT IS IRR........................................................................................................................3

1.0.2 WHAT IS IRR USED FOR....................................................................................................3
1.0.3 IRR FORMULA.....................................................................................................................3
1.0.4 POSITIVE OR NEGATIVE IRR..........................................................................................3
1.0.5 LIMITATIONS OF IRR........................................................................................................4
2.0 WEIGHTED AVERAGE COST OF CAPITAL (WACC).........................................................4
2.0.1 WHAT IS WACC...................................................................................................................4
2.0.2 WHO USES WACC...............................................................................................................4
2.0.3 WACC FORMULA................................................................................................................5
2.0.4 LIMITATIONS OF WACC...................................................................................................5
3.0 IRR VS WACC..............................................................................................................................6
4.0 SOLUTIONS..................................................................................................................................6
5.0 CONCLUSION..............................................................................................................................8
6.0 REFERENCES..............................................................................................................................8

1.0 INTERNAL RATE OF RETURN (IRR)

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1.0.1 WHAT IS IRR

Internal rate of return (IRR) is the discount rate that makes the net present value of all cash
flows (both positive and negative) equal to zero for a specific project or investment.

1.0.2 WHAT IS IRR USED FOR

The internal rate of return is used to evaluate projects or investments. The IRR estimates a
project’s breakeven discount rate or rate of return, which indicates the project’s potential for
profitability. 

Based on IRR, a company will decide to either accept or reject a project. If the IRR of a new
project exceeds a company’s required rate of return, that project will most likely be accepted.
If IRR falls below the required rate of return, the project should be rejected.
1.0.3 IRR FORMULA

0 (NPV) = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n

Where:  

 P0 equals the initial investment (cash outflow) 

 P1, P2, P3..., equals the cash flows in periods 1, 2, 3, etc.  
 IRR equals the project's internal rate of return
 NPV equals the Net Present Value
 N equals the holding periods
1.0.4 POSITIVE OR NEGATIVE IRR

A positive IRR means that a project or investment is expected to return some value to the
organization. 

A negative IRR can happen mathematically if the project’s cash flows are alternately positive
and negative over its expected duration. A negative IRR is indicative of a more complicated
cash flow stream that may make the metric less useful. 

Generally, a company would decline to make an investment in something with a negative

IRR.

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1.0.5 LIMITATIONS OF IRR

IRR allows managers to rank projects by their overall rates of return rather than their net
present values. The investment or project with the highest IRR is usually preferred. This easy
comparison makes IRR attractive, but there are limits to its usefulness: 

 IRR works only for investments that have an initial cash outflow (the purchase of the
investment) followed by one or more cash inflows. RR can't be used if the investment
generates interim negative cash flows. 
 IRR does not measure the absolute size of the investment or the return. This means
that IRR can favour investments with high rates of return, even if the dollar amount of
the return is very small. 
o For example, a $1 investment returning $3 will have a higher IRR than a $1
million investment returning $2 million. The latter, however, brings in $1
million dollars (instead of just $2).
Overall, IRR is best-suited for analysing venture capital and private equity investments.

2.0 WEIGHTED AVERAGE COST OF CAPITAL (WACC)

2.0.1 WHAT IS WACC

The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in

which each category of capital is proportionately weighted. All sources of capital, including
common stock, preferred stock, bonds, and any other long-term debt, are included in a
WACC calculation.

A firm’s WACC increases as the beta and rate of return on equity increase because
an increase in WACC denotes a decrease in valuation and an increase in risk.

2.0.2 WHO USES WACC

Securities analysts frequently use WACC when assessing the value of investments and when
determining which ones to pursue. For example, in discounted cash flow analysis, one may
apply WACC as the discount rate for future cash flows in order to derive a business's net
present value. WACC may also be used as a hurdle rate against which companies and

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investors can gauge return on invested capital (ROIC) performance. WACC is also essential

in order to perform economic value-added (EVA) calculations.

Investors may often use WACC as an indicator of whether or not an investment is worth
pursuing. Put simply, WACC is the minimum acceptable rate of return at which a company
yields returns for its investors. To determine an investor’s personal returns on an investment
in a company, simply subtract the WACC from the company’s returns percentage.

