Question

Which of the following decision measures should capital budgeting decision makers consider? a. discounted payback b. NPV c. IRR d. MIRR e. Although NPV is considered the most important method in the decision process, the other measures can provide different relevant information that is useful to the process and thus should be used when appropriate

Answer 1

Capital Budgeting Decision Makers consider NPV Method but other methods have some aspects which requires their usage in specific situations.

NPV (Net Present value) Method is one of the most popular methods used for capital budgeting decisions. In this method, cash flows received in the future are discounted with the required rate to determine the present value. This present value is compared with the cost of the project. It the present value is more than the cost of the investment, then the proposal is accepted. It helps in calculating returns in absolute terms. It helps in solving capital rationing problems. It considers the wealth maximisation aspect too. IRR method helps us in calculating the rate which is internal to a given project for discounting various cash flows accruing from a project. It is the rate which equates the present value of cash inflows to the present value of cash outflows. Projects are accepted when IRR is greater than or equal to the minimum rate of return. However, this technique is based upon reinvestment rate assumption which is not in the case of NPV. It is complex to calculate as compared to simple NPV. MIRR method also helps in calculating the internal rate of return. The only difference (on comparing with IRR) that MIRR considers is the cash flows are reinvested at the cost of capital and the outflows are financed at the firm's financing cost. MIRR is better as compared to IRR since the problem of multiple IRR's is solved. Also, the issue of reinvesting at IRR is also solved by MIRR.  Payback Method calculates the time period to recover the original investment of the project. This method is highly simple but with a major drawback. It doesn't consider the time value of money which has so far been considered by NPV, IRR and MIRR. Discounted Payback Method has plugged the deficiency of Payback Method. This is computed by calculating the cumulative present value of cash inflows until they become equal to the present value of cash outflows. A project is generally accepted if the discounted payback period is less than the maximum discounted payback period. But, the decision to set this period is highly subjective. It ignores wealth maximisation aspect.

The reason of conflict in rankings of IRR and NPV:

NPV and IRR may result in contradictory results in case of mutually exclusive projects. NPV helps in calculating the returns in absolute form whereas IRR implies reinvestment at IRR. Contradictory results can also occur due to the different life expectancies of the project and different sizes of investment. The preferred technique is NPV since the cost of capital is a more realistic reinvestment rate. IRR may result in multiple IRR's and it is based upon reinvestment at IRR assumption too.

The decision, however, should not be based on only one technique. When an inconsistency is experienced, the project yielding larger NPV is preferred because of the larger cash flow it generates. It can be preferred in the circumstance of multiple IRR's too. IRR method is preferred when the decision to evaluate a project is solely based on the hurdle rate.