A1) b)

NPV – is the total present values of each of a project’s cash flows (using a present value

discount factor) less the initial investment.

The NPV rule states that managers increase shareholders’ wealth by accepting projects that

are worth more than they cost. Hence, they should accept all projects with a positive NPV.

When choosing between mutually exclusive projects, choose the one that offers the highest

net present value.

Advantages

Considers all cash flows of projects.

Uses relevant cash flows

Allows for the time value of money. Discounting cash flows to present value takes

account of the impact of interest, risk over time and inflation.

Gives an absolute measure of return. The NPV of an investment represents the

actual surplus raised by the project. This allows a business to plan more effectively

and to compare projects.

It is directly related to the objective of maximisation of shareholders’ wealth (value of

the business). If the cost of capital reflects the shareholders’ required rate of return,

then the NPV reflects the theoretical increase in their wealth. For a company, this is

considered to be the primary objective of the business.

All relevant, measurable financial information concerning the decision is taken into

account

It is additive which means that if the cash flow is doubled then the NPV is doubled

It is practical and easy to use (once the anticipated cash flows have been identified –

which is difficult to do in reality)

It gives clear and unambiguous signals to the decision maker

Disadvantages

Difficulty obtaining all relevant costs/benefits.

Difficult to calculate and to explain to managers, because the understanding of the

NPV requires an understanding of discounting. The NPV method is not intuitive like

payback method. Therefore, it may be rejected in favour of simpler techniques.

Assumes cash flows occur at annual intervals.

The need to estimate a cost of capital. The calculation of the cost of capital in

practice is complicated (it involves gathering and analysing data). 6

IRR – is the discount rate that gives the project a zero NPV.

Decision rule:

Accept an investment project if the opportunity cost of capital (let’s call it r) is less than the

internal rate of return (IRR).

Advantages

Represents a break-even point.

All relevant information about the decision is taken into account by IRR

Takes into account time value of money

Considers all cash flows of projects

A company selecting projects where the IRR exceeds the cost of capital should

increase shareholders’ wealth

Disadvantages

May conflict with NPV decision.

Non-conventional cash flows (more than one change in the direction of cash inflows

and outflows) may give rise to no IRR or multiple IRRs. Even if the project does have

on IRR, the decision rule may lead to the wrong result as the project may not earn a

positive NPV at any cost of capital.

IRR fails to recognise value; it is only concerned with percentage returns

The technique assumes cash invested at IRR.

It is not possible to compare projects if scales of their investments are different

because a small scale project may have a high IRR but actually increase wealth by

very little in absolute terms.

Interpolation only provides an estimate. The cost of capital calculation itself is also only

an estimate and if the margin between required return and the IRR is small, this lack

of accuracy could actually mean the wrong decision is taken.