Project appraisal techniques are used to evaluate potential investment opportunities and determine the ones that will generate the greatest return for the company’s shareholders. Hence, it is vital for the firm to employ high-quality methods in analyzing investment options to secure ongoing funding from shareholders. There are two types of project appraisal techniques: non-discounted cash flows and discounted cash flows.
The Net Present Value and internal rate of return are widely used in large corporations as examples of discounted cash flows. They are considered more effective than traditional techniques like payback and accounting rate of return. This paper will discuss the use of the Net Present Value, including its considerations for specific cases such as unequal lives and mutually exclusive projects. Finally, it will conclude by analyzing and comparing different project appraisal techniques to determine the best one for investment appraisal.
The Net Present Value (NPV) method is employed by 75% of companies in making investment project decisions. The method’s popularity stems from two main reasons. Firstly, the NPV rule considers the time value of money, acknowledging that a pound today holds greater value than a pound in the future due to the ability to invest it and earn immediate interest. Secondly, NPV relies solely on projected cash flows from the project and the cost of capital’s opportunity cost.
Another reason for the preference of this technique is that the present values are measured in today’s pounds, which makes them additive. This additivity property is important because it prevents managers from being misled into accepting a low NPV project just because it is packaged with a high NPV project (Brealey and Myers 116-19). Additionally, managers widely use this technique because it simplifies their work by incorporating various aspects that would need to be evaluated separately if other investment appraisal methods were used.
The NPV rule allows managers to compare the marginal return on investment with the rate of interest on equivalent financial investments in the capital market. This provides several advantages. However, in order to include special cases such as unequal lives and mutually exclusive projects, extensions were made to the Net Present Value method. Unequal lives, also known as the ‘horizon’ problem, are addressed in this extended approach (Solomon).
This issue arises when investment projects of different durations are considered, a topic that has been widely debated. Unequal durations are not a concern for independent projects, but may be problematic for mutually exclusive projects. However, it is uncertain whether it is suitable to apply the analysis to a common duration even in these cases. Furthermore, there is disagreement as to whether the extension should only occur if there is a high likelihood that the projects will be repeated after their initial durations (Brigham and Houston 424-26). The initial solution proposed was the replacement chain approach.
Supporters of this method claim that one project’s cash flows are received sooner than another project’s, allowing the firm more time to reinvest the funds. However, this argument is invalid because a firm can always secure money at a predetermined rate, regardless of the project it intends to undertake. Nevertheless, there are three instances where this rule does not apply, as stated by Hirschleifer: when the investments are closely connected to the project, when both projects utilize the same physical resource, and when replication is evident.
Determining the value of mutually exclusive projects with different durations can be intricate. For instance, when comparing a project with a lifespan of 5 years to another with a lifespan of 20 years, a replacement chain analysis spanning two decades would be necessary. Hence, computing the equivalent annual annuity is often a more straightforward approach. While the replacement chain method may be simpler to comprehend for decision makers, the equivalent annual annuity method is typically easier to apply. Both methods yield the same conclusion when uniform assumptions are employed.
One of the main weaknesses in these types of analysis is that if inflation is anticipated, the cost of replacement equipment will increase. This also means that the sales and operating costs will fluctuate, rendering the conditions set in the analysis to be inaccurate. Another potential challenge is if future replacements incorporate a different technology, which would alter the cash flows. While this issue can be addressed in replacement chain analysis, it cannot be resolved using the equivalent annual annuity approach.
In conclusion, estimating the lifespans of projects is challenging and can lead to speculation about their duration. As a result, managers tend to assume all projects have the same lifespan for practical reasons. However, a problem arises if mutually exclusive projects have significantly different durations. In these cases, NPV must adapt its approach to consider the project that generates the highest positive NPV, as this will contribute the most to shareholders’ wealth.
In the case of mutually exclusive investments, ranking becomes crucial as only one project can be chosen from a group. These investment decisions rely on two important assumptions (Pike and Neale 79-85). The first assumption is the presence of a perfect capital market, where managers will always have access to finance for positive NPV projects. The second assumption is that the discount rate accurately represents the project’s risk level.
The discount rate should reflect the return available in the capital market for a similar risk investment. Another assumption that must be made in the case of mutually exclusive projects with different durations is that these projects are separate investments. This implies that they do not form part of a replacement chain, and it is assumed that the chosen mutually exclusive project will not be replaced at the end of its lifespan. If this assumption is not made, then a more complex decision rule is needed (Brealey and Myers 126-29).
Although the NPV method has incorporated modifications for special cases, not all other appraisal techniques have been equally successful. The internal rate of return calculates the average annual return over an investment’s lifespan and determines a break-even rate of return. This rate indicates the discount rate at which an investment generates a positive or negative NPV. In my analysis of evaluative techniques, I will exclude non-discounted cash flow methods as they do not consider cash flow timing, rendering them inappropriate for appraisal purposes.
This analysis aims to compare two discounted cash flow techniques: Net Present Value (NPV) and internal rate of return (IRR). The objective is to determine the superior investment criterion for a firm seeking to maximize its wealth. NPV automatically evaluates the project against the alternative capital market investment forgone, making it a crucial consideration. Conversely, the IRR method does not consistently provide insight into how much better or worse the project is compared to the capital market investment alternative.
Mutually exclusive projects are a topic of discussion. In such cases, ranking plays a vital role as only one alternative from a group of mutually exclusive options can be chosen for execution. The Net Present Value (NPV) can provide the correct decision advice with a slight modification to the basic rule. On the other hand, using the Internal Rate of Return (IRR) in this situation involves a more complex decision rule known as Dorfman, as the IRRs of differential cash flows need to be calculated.
When choosing between mutually exclusive projects, NPV is often preferred due to its simpler calculation method. For instance, if a company has multiple options, using the NPV rule only involves determining the NPV of each project and selecting the one with the highest positive value. In