Question

8a. Explain why it is better to make decisions about acceptance or rejection of proposed projects based on project net present value rather than on project internal rate of return.

b. If a firm uses internal rate of return as the basis for its capital budgeting decisions, identify two things the firm should do to avoid making bad decisions due to shortcomings of the internal rate of return as a decision rule.

Answer 1

Net present value:

The net present value actually indicates how much money the company will earn, at present value, in monetary terms. IRR is just an indicator to indicate what return the company will earn, IRR typucally does not take into account size of the project and therefore, may not really work when comparing projects of different sizes. A project may have marginally lesser IRR, but the volume of moeny to be made may be significantly higher owing to the size of the projecy, naturally, the analysis of NPV will be a better indicator in such cases. Further, IRR often only indicates in percentage terms, whether the company will recover their cost of capital or not. Fixing an ideal IRR which takes into account the profitability factor is often difficult

Answer B

Two mistakes to avoid:

- Companies using IRR should ensure that the IRR used is appropriate. It is often difficult to identify the ideal IRR benchmark. Too high a benchmark may mean that even profitable projects may be rejected. Too low a benchmark may mean low profitability projects may also be selected.

- In case the project has mix cash inflows and outflows, the entity can end up with multiple IRRs. In such situations, IRR analysis should be avoided.

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