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MINING ENGINEERING
OCTOBER 1998
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FIGURE 1
Value
Harvest at
TABLE 1
Ranking of projects with NPV and IRR with unequal investment or project life.
Years:
Case (a): Unequal project life
CFl*
CF2
NPV
IRR
-100
-100
50
65
50
65
50
65
50
0
50
0
80.24
56.12
41.04
42.57
-100
-50
50
35
50
35
50
35
50
35
50
35
80.24
76.17
41.04
64.12
Calculation of CFZ*
CF2
CFr
CF2"
Case (b): Unequal initial investment
CFl*
CF2
Calculation of CF2'
CF2
CFa
CF2"
Notes:
CFr = reinvested cash flow.
CFa = cash flow from alternative (opportunity) investment.
CFl* and CF2* = the t w o cash flows used to compare NPVs and IRRs.
MARR = Minimum acceptable rate of return = OCC = Opportunity cost of capital = 12.00%.
70
OCTOBER 1998
MINING ENGINEERING
vestments using NPV but not IRR, unless IRR is calculated correctly. What must be compared again are the
total cash flows that result from the two investments
over the same length of time. If $100 is available for investment and only $50 is placed into CF2, then an account must be made of the earnings of the remaining $50
not invested in CF2.The combined cash flow of CF2 plus
the alternative investment yields CF2*, which is the cash
flow that must be compared with CFl*. Again, what is
important is that the investment of the unspent $50 be
included in the two cash-flow comparisons, regardless of
how the $50 is invested.
The result of having both unequal project lives and
unequal initial investments combines Cases (a) and (b),
and the same principles apply. Again, what is important
is that the investment of the unspent capital and the reinvestment in the remaining two years be included in the
two cash flow comparisons, however these two items are
invested.
The three additional requirements mentioned above
are discussed in Torries (1998).The solution to the ranking problems associated with unequal project lives and
initial investments is to simply comply with the theoretical requirements of NPV and IRR. If the comparisons of
cash flows are handled properly, no conflicts exist, and an
incremental I R R need not be calculated. There is no
theoretical reason not to use I R R as a measure of
project feasibility.
71
mined directly by its own cash-flow profile and is independent of any explicit reinvestment activities or rates.
Consequently, IRR is a measure of growth of capital that
has the same characteristics as quoted savings rates. This
means it is correct to directly compare the two and to say
that a project with an I R R of 40% yields a return four
times greater than a savings account with an interest rate
of 10%.The reinvestment assumption required of IRR is
not a valid reason to prefer NPV as a merit measure. For
a history of the debate, see Solomon (1956). Renshaw
(1957), Dudly (1972). Grant (1982), Lohmann (1988) and
Beaves (1 988).
TABLE 2
IRR
1. Measures the rate of wealth accumulation or the
rate of change of wealth. This measure indicates the
efficiency of use of capital investments. However, IRR
does not indicate the value of a project.
2. IRR is independent of the size of the initial
investment. To make IRR larger, the investment must
earn a higher return
72
Conclusion
This paper demonstrates that both NPV and IRR
have valid uses as merit measures for practical application of investment evaluation methods. Because of the
multigoal nature of most investors, the differences in
perspective given by NPV and IRR should be considered a benefit rather than a fault to be corrected. This
paper also shows that IRR has no greater number of
faults than does NPV, even when multiple root problems
are included.
In addition to IRR and NPV, all other bits of information, such as expectations about the future and the
timing of the investment, must also be considered by the
decision-maker. Each investor has a particular set of investment goals and constraints. It is prudent to supply
the investor with as much information as possible and let
the individual investor use the information in a manner
appropriate for the situation. Each investor must then
integrate all project-feasibility information with the
investor's attitude toward risk to reach correct investment decisions.
References
Au. T., and Au. T.. 1992. Engineering Ecor~omicsfor Capital Investrnc7ntAncrlysis. 2"" Ed.. Prentice-Hall, Englewood Cliffs, NJ.
Baumol. W.. 1965, Economic Theory and Operatior~sAnalysis, 2nd
Ed., Prentice-Hall. Englewood Cliffs: NJ.
Beaves, R.G., 1988:'Net present value and rate of return: Implicit and explicit reinvestment assumptions." The Engineering Economist. Vol. 33. p. 275.
Bhappu, R., and Guzman: J.. 1994,"Mineral investment decision
making: A study of mining company practices," Proceedings, Third
Annual Meeting of the Mineral Economics and Marlagement Societj~
73