Question

1 (b) Compare the merits of the net present value (NPV), internal rate of return (IRR) and discounted payback period methods of capital investment project appraisal, assuming the firm’s objective is to maximise the wealth of its equityholders. What conditions must apply for the net present value (NPV) and internal rate of return (IRR) methods to always give the same signal to accept or reject a capital investment project? (210 words)

Answer 1

The Net present Value Method is the present value of inflows less the initial outflow. The Net present Value method is used to evaluate investment proposals. The NPV method assumes that the cash flows from the project are reinvested at cost of capital. This is a realistic assumption. The NPV gives a dollar value. The result from an NPV calculation is an absolute measure. When NPV is used as a criteria to evaluate investment proposals the projects which have a positive NPV are accepted. This is because the positive NPV implies that the proposal would add value to the firm and thereby maximising shareholder value. If NPV is negative then the proposal is rejected as it does not add positive value to the firm. Now the IRR(Internal Rate of Return) method gives the rate at which the NPV of a project will be equal to zero. When IRR is used as an investment evaluation criteria the projects with IRR lower than cost of capital are rejected and the projects with IRR greater than cost of capital are accepted. The IRR method makes an implicit assumption that the cash flows are reinvested at the IRR .This is an unrealistic assumption. Also the IRR method is a relative measure and is not a dollar value.IRR can be used to rank projects. The discounted payback method helps determine the time taken to recoup the initial outflow for a project. The discounted payback period takes into consideration the time value of money which was ignored in regular payback method.

When it comes to the evaluation of independent projects the NPV and IRR results will be the same. When it comes to mutually exclusive project the NPV and IRR methods may give conflicting results this maybe due to the difference nature of cashflows or size of the projects.In such instances the NPV method is used,since the underlying assumption in NPV method is superior to the IRR method assumption.