Question

Pyramid Printing Company’s Controller, Sally Sound, and the Production Manager, Darrell Dailey, once again discuss potential operational improvements. After successfully implementing JIT and subletting the warehouse space, Pyramid was flush with cash. As a result, Darrell inquired whether it was time to purchase another press. Henry Hines, Pyramid Printing’s Sales Manager, suggested that the market be tested to ensure the press would be full in terms of capacity prior to use.

Sally and Darrell then discuss their choice of decision model; Sally prefers net present value, and Darrell prefers internal rate of return. Consider the use of these models. Which model is better for use? Are there circumstances one must consider regarding the outcomes of these two decision models? Do these models both deliver the same level of accuracy for decision making?

Please provide detail information..

Answer 1

For deciding on the project,the company must estimate the cost of capital first.

Then it should decisde onthe risk of project . Based on the cost of capital and the risk level, it should decide on the MARR (Minimum Annual Return Rate)

In Net Present Value model, the future cashflows throughout the life of the project are discounted at the MARR toarrive at the Present Value of cash flows. The sum of cash flows is the Net Present Value(NPV) of the project.If NPV is positive ,the project is selected. Aproject having highest NPV is selected.

In Internal Rate of Return (IRR)method , instead of finding present values of cash flows by discounting,the internalrate of return of the cash flows is determined.Internal rate of return is the discount rate at which NPV=0

If IRR ishigher than IRR, the project is accepted. The project with highest IRR (above MARR) is selected.

The main disadvantages of IRR method:

1. A project may have higher IRR , but may have lower NPV.In such case ,selecting a project with higher IRR may not result in maximizing shareholders'wealth

2.There is possibility of more than one IRR for a project

3.IRR assumes that positive cash flows are reinvested at the IRR rate

For mutually exclusive projects NPV method should be used, because this method maximizes the shareholders'wealth.

For the shortlisting of acceptable projects , IRR and NPV methods give the same results.

For selection of mutually exclusive projects, the project with the highest NPV should be selected