2.0.3 WACC FORMULA

WACC=E/V ∗ Re + D/V ∗ Rd ∗ (1−Tc)

where:

Re = Cost of equity

Rd = Cost of debt

E = Market value of the firm’s equity

D = Market value of the firm’s debt

V = E + D = Total market value of the firm’s financing

E/V = Percentage of financing that is equity

D/V = Percentage of financing that is debt

Tc = Corporate tax rate

2.0.4 LIMITATIONS OF WACC

The WACC formula seems easier to calculate than it really is. Because certain elements of
the formula, like the cost of equity, are not consistent values, various parties may report them
differently for different reasons. As such, while WACC can often help lend valuable insight
into a company, one should always use it along with other metrics when determining whether
or not to invest in a company.

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3.0 IRR VS WACC

Weighted Average Cost of Capital (WACC) is how much it costs for a company to finance
itself using capital from bondholders, other lenders, and shareholders. In relation to the IRR
formula, WACC is the "required rate of return" that a project or investment's IRR must
exceed to add value to the company. This return rate may also be referred to as a hurdle rate,
opportunity cost, or cost of capital.

For example, if a company's WACC is 10%, a proposed project must have an IRR of 10% or
higher to add value to the company. If a proposed project yields an IRR lower than 10%, the
company's cost of capital is more than the expected return from the proposed project or
investment. 

4.0 SOLUTIONS
Question :-

Suppose that your company’s weighted-average cost of capital is 9 percent. Your company
is planning to undertake a project with an internal rate of return of 12%, but you believe
that this project is not a good investment for the firm.

Answers:-

The following argument can be framed to convince that a project with higher rate of return
cannot be accepted:
1. Major assumption of Internal rate of return methodology is that the interim cash flows
will be reinvested at the same rates of return (in this case 12%) , which may not necessarily
hold true
2. Internal rate of return methodology assumes that the company has additional projects
with equally attractive prospects, in which it can invest interim cash flows
3. Internal rate of return methodology's assumptions about reinvestments can lead to
major capital budget distortions. 
For example: Consider a hypothetical assessment of two projects , A & B, with identical
cash flows , risk levels and durations as well as identical Internal rate of return values of
12%. Using Internal rate of return as a decision making yardstick, an executive would feel
confidence in being indifferent toward choosing between the two projects. However, it
would be a mistake to select either project without examining relevant reinvestment rate for
interim cash flows. Suppose Project B's interim cash flow can be redeployed only at a

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typical 9% cost of capital, while Project A's cash flows could be reinvested in an attractive
follow on project of 12%, Project A is unambiguously preferable. The above logical
arguments can be used to convince to forego the project despite its high internal rate of
return.

Question:-
What logical arguments might you use to convince your boss to forego the project despite
its high rate of return?
Answers:-

 Project depends on may scenarios and situations which may materialize

 Project is not company's core operation and it is depended on other parties
 Laws and regulations may change causing loss of investment
 Technology may change leading to lower revenues in future
 Cost of investment is too much
 Payback is out of company's acceptable range

Question:-
Is it possible that making investments with expected returns higher than your company’s
cost of capital will destroy value?
Answers:-

 Yes, it is possible

Question:-
If so, how?
Answers:-

 If a project undertaken is against the value or objectives of the firms, it can affect the
reputation of the firm
 If the project is too risky and involves huge stake at risk, it can destroy value
 If the project is dependent on multiple scenarios, some of which may not happen, it
can destroy the value of the firm
 If the project undertaken is viewed as a divergence from company's core operations, it
can destroy value.

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5.0 CONCLUSION

In conclusion, IRR and WACC have their own advantages and disadvantages. The best
decision can be made decision through the company’s investment. The main objective should
be in maximizing the stakeholder’s values.

6.0 REFERENCES

 https://investinganswers.com/dictionary/i/internal-rate-return-irr#:~:text=Internal
%20rate%20of%20return%20(IRR)%20is%20the%20discount%20rate%20that,a
%20specific%20project%20or%20investment.
 https://www.investopedia.com/terms/w/wacc.asp
 https://medium.com/magnimetrics/understanding-the-weighted-average-cost-of-
capital-wacc-948182d97e6
 https://corporatefinanceinstitute.com/resources/knowledge/finance/internal-rate-
return-irr/
 https://www.arborcrowd.com/education/why-irr-matters-evaluating-real-estate-
investment-returns/

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