The finance department of a large corporation has evaluated a possible capital project using the NPV method, the Payback Method, and the IRR method. The analysts are puzzled, since the NPV indicated rejection, but the IRR and Payback methods both indicated acceptance. Explain why this conflicting situation might occur and what conclusions the analyst should accept, indicating the shortcomings and the advantages of each method. Assuming the data is correct, which method will most likely provide the most accurate decisions and why?
When the project is an independent one it indicates that the decision to invest in a particular project is free of any other project, NPV,IRR and Payback will provide the same result which means there will be either rejection or acceptance. It is to be noted that when NPV, IRR and Payback is done for evaluation of mutually exclusive projects, which means the decision must be one project or another then such metrics do not match. The above case is similar in nature which means that the timing of cash flows has resulted in the difference. The project size is also an important consideration as it tends to influence the choice of method and the result. Hence, the best method must be selected which suits the organization.
NPV, IRR and Payback - advantages and disadvantages
NPV is a direct measure and hence the contribution of the stockholder can be matched with ease and flexibility. Hence, it can be said to be the best method which provides the basis for contribution. It is the most widely used method and the business rule functions mainly on this which is to accept all project or investments where NPV of cash flow is greater than zero (Berk et. al, 2015). The risk linked with future cash flow is known.
In case of IRR the return is shown derived from the original money invested and is known to be a proper evaluation of return which is based on discounted cash flows hence accounts for the time value of money. Guidance is generated too which helps in tackling risks (Berk et. al, 2015).
Payback provides a simple understanding and decision is done simply on the cut off date rules
NPV – does not provide the time frame how much time would be taken establish a positive NPV. Also it is seen that there is no capital rationing in this method.
IRR – There are many cons associated with IRR which are multiple or no returns at all. If the discount rate changes then it is impossible for comparing. The major shortfall which can be seen in this method is that the IRR cannot be added together which do not allow the projects to be evaluated on a combined basis (Moten & thron, 2013).
Payback – The time value of money is altogether ignored. Moreover, the payback period rejects all cash flows which happen after the payback period reaches. It can be used when there is a clear cut off period otherwise utilizing this concept is very difficult.
Considering the advantages and disadvantages of all the methods above it can be said that the company must go with the Net Present Value as it provides a base for the time value of money. Since, NPV projected a rejection it must be noted and hence must be followed as large organization usually depends on NPV as it well suited with the future cash flows and the risk factor is also known with this method. Therefore, NPV must be taken into consideration and the decision of rejecting the project should be applied.
Berk, Johnathan; DeMarzo, Peter; Stangeland, David (2015). Corporate Finance (3rd Canadian Edition ed.). Toronto: Pearson Canada.
Moten, J. and Thron, C.(2013) Improvements on Secant Method for Estimating Internal Rate of Return, International Journal of Applied Mathematics and Statistics, 4(2), 22-48