Question

Suppose your firm is considering investing in a project with the cash flows shown as follows, that the required rate of return on projects of this risk class is 8 percent, and that the maximum allowable payback and discounted payback statistic for the project are three and three and a half years, respectively. . Use the IRR decision rule to evaluate this project; should it be accepted or rejected and why? Time 0 1 2 3 4 5 Cash Flow -100,000 30,000 45,000 55,000 30,000 10,000

I have solved this problem but I need to know How are the conclusions utilizing both methods similar? How are the methods different? Is there a method that you consider to be more appropriate for the situation?

Answer 1

Using payback and discounted payback rule, As Payback < Max Allowable payback and Discounted payback < Max allowable discounted payback , project must be accepted.

Using IRR rule, as IRR> Cost of capital , the project must be accepted.

Though both methods yield similar results, these results and methods are independent and not related. So the question why utlizing both methods may not arise.

Methods are different because in the first case (payback and discounted payback) it yields the number of years to payback the investment. In discounted payback, the time value of money is employed to arrive at the discounted pay back period. IRR yields the rate of return at which the NPV of cash flows is zero.

As the project has a conventional cash flow pattern, IRR is a very good method to evaluate the project. However. NPV is the most appropriate at all times as it provides the absolue value addition to the investors.

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