Question

Please respond to the following:

How is the NPV rule related to the goal of maximizing shareholder wealth, and under what conditions would you expect the NPV and IRR rules to return the same accept / reject decision? Identify one problem with using IRR as part of this decision-making process. What value might the financial decision maker gain by adding the profitability index to the decision-making process?

Answer 1

The Net Present Value rule calculates the present value of all the cash outflows minus the cash inflows that a project will have either today or in future years. A positive NPV indicates that the investment is having the potential to increase the value of the firm in near future. This in turn will lead to maximizing shareholder wealth.

IRR stands for Internal Rate of Return. It is the rate of interest at which the net present value of all the probable cash inflows and outflows will be equal to zero.

Under the following conditions the NPV and IRR rules to return give the same accept or reject decision-:

(i) when there are a lot of independent investment proposals which are mutually exclusive that means they are in no competition with one another and so they can be accepted or rejected on the basis of a minimum required rate of return.

(ii) Traditional proposals for investment in a project that require a substantial amount of cash outflows in the start of project which may result in cash inflows in the subsequent years of the life of the project.

The problem with using IRR as a part of this decision making process-:

While making a decision for selection between two mutually exclusive projects, the decision is not restricted to deciding which project is best but also deciding whether or not all or any of the project is worth at the first place. The IRR method may project a gives a percentage value but the percentage interpretation value is in itself not enough to decide about the project. This is related with the economies of scale, which the IRR ignores.

Further, even with simple decision making the IRR method, assumes that cash flows will be reinvested at the rate of Internal return for the remaining life of the project. That means in case of low return reinvestment shall be at low rate of return and if the project has a very high rate, it is assumed that the reinvestment will be made at a very high rate of return. This situation is practically not possible.

The financial decision maker might gain the following by adding the profitability index to the decision-making process-

When the entity has to choose between two mutually exclusive projects the project with the highest profitability index is accepted. Highest profitability index represents that the most productive use of limited capital. The cost- benefit analysis is regarded the most for the project with highest profitability index. So the decision makers may decide to opt for Profitability index usage for decision making.