Today in the market so many business are looking forward to expand their business. And successful company always have the good offer for the implementing the new business in the market. And for that before they make the decision to make the investment in the project or not they always use the investment appraisal method. To find out the project is going to give them benefit in the short term or long term, or which project is more beneficial to the company than the other one and to decide that they use this method. With the help of this method they can find out easily its right to spend money in the business or not.
There are basically two types of the method.
Discounted case flow method (DCF)
In traditional method they are further divided in the accounting rate of return (ARR) and payback method. Whereas the discounted cash flow method they are divided Net Present Value (NPV) and Internal Rate Return (IRR).In these all method pay back method uses the profit in its calculation where as other method use the cash flow in there calculation.(timeweb,2001-2009)(B) What is the payback period of each project? If AP Ltd imposes a 3 year maximum payback period which of these projects should be accepted? (C) What are the criticisms of the payback period?
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With the use of the payback period there are some of the limitations of this method because it ignores the time value of money. It only gives the favour to the short term project over the longer term project. And thus it also ignores the cash flow after the payback period. Sometimes even the long term project more beneficial than the shorter one but it only go ahead with the short term project. It also does not identify which project is good to go for when the payback period of the two projects are the same. (Accounting for management, 2008)(D) Determine the NPV for each of these projects? Should they be accepted - explain why? (E) Describe the logic behind the NPV approach.
The main logic behind the NPV (net present value) method is nothing but the difference between the present value of cash inflows and the present value of cash outflows. It takes count of time value of money because of that it is considering the events throughout the life time of the project so it over comes the weakness of the pay back method. And it also takes discount rate in it calculation so because of that we can calculate at the different discount rate project's risk.
The main logic behind the NPV method is
If NPV is positive for the project, than you can do investment in that project. That stand for it covers the all investment in the project so project is giving the profit.
If NPV is negative for the project, than you cannot do investment in that project which stand for it will not cover the investment which is done in the given project.
If NPV is zero for that project, you can invest in that project because that project is not given profit or loss. So whatever you are spending in that project that is recovered.(F) What would happen to the NPV if: (1) The cost of capital increased? (2) The cost of capital decreased?
Before that I will explain the relation between the NPV and the cost of capital.
They are inversely proposal to each other that means
If cost of capital is increases, than the NPV will be decreases.
If cost of capital is decreases, than the NPV will be increases.(G) Determine the IRR for each project. Should they be accepted?
IRR OF THE PROJECTS(H) How does a change in the cost of capital affect the project's IRR?
IRR is the nothing but the discount rate at which the NPV of the project become the zero and it is the calculation of the capital efficiency. From above you can see that the as cost of capital increases the IRR is going to decrease and at the one cost of capital it comes to zero and if you further increase then it goes to in the negative.
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So, from we can see that if the IRR is exceeded than the cost of the capital than the project will be accepted. While if the IRR will be less than the cost of the capital than the project will be rejected. (Kind, Jhon, 1999)(I) why is the NPV method often regarded to be superior to the IRR method?
Between the NPV method and IRR method NPV method is superior to uses because of the some of the advantages of the NPV method over the IRR method.
- Multiple IRR problems
- Reinvestment assumption
Multiple IRR problems is the when cash flows during the project lifetime is negative. That is stand for the project operates at a loss or the company needs to contribute more capital. (Investopedia ULC,2009) So, there will be two IRR point where NPV becomes zero. And among both of them one might be closer to zero or away from zero. So, from that condition we cannot say for the project at which IRR point we have to consider. On the other hand there will not be such thing happens in the NPV there will be only two condition apply which is NPV>0 and NPV=0 where project will be accepted and if NPV<0 project will be rejected .so thus NPV method is better over the IRR method to chose the project.
Reinvestment assumption is the 'IRR implicitly assumes that positive cash flows generated are reinvested at the IRR, not the discount rate' (Ray Martin, 1982-1997).on the other hand the discount rate is representing the cost of the capital not the IRR. So that this assumption making the IRR inappropriate for calculating to invest the money on the project or not. So that conflicts and thus the reinvestment on the calculation on IRR is not the good option to choose. And over here same NPV overcome this fault on IRR.
- Kind, John (1999) Accounting and Finance for Manager, Kogan page-limited Pp 126-128 Online:
- Accounting for management (2008) pay back method [Online] (Access on 16/11/09)
- Received from: http://www.accountingformanagement.com/pay_back_method_of_capital_budgeting_decisions.htm
- Investopedia ULC (2009) advantage and disadvantage of NPV and IRR [Online] (Access on: 22/11/09)
- Received on: http://www.investopedia.com/study-guide/cfa-exam/level-1/corporate-finance/cfa13.asp
- Time web (2001-2009) investment appraisal [Online] (Access on:14/11/09)
- Received from: http://www.bized.co.uk/timeweb/reference/using_experiments.htm
- Ray Martin (1982-1997) tripod-internal rate of return [Online] (Access on: 24/11.09)
- Received on: http://members.tripod.com/~Ray_Martin/DCF/nr7aa003.html