Question

Explain why firms choose to decentralize and give an example

Explain why NPV is generally preferred over IPR when choosing among competing or mutually exclusive project. Why would managers continue to use IRR to choose among mutually exclusive projects?

Answer 1

Reasons why firms choose to decentralize-

1) It facilitates quick decision-making by the managers which consequently saves the time and money of the company.

2) It reduces the heavy workload of top executives as a result of which they tend to focus more on the strategic future plans that are necessary for the growth of the business.

3) Decentralization helps in empowering the managers by way of motivating them to work even harder to justify the faith and trust pit in them by their seniors, which ultimately results in better communication between the managers and their sub-ordinates which eventually leads to high morale at the place of work.

Example- Sam is a manager at ABC Inc. who would like to enter into an agreement with a vendor who is offering his products at attractive prices. In case of a centralized organization, Sam had to make a request to the senior management and look for their approval or dusapproval. Any sort of delay could cost him that deal, but in a decentralized organization, the decision-making authority is with Sam. He is not supposed to seek the approval from his seniors, however such authority is limited to some extent.

NPV method is a method where investment propsals are ranked on the basis of NPV which refers to the present value of future cash flows discounted at the marginal cost of capital. If NPV is positive, then the project should be accepted and vice-versa.

Reasons for choosing NPV over IRR when choosing among mutually exclusive projects-

1) The assumptions in respect of the rate of reinvestment are much more realistic under net present value method as compared to IRR.

2) NPV method acts as a way better indicator of shareholders' wealth and profitability than IRR method irrespective of the fact that the cash flows are not normal, there are differences in project size or in the timing of cash flows.

3) NPV method gives a clear cut accept or reject decision as opposed to IRR method.

IRR refers to the rate at which the NPV of a project becomes zero. As per IRR method, a project is acceptable only when the discount rate is higher than the cost of capital of the project, also called the hurdle rate. An IRR which is less than the hurdle rate means a cost to shareholders whereas an IRR which is more than the hurdle rate means a return on investment, thus enhancing the wealth of the shareholders. Hence, the managers continue to use IRR to ascertain the hurdle rate against which they can choose or assess the financial feasibility of the proposed mutually exclusive projects.