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 + Bi [ERm Rf ]__; where Bi =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 finds 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 on the graph as points where the NPV profiles 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 profiles 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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If you are new here and wish to now learn these concepts in a better manner via the video format on youtube, you can click __here____.__

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