Net present value vs Internal rate of return Essay

How do the results of the NPV technique relate to the goal of maximizing shareholder wealth? The NPV technique measures the present value of the future cash flows that a project will produce. A positive NPV means that the investment should increase the value of the firm and lead to maximizing shareholder wealth. A positive NPV project provides a return that is more than enough to compensate for the required return on the investment. Thus, using NPV as a guideline for capital investment decisions is consistent with the goal of creating wealth. In theory, why is NPV the most appropriate technique for making capital budgeting decisions? The NPV method is theoretically the most appropriate method for making capital budgeting decisions because it measure wealth creation, which is the assumed goal of financial management. NPV is an absolute measure of a project’s profitability and indicates the expected change in owners’ wealth from a capital investment. As an evaluation technique, NPV considers all expected future cash flows, the time value of money, and the risk of the future cash flows. Thus, NPV can help identify projects that maximize shareholder wealth. If a firm selects a project with an NPV of $75,000, what impact should this decision have on shareholder wealth? If the estimated cash flows and discount rate are accurate, this project should increase shareholder wealth by $75,000. If a project’s NPV is positive, what does this suggest about the required versus estimated return on the project? What does this suggest about accepting the project? A positive NPV suggests that the estimated return on the project is greater than the required return for the project. The NPV decision rule is to accept a project whose NPV is greater than zero because this investment should increase shareholder wealth. The IRR measures a project’s yield or expected rate of return. This return does not depend on anything except the cash flows of the project. Thus, the IRR provides a single number summarizing the merits of a project. Mathematically, the IRR is that rate of return (discount rate) that makes the present value of all expected future cash flows equal to zero. That is, the IRR is the discount rate that causes a project’s NPV to equal zero. Why may using the IRR method as a decision criterion not lead to maximizing shareholder wealth? What factors can lead to misleading results when comparing the IRR with the NPV? If projects are independent and are not subject to capital rationing, using the IRR method in evaluating projects indicates the ones that maximize shareholder wealth. However, using the IRR method as a decision criterion may sometimes lead to selecting projects that do not maximize wealth if the projects are mutually exclusive or capital rationing exists. When evaluating mutually exclusive projects, the IRR may indicate a different decision than the NPV because of the reinvestment rate assumption. The IRR implicitly assumes reinvestment of all intermediate cash inflows at the IRR, whereas the NPV implicitly assumes reinvestment of all intermediate cash inflows at the cost of capital. This reinvestment rate assumption may lead to different decisions in selecting among mutually exclusive projects when any of the following factors apply: (1) differences in timing of cash flows among the projects, (2) differences in scale, and (3) differences in the useful lives of the projects. What are the similarities and differences in decision rules when using NPV versus IRR? For independent projects with conventional cash flows and no capital rationing, the NPV and IRR generate the same accept-rejected decision. Thus, the decision rules are similar for investment projects. The decision rule for NPV is to accept the project if the NPV is positive and reject the project if the NPV is NPV is negative. The decision rule for IRR is to accept the project if the IRR equals or is greater than the required rate of return and reject the project if the IRR is less than the required rate of return. Technically, the firm should be indifferent between accepting and rejecting a project with an NPV equal to zero or an IRR equal to the cost of capital because such an investment would not change shareholder wealth. The cost of capital is the discount rate for the NPV and the hurdle rate for the IRR. The firm should accept the project because it has a positive NPV. However, the discounted payback method is inconsistent with shareholder wealth maximization because the method ignores some cash flows that contribute to the present value of investment. What are two reasons for the superiority of the NPV method in evaluating capital investment projects? The NPV method is the best approach in evaluating projects because it measures the amount by which a capital investment creates wealth. This is because the NPV is an absolute measure of a project’s worth. In addition, NPV has a more realistic reinvestment rate assumption than IRR. It implicitly assumes reinvestment of intermediate cash inflows at the required rate of return. Both reasons supporting the superiority of the NPV method assume that managers invest the cash flows from the investment for the benefit of shareholders. In summary, no other capital budgeting technique does a better job of measuring wealth creation than the NPV method. Which capital budgeting techniques are increasing in popularity? Which are decreasing in popularity? Survey results suggest an increased use of more sophisticated capital budgeting techniques. The use of discounted cash flow techniques, specifically NPV and IRR, has increased in popularity over time. Several reasons may explain increasing popularity of these methods such as the widespread use of personal computers with spreadsheet programs that reduce the knowledge and effort required to calculate discounted cash flow measures and increased familiarity of managers with these techniques. NPV has been the dominant method taught in business schools for many years and many financial managers hold business degrees, especially MBAs. The popularity of the IRR is mostly likely because it is a measure of yield and is easy to explain to people who do not have formal training in finance. Since financial managers often deal in yields, some may be slightly more comfortable dealing with the IRR than NPV. Methods declining in popularity include the use of the payback period, although still popular, and the accounting rate of return. The rationale for this decline in popularity likely results from several factors including their simplicity and failure to consider the time value of money. In addition, the accounting rate of return uses accounting income instead of the cash flows.