QUANTITATIVE METHODS FOR CHOOSING PROJECTS - Internal Rate Of Return (IRR)
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The document discusses internal rate of return (IRR) and real options for evaluating investment projects. IRR is the discount rate that makes the net present value of a project equal to zero. It is calculated through trial and error by changing the discount rate in the NPV equation until NPV equals zero. Real options view some investments, like R&D, as analogous to stock options where the initial investment is like an option premium and future investments to commercialize the technology are like the exercise price. Real options analysis can provide additional insights for investment decisions compared to traditional net present value analysis.
QUANTITATIVE METHODS FOR CHOOSING PROJECTS - Internal Rate Of Return (IRR)
- 1. NADYA SAFITRI DONGORAN SISTEM INFORMASI UNIVERSITAS ISLAM NEGERI SULTAN SYARIF KASIM RIAU QUANTITATIVE METHODS FOR CHOOSING PROJECTS - Internal Rate Of Return (IRR)
- 2. Internal Rate of Return (IRR) The internal rate of return of a project is the discount rate that makes the net present value of the investment zero. Managers can compare this rate of return to their required return to decide if the investment should be made. Calculating the IRR of a project typically must be done by trial and error, substituting progressively higher interest rates into the NPV equation until the NPV is driven down to zero. Calculators and computers can perform this trial and error. This measure should be used cautiously, however; if cash flows arrive in varying amounts per period, there can be multiple rates of return, and typical calculators or computer programs will often simply report the first IRR that is found.
- 3. Real Options Real options The application of stock option valuation methods to investments i nonfinancial assets. In “real options,” the assets underlying the value of the option are nonfinancial resources. An investor who makes an initial investment in basic R&D or in breakthrough technologies is, it is argued, buying a real call option to implement that technology later should it prove to be valuable. provides examples of investment decision that can be viewed as real call options. With respect to research and development: The cost of the R&D program can be considered the price of a call option. The cost of future investment required to capitalize on the R&D program (such as the cost of commercializing a new technology that is developed) can be considered the exercise price. The returns to the R&D investment are analogous to the value of a stock purchased with a call option
- 4. Examples of Real Call Options Source: From K. D. Miller and T. B. Folta, “Options Value and Entry Timing,” Strategic Management Journal, Vol. 23, pp. 655–665. Copyright © 2002 John Wiley & Sons Limited. Reproduced with permission.
- 5. The Value of a Call Option at Expiration
- 6. Reference M. Amran and N. Kulatilaka, Real Options (Boston: Harvard Business School Press, 1999); F. P. Boer, “Valuation of Technology Using Real Options,” Research Technology Management 43 (2000), pp. 26–31; and R. T. McGrath, “Assessing Technology Projects Using Real Options Reasoning,” Research Technology Management 43 (July–August, 2000), pp. 35–50. M. Benaroch and R. Kauffman, “Justifying Electronic Banking Network Expansion Using Real Options Analysis,” MIS Quarterly 24 (June 2000), pp. 197– 226. M. Perlitz, T. Peske, and R. Schrank, “Real Options Valuation: The New Frontier in R&D Evaluation?” R&D Management 29 (1999), pp. 255–70.