Question

Net Present Value (NPV) method, Internal Rate of Return (IRR) method, Equivalent Annual Annuity (EAA) method and Payback Period method are the main important decision-making tools for corporate investment. Please address the following in your answer.

- Investment decisions and the process

- decision making tools listed above

- advantages and disadvantages of these decision making tools

- use of EAA method

- conflict between NPV and IRR

- why NPV method should be used when there is a conflict

- capital rationing

- the affect of these on decision making

Answer 1

Net Present Value

As an organization expands, it needs to take important decisions which involve immense capital investment. An organization must take the decisions regarding the expansion of business and investment very wisely. In such cases, the organization will take assistance of Capital Budgeting tools, one of the most popular NPV method and take a call on the most profitable investment.

Net present value is a tool of Capital budgeting to analyze the profitability of a project or investment. It is calculated by taking the difference between the present value of cash inflows and present value of cash outflows over a period of time.

As the name suggests, net present value is nothing but net off of the present value of cash inflows and outflows by discounting the flows at a specified rate.

ormula for NPV

NPV = (Cash flows)/( 1+r)i

i- Initial Investment

Cash flows= Cash flows in the time period

r = Discount rate

i = time period

o derive the present value of the cash flows we need to discount them at a particular rate. This rate is derived considering the return of investment with similar risk or cost of borrowing, for the investment.

NPV takes into consideration the time value of money. The time value of money simply means that a rupee today is of more value today than it will be tomorrow. NPV helps in deciding whether it is worth to take up a project basis the present value of the cash flows.

After discounting the cash flows over different periods, the initial investment is deducted from it. If the result is a positive NPV then the project is accepted. If the NPV is negative the project is rejected. And if NPV is zero then the organization will stay indifferent.

Advantages of Net present value method

Time value of money

Net present value method is a tool for analyzing profitability of a particular project. It takes into consideration the time value of money. The cash flows in the future will be of lesser value than the cash flows of today. And hence the further the cash flows, lesser will the value. This is a very important aspect and is rightly considered under the NPV method. This allows the organisation to compare two similar projects judiciously, say a Project A with a life of 3 years has higher cash flows in the initial period and a Project B with a life of 3 years has higher cash flows in latter period, then using NPV the organisation will be able to choose sensibly the Project A as inflows today are more valued than inflows later on.

Comprehensive tool

Net present value takes into consideration all the inflows, outflows, period of time, and risk involved. Therefore NPV is a comprehensive tool taking into consideration all aspects of the investment.

Value of investment

The Net present value method not only states if a project will be profitable or not, but also gives the value of total profits. Like in the above example the project will gain Rs. 29881 after discounting the cash flows. The tool quantifies the gains or losses from the investment.

Limitations of the Net Present Value method

Discounting rate

The main limitation of Net present value is that the rate of return has to be determined. If a higher rate of return is assumed, it can show false negative NPV, also if a lower rate of return is taken it will show the false profitability of the project and hence result in wrong decision making.

Different projects are not comparable

NPV cannot be used to compare two projects which are not of the same period. Considering the fact that many businesses have a fixed budget and sometimes have two project options, NPV cannot be used for comparing the two projects different in period of time or risk involved in the projects.

Multiple Assumptions

The NPV method also makes a lot of assumptions in terms of inflows, outflows. There might be a lot of expenditure that will come to surface only when the project actually takes off. Also the inflows may not always be as expected.

Today most softwares perform the NPV analysis and assist management in decision making. With all its limitations, the NPV method in capital budgeting is very useful and hence is widely used.

Internal Rate of Return (IRR) method

IRR is the rate at which the net present value of the costs of an investment equals the net present value of the expected future revenues of the investment. Management can use this return rate to compare other investments and decide what capital projects should be funded and what ones should be scrapped.

Equivalent Annual Annuity Approach

Equivalent annual annuity (EAA) approach (also called the annual net present value method) ranks projects based on their net present value per year which is calculated by dividing the net present value by the present value of annuity factor corresponding to the hurdle rate and life of the project.

The project with higher annual net present value is accepted. Annual net present value method is also called the equivalent annual annuity approach.

Annual net Present Value =	Net Present Value
Annuity Discount Factor for the Project Life

In the replacement chain method, the cash flows projections for the projects under consideration are repeated up to the least common useful life. For example, if Project A has a life of 3 years and Project B has a life of 5 years, 15 years is the least common life, i.e. if Project A is repeated 5 times and Project B is repeated 3 times, both will have equal useful lives. Net present value and internal rate of return for that common useful life are compared and the project with higher NPV and IRR is accepted. Replacement chain analysis is also called common-life approach.