Net Present Value (NPV)
Defining the NPV method is simple; the present value of cash inflows minus the present value of cash outflows, which arrives at a dollar amount that is the net benefit to the organization.
To compute NPV and apply the NPV rule, the authors of the reference textbook define a five-step process to be used in solving problems (Ang and Chng, 2013):
Identify all cash inflows and cash outflows.
Determine an appropriate discount rate (r).
Use the discount rate to find the present value of all cash inflows and outflows.
Add together all present values. (From the section on cash flow additively, we know that this action is appropriate since the cash flows have been indexed to t = 0.) (Holland and Torregrosa, 2008)
Make a decision on the project or investment using the NPV rule: Say yes to a project if the NPV is positive; say no if NPV is negative. As a tool for choosing among alternates, the NPV rule would prefer the investment with the higher positive NPV (Di Bella, 2011).
The Internal Rate of Return
The IRR, or internal rate of return, is defined as the discount rate that makes NPV = 0. Like the NPV process, it starts by identifying all cash inflows and outflows. However, instead of relying on external data (i.e. a discount rate), the IRR is purely a function of the inflows and outflows of that project. The IRR rule states that projects or investments are accepted when the project's IRR exceeds a hurdle rate. Depending on the application, the hurdle rate may be defined as the weighted average cost of capital (McMillan, 2010).
Advantages and disadvantages
While useful NPV and IRR methods are useful methods for determining whether to accept a project, both have their advantages and disadvantages (Peterson Drake and Fabozzi, 2002).
With the NPV method, the advantage is that it is a direct measure of the dollar contribution to the stockholders.
With the IRR method, the advantage is that it shows the return on the original money invested.
With the NPV method, the disadvantage is that the project size is not measured.
With the IRR method, the disadvantage is that, at times, it can give you conflicting answers when compared to NPV for mutually exclusive projects. The 'multiple IRR problem' can also be an issue, as discussed below (Quiry, 2009).
Under what circumstances might net present value method be preferred over internal rate of return method?
Each of the two rules used for making capital-budgeting decisions has its strengths and weaknesses. The NPV rule chooses a project in terms of net dollars or net financial impact on the company, so it can be easier to use when allocating capital.
However, it requires an assumed discount rate, and also assumes that this percentage rate will be stable over the life of the project, and that cash inflows can be reinvested at the same discount rate. In the real world, those assumptions can break down, particularly in periods when interest rates are fluctuating. The appeal of the IRR rule is that a discount rate need not be assumed, as the worthiness of the investment is purely a function of the internal inflows and outflows of that particular investment. However, IRR does not assess the financial impact on a firm; it only requires meeting a minimum return rate (Zhao, Al Bahar and Chang, 2013).
Discuss the possible impact that an individual manager’s performance criteria may have on capital investment decision-making.
Capital investment decisions also can be called ‘capital budgeting’ in financial terms. Capital investment decisions aim includes allotting the capital investment funds of the firm in the most effective manner to make sure that the returns are the best possible returns. Assessing projects as well as the allocation of the capital depends on the project requirements are some of the most crucial capital investment decisions aspects.
There might be many different criteria’s for choosing the appropriate and right capital investment decision. For e.g., a company might stress on projects that assure for prompt returns while a few other companies might assert on projects which ensure for a growth in the long term. The important aim of capital investment decision is increasing the firms’ value by taking on a good project at the perfect time.
The power to study as well as take capital investment decisions permits an individual as the manager or owner of a particular business to make sure that their resources which are limited are apportioned to the project(s) which would best accomplish their strategically goals (thus they also are at times denoted as strategic capital investment decisions). Capital investment decisions mostly are regulated by the procedure of rating and identifying the organization's capital investments. The company ought to decide as to which of the capital investments that are given, would ensure the maximum value to their business and thus they can make their capital investment decision (Di Bella, 2011).
In the capital investment appraisal process risk and uncertainty are viewed as a company-wide risk. Are there any differences and similarities between the risk and uncertainty? Explain.
Risk and uncertainty both relate to the same underlying concept—randomness. Risk is randomness in which events have measurable probabilities, wrote economist Frank Knight in 1921 in Meaning of Risk and Uncertainty. Probabilities may be attained either by deduction (using theoretical models) or induction (using the observed frequency of events). For example, we can easily deduce the probabilities of the possible outcomes of a game of dice. Similarly, economists can deduce probability distributions for stock market returns based on theoretical models of investor behavior.
On the other hand, induction allows us to calculate probabilities from past observations where theoretical models are unavailable, possibly because of a lack of knowledge about the underlying relation between cause and effect. For instance, we can induce the probability of suffering a head injury when riding a bicycle by observing how frequently it has happened in the past. In a like manner, economists estimate probability distributions for stock market returns from the history of past returns.
Ang, R. and Chng, V. (2013). Value Investing in Growth Companies. Hoboken: Wiley.
Di Bella, G. (2011). The Impact of the Global Financial Crisis on Microfinance and Policy Implications. Washington: International Monetary Fund.
Harris, P. (2013). Profit Planning. Oxford: Goodfellow Publishers Ltd.
Holland, J. and Torregrosa, D. (2008). Capital budgeting. [Washington, D.C.]: Congress of the U.S., Congressional Budget Office.
McMillan, E. (2010). Not-for-profit budgeting and financial management. Hoboken, N.J.: Wiley.
Peterson Drake, P. and Fabozzi, F. (2002). Capital budgeting. New York, NY: Wiley.
Quiry, P. (2009). Corporate Finance. John Wiley & Sons.
Zhao, J., Al Bahar, S. and Chang, S. (2013). Advances in civil engineering and building materials. Leiden, The Netherlands: CRC Press/Balkema.