Question

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

NPV is the sum of negative outward cash flows and positive inward cash flows discounted back to present or year 0 in cash flow chain. If NPV is positive, this means that inflows discounted at opportunity cost of capital are more than the outflows. A positive NPV project adds to the value of firm and maximizes shareholders wealth. For a company the project that provides larger NPV given sufficient funds to invest shall be chosen to maximize shareholders wealth.
IRR on the other hand is the rate at which NPV is zero. If IRR is greater than cost of capital or opportunity cost of the firm, the project shall be chosen. The condotions under which NPV and IRR will yield same results are :
There shall be only one outflow in the beginning. This shall result in only one IRR. For nPV cash flows are discounted at cost of capital while for IRR cash flows are discounted at the rate of IRR. Hence with conventional cash flows (-|+|+) no conflict in decision arises; in this case both NPV and IRR lead to the same accept/reject decisions. NPV method is consistent with the shareholder wealth maximisation; hence, it should be preferred over IRR.

One problem with IRR is that with non conventional cash flows, there can be more than one IRR and this leads to errors in capital budgeting.

Profitability index (PI) is ratio of Present Value of future cash flows to initial investment. If PI>1 then invest else if it is les sthan 1 do not invest as it will decrease shareholders wealth. PI is  useful tool when ranking projects because it enables us to quantify the amount of value created per unit of investment. Hence even two profitable investments can be compared.