Question

Projection decision is very important in business. The two important metrics firms use are NPV and IRR. Explain how you would compute & use these two metrics when in ranking projects. Discuss the flaws and advantages of each metric & how to overcome those flaws. Please be specific when deciding independent projects and when deciding mutually exclusive projects.

Answer 1

Net Present Value (NPV)

The net present value technique is a discounted cash flow method that considers the time value of money in evaluating capital investments. An investment has cash flows throughout its life, and it is assumed that an amount of cash flow in the early years of an investment is worth more than an amount of cash flow in a later year.

The net present value method uses a specified discount rate to bring all subsequent cash inflows after the initial investment to their present values (the time of the initial investment is year 0).

The net present value of a project is the amount, in current value of amount, the investment earns after paying cost of capital in each period.

Net present value = Present value of net cash inflow - Total net initial investment

Since it might be possible that some additional investment may also be required during the life time of the project then appropriate formula shall be:

Net present value = Present value of cash inflows - Present value of cash outflows

Steps to calculating Net Present Value (NPV):

The steps to calculating net present value are: -

1. Determine the net cash inflow in each year of the investment

2. Select the desired rate of return or discounting rate or Weighted Average Cost of Capital.

3. Find the discount factor for each year based on the desired rate of return selected.

4. Determine the present values of the net cash flows by multiplying the cash flows by respective discount factors of respective period called Present Value (PV) of Cash flows

5. Total the amounts of all PVs of Cash Flows Decision Rule:

If NPV ≥ 0	Accept the Proposal
If NPV ≤ 0	Reject the Proposal

The NPV method can be used to select between mutually exclusive projects; the one with the higher NPV should be selected

Advantages of NPV

Ø NPV method takes into account the time value of money.

Ø The whole stream of cash flows is considered.

Ø The net present value can be seen as the addition to the wealth of shareholders. The criterion of NPV is thus in conformity with basic financial objectives.

Ø The NPV uses the discounted cash flows i.e., expresses cash flows in terms of current rupees. The NPVs of different projects therefore can be compared. It implies that each project can be evaluated independent of others on its own merit.

Limitations of NPV

Ø It involves difficult calculations.

Ø The application of this method necessitates forecasting cash flows and the discount rate. Thus accuracy of NPV depends on accurate estimation of these two factors which may be quite difficult in practice.

The decision under NPV method is based on absolute measure. It ignores the difference in initial outflows, size of different proposals etc. while evaluating mutually exclusive projects.

Internal Rate of Return Method (IRR)

The internal rate of return method considers the time value of money, the initial cash investment, and all cash flows from the investment. But unlike the net present value method, the internal rate of return method does not use the desired rate of return but estimates the discount rate that makes the present value of subsequent cash inflows equal to the initial investment. This discount rate is called IRR.

IRR Definition: Internal rate of return for an investment proposal is the discount rate that equates the present value of the expected cash inflows with the initial cash outflow.

This IRR is then compared to a criterion rate of return that can be the organization’s desired rate of return for evaluating capital investments.

Calculation of IRR: The procedures for computing the internal rate of return vary with the pattern of net cash flows over the useful life of an investment.

Scenario 1: For an investment with uniform cash flows over its life, the following equation is used:

Step 1: Total initial investment =Annual cash inflow × Annuity discount factor of the discount rate for the number of periods of the investment’s useful life

A = Total initial cash disbursements and commitments for the investment/Annual (equal) cash inflows from the investment

Step 2: Once A has been calculated, the discount rate is the interest rate that has the same discounting factor as A in the annuity table along the row for the number of periods of the useful life of the investment. If exact value of ‘A’ could be found in Present Value Annuity Factor (PVAF) table corresponding to the period of the project the respective discounting factor or rate shall be IRR. However, it rarely happens therefore we follow the method discussed below:

Step 1: Compute approximate payback period also called fake payback period.

Step 2: Locate this value in PVAF table corresponding to period of life of the project. The value may be falling between two discounting rates.

Step 3: Discount cash flows using these two discounting rates.

Step 4: Using Interpolation, IRR can be Computed.

Acceptance Rule

The use of IRR, as a criterion to accept capital investment decision involves a comparison of IRR with the required rate of return known as cut off rate. The project should the accepted if IRR is greater than cut-off rate. If IRR is equal to cut off rate the firm is indifferent. If IRR less than cut off rate the project is rejected. Thus,

If IRR ≥ Cut-off Rate or WACC	Accept the Proposal
If IRR ≤ Cut-off Rate or WACC	Reject the Proposal

Reinvestment Assumption

The Net Present Value technique assumes that all cash flows can be reinvested at the discount rate used for calculating the NPV. This is a logical assumption since the use of the NPV technique implies that all projects which provide a higher return than the discounting factor are accepted.

In contrast, IRR technique assumes that all cash flows are reinvested at the projects IRR. This assumption means that projects with heavy cash flows in the early years will be favoured by the IRR method vis-a-vis projects which have got heavy cash flows in the later years. This implicit reinvestment assumption means projects with cash flows concentrated in the earlier years of life will be preferred by the method relative to other Projects.

Advantages of IRR

Ø This method makes use of the concept of time value of money.

Ø All the cash flows in the project are considered.

Ø IRR is easier to use as instantaneous understanding of desirability can be determined by comparing it with the cost of capital

Ø IRR technique helps in achieving the objective of maximisation of shareholder’s wealth.

Limitations of IRR

Ø The calculation process is tedious if there are more than one cash outflows interspersed between the cash inflows, there can be multiple IRR, the interpretation of which is difficult.

Ø The IRR approach creates a peculiar situation if we compare two projects with different inflow/outflow patterns.

Ø It is assumed that under this method all the future cash inflows of a proposal are reinvested at a rate equal to the IRR. It is ridiculous to imagine that the same firm has a ability to reinvest the cash flows at a rate equal to IRR.

Ø If mutually exclusive projects are considered as investment options which have considerably different cash outlays. A project with a larger fund commitment but lower IRR contributes more in terms of absolute NPV and increases the shareholders’ wealth. In such situation decisions based only on IRR criterion may not be correct.