Question

Explain the project assessment methods the organization should have used to assess these projects (IRR, NPV, payback, and ARR). What are the advantages and drawbacks to using each one?

Answer 1

Net Present Value (NPV)

The net present value (NPV) method is widely used in capital budgeting and investment decisions. It is also considered as the best single screening criterion to reject or accept a project because the NPV method takes into account the time value of money concept. Its value reflects an expected change in shareholders’ value caused by a project.

Decision rule

The decision rule in using the NPV method is rather straightforward. The threshold value of zero indicates that a project’s cash flows exactly cover the cost of invested capital and provide the required rate of return on invested capital. The general rules can be stated as follows:

• A stand-alone project should be accepted if its NPV is positive, rejected in case it is negative, and stay indifferent if zero.
• In the case of considering a number of independent projects, all those that have a positive NPV should be accepted.
• Among several mutually exclusive projects, the one with the highest positive net present value should be accepted.

Advantages of the Net Present Value Method

• The most important feature of the net present value method is that it is based on the idea that dollars received in the future are worth less than dollars in the bank today. Cash flow from future years is discounted back to the present to find their worth.
• The NPV method produces a dollar amount that indicates how much value the project will create for the company. Stockholders can see clearly how much a project will contribute to their value.
• The calculation of the NPV uses a company's cost of capital as the discount rate. This is the minimum rate of return that shareholders require for their investment in the company

Disadvantages of Net Present Value

• The biggest problem with using the NPV is that it requires guessing about future cash flows and estimating a company's cost of capital.
• The NPV method is not applicable when comparing projects that have differing investment amounts. A larger project that requires more money should have a higher NPV, but that doesn't necessarily make it a better investment, compared to a smaller project. Frequently, a company has other qualitative factors to consider.
• The NPV approach is difficult to apply when comparing projects that have different life spans. How do you compare a project that has positive cash flows for five years versus a project that is expected to produce cash flows for 20 years?

Internal rate of return (IRR)

Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero.

Decision rule

Internal rate of return is used to evaluate the attractiveness of a project or investment. If the IRR of a new project exceeds a company’s required rate of return, that project is desirable. If IRR falls below the required rate of return, the project should be rejected.

Advantages of Internal Rate of Return Method

• It considers the time value of money even though the annual cash inflow is even and uneven.
• The profitability of the project is considered over the entire economic life of the project. In this way, a true profitability of the project is evaluated.
• There is no need of the pre-determination of cost of capital or cut off rate. Hence, Internal Rate of Return method is better than Net Present Value method.
• Sometimes, the pre-determination of cost of capital is very difficult. At that time, Internal Rate of Return can be used to evaluate the project.
• The ranking of project proposals is very easy under Internal Rate of Return since it indicates percentage return.
• It provides for maximizing profitability.
• Internal Rate of Return takes into account the total cash inflow and outflows.
• It gives much importance to the objective of maximizing shareholder’s wealth.

Disadvantages of Internal Rate of Return Method

• This method assumed that the earnings are reinvested at the internal rate of return for the remaining life of the project. If the average rate of return earned by the firm is not close to the internal rate of return, the profitability of the project is not justifiable.
• It involves tedious calculations.
• This method gives importance only to the profitability but not consider the earliest recouping of capital expenditure. The reason is that sometimes Internal Rate of Return method favors a project which comparatively requires a longer period for recouping the capital expenditure. Under the conditions of future is uncertainty, sometimes the full capital expenditure can not be recouped if Internal Rate of Return followed.
• The results of Net Present Value method and Internal Rate of Return method may differ when the projects under evaluation differ in their size, life and timings of cash inflows.

Accounting rate of return (ARR)

The accounting rate of return (ARR) is the amount of profit, or return, an individual can expect based on an investment made. Accounting rate of return divides the average profit by the initial investment to get the ratio or return that can be expected. ARR does not consider the time value of money, which means that returns taken in during later years may be worth less than those taken in now, and does not consider cash flows, which can be an integral part of maintaining a business.

Advantages of Accounting Rate of Return Method (ARR Method)

• It is very easy to calculate and simple to understand like pay back period. It considers the total profits or savings over the entire period of economic life of the project.
• This method recognizes the concept of net earnings i.e. earnings after tax and depreciation. This is a vital factor in the appraisal of a investment proposal.
• This method facilitates the comparison of new product project with that of cost reducing project or other projects of competitive nature.
• This method gives a clear picture of the profitability of a project.
• This method alone considers the accounting concept of profit for calculating rate of return. Moreover, the accounting profit can be readily calculated from the accounting records.
• This method satisfies the interest of the owners since they are much interested in return on investment.
• This method is useful to measure current performance of the firm.

Disadvantages of Accounting Rate of Return Method

• The results are different if one calculates ROI and others calculate ARR. It creates problem in making decisions.
• This method ignores time factor. The primary weakness of the average return method of selecting alternative uses of funds is that the time value of funds is ignored.
• A fair rate of return can not be determined on the basis of ARR. It is the discretion of the management.
• This method does not consider the external factors which are also affecting the profitability of the project.
• It does not taken into the consideration of cash inflows which are more important than the accounting profits.
• It ignores the period in which the profits are earned as a 20% rate of return in 10 years may be considered to be better than 18% rate of return for 6 years. This is not proper because longer the term of the project, greater is the risk involved.
• This method cannot be applied in a situation when investment in a project to be made in parts.
• This method does not consider the life period of the various investments. But average earnings is calculated by taking life period of the investment. As a result, average investment or initial investment may remain the same whether investment has a life period of 4 years or 6 years.
• It is not useful to evaluate the projects where investment is made in two or more installments at different times.