Question

How might the Capital Budgeting process change when the firm faces a dollar limit on capital investment projects? Provide an argument for why NPV is a superior capital budgeting technique over the IRR.

Answer 1

Capital budgeting is the process a business undertakes to evaluate potential major projects or investments. Capital budgeting involves choosing projects that add value to a company. The capital budgeting process can involve almost anything including acquiring land or purchasing fixed assets like a new truck or machinery. Corporations are typically required, or at least recommended, to undertake those projects which will increase profitability and thus enhance shareholders' wealth.

When a firm faces capital constraints (known as Capital Rationing), it must choose the most value-adding project amidst the alternatives. There are multiple measures that firms employ to choose among the alternatives. The payback period (PB), internal rate of return (IRR) and net present value (NPV) methods are the most common approaches to project selection. Although an ideal capital budgeting solution is such that all three metrics will indicate the same decision, these approaches will often produce contradictory results.

NPV - When NPV is zero, the project’s cash flows are great enough to meet the project’s required rate of return and pay back the capital invested. When NPV is positive, there are enough cash flows to pay back the project’s debt and provide a return to shareholders. NPV is also expressed as a dollar value, which provides a good indicator of profitability and growth in shareholder wealth.

IRR - For a project to be acceptable under the IRR method, the discount rate must exceed the project’s cost of capital, otherwise known as the hurdle rate. An IRR less than the hurdle rate represents a cost to shareholders, while an IRR greater than the hurdle rate represents a return on investment, increasing shareholder wealth.

NPV is considered to IRR due to following reasons:

1. Reinvestment rate assumption - The NPV method assumes that cash flows will be reinvested near or at the project’s current cost of capital, while the IRR method assumes that the firm can reinvest cash flows at the project’s IRR. The assumption that the firm will reinvest its cash flows at the current cost of capital is more realistic than the assumption that cash flows can be reinvested at the projects IRR. This is because the IRR may not reflect the true rate at which cash flows can be reinvested.

2. Mutually exclusive projects - The NPV and IRR methods will return conflicting results when mutually exclusive projects differ in size, or differences exist in the timing of cash flows. When mutually exclusive projects exhibit these attributes, their NPV profiles will cross when plotted on a graph. This point at which they cross is defined as the crossover rate, which happens because one project’s NPV is more sensitive to the discount rate caused by the differences in the timing of cash flows.

3. Non-normal cash flows - NPV also has an advantage over IRR when a project has non-normal cash flows. Non-normal cash flows exist if there is a large cash outflow during or at the end of the project. The presence of non-normal cash flows will lead to multiple IRRs. Hence, the IRR method cannot be employed in the evaluation process. Mathematically, this problem will not occur if the NPV method is employed. The NPV method will always lead to a singular correct accept-or-reject decision.