DISCOUNTED CASHFLOW TECHNIQUES ( DCF)-NEED FOR PROJECT APPRAISAL
DISCOUNTED CASHFLOW TECHNIQUES ( DCF)-NEED FOR PROJECT APPRAISAL
Net present value (NPV) is the sum of the present values of all cash inflows and outflows associated with a project.Internal rate of return (IRR) is the actual rate of return expected from an investment. The IRR is the discount rate that makes the investment's net present value equal to zero. If an investment's net present value is positive, them it's internal rate of return exceeds its cost of capital; if an investment net present value is negative, then its internal rate of return is less than its cost of capital.
NPV vs. IRR
Net Present Value (NPV) and Internal Rate of Return (IRR) Methods are the group of the same sequence, i.e., discounted cash flow method, yet they are different from each other in several aspects. The difference between the two is as follows:
The Net Present Value Method takes the interest rate as a known factor while Internal Rate of Return Method takes interest rate as an unknown factor.
The Net Present Value Method seeks to find out the amount that can be invested in a given project so that its anticipated earnings will exactly suffice to repay this amount with interest at the market rate. On the other hand, Internal Rate of Return Method seeks to find the maximum rate of interest at which the funds invested in the project could be repaid out the cash inflows arising out of that project.
Both the Net Present Value Method and Internal Rate of Return Method proceed on this presumption that cash inflows can be reinvested at the discounting rate in the new projects. However, reinvestment of funds at the cut-off rate is more possible than at the internal rate of return. Hence, Net Present Value Method is more reliable than the Internal Rate of Return Method for ranking two or more capital investment projects.
Similarities in results unde.r NPV and IRR
Both NPV and IRR will give up the same result (i.e., acceptance or rejection) regarding an investment proposal in following cases:
i. Projects involving conventional cash flows, i.e., when an initial outflow is followed by a series of inflows.
ii. Independent investment proposals, i.e., proposals the acceptance of which does not preclude the acceptance of others.
The reason for similarity in results in the above cases is simple. In case of NPV method, a proposal is acceptable if its NPV is positive. NPV will be positive only when the actual return on investment is more than the cut-off rate. In case of IRR method a proposal is acceptable only when the IRR is higher than the cut-off rate. Thus, both methods will give consistent results since the acceptance or rejection of this proposal under both of them is based on the actual return being higher than the cut-off rate.
Conflicting results under NPV and IRR
NPV and IRR methods may give conflicting results in case of mutually exclusive projects, i.e., projects where acceptance of one would result in non-acceptance of the other. Such conflict of result may be due to any one or more of the following reasons:
The projects require different cash outlays.
The projects have unequal lives.
The projects have different patterns of cash flows.
In such a situation, the result given by the NPV method should be relied upon. This is because the objective of a company is to maximize its shareholders' wealth. IRR method is concerned with the rate of return on investment rather than total yield on investment hence it is not compatible with the goal of wealth maximization. NPV method considers the total yield on investment. Hence, in case of mutually exclusive projects, each having a positive NPV, the one, with the largest NPV will have the most beneficial effect on shareholders' wealth.
In case of projects requiring different cash outlays, the problem can also be resolved by adopting incremental approach, a modified form of IRR method. According to this approach in case of two mutually exclusive projects requiring different cash outlays, the IRR of incremental outlay of the project requiring a higher investment is calculated. In case this IRR is higher than the required rate of return, the project having greater non-discounted cash flows should be accepted otherwise it should be rejected.
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