Question

In what types of situations would capital budgeting decisions be made solely on the basis of project's net present value (NPV)? *Emphasis on solely* Identify potential reasons that might drive higher NPV for a given project. Why would a project choose NPV and not use IRR, payback, or discounted payback methods? Substantiate your response by providing an example to explain your thought process.

Answer 1

Situations in which there is only one alternative having a positive NPV, capital budgeting decisions would be made solely on the basis of the project's net present value. This is because no project is acceptable if it has a negative NPV.

NPV can be driven higher either by higher positive cash-flows or lower discount rate. For eg. if a project has lower initial investment and very high returns (positive cash-flows), the NPV would be higher. Also, if the discount rate (required rate of return) is too less for the project, the NPV would be higher.

NPV holds an edge over other critetion like IRR, payback and discounted payback. Payback method doesn't even consider the time value of money. Here, for eg, a project if has a large postive cash flow only after 20 years, it is given the same weightage as the positive cash flow in year 1. Hence, this is a big flaw. In the discounted cash-flow method, even though the time valu of money is considered, the cash-flows beyond the discounted payback period are ignored. Thus if a project has a large positive or negative cash flows after the discounted payback period, it is directly ignored. IRR measures the internal return, however, here there can be conflict between NPV and IRR. IRR, cannot be obtained for all the projects and there can be a problem of multiple IRR. All these shortcomings are overcome in the NPV method hence it is the one which is considered and given the highest preferance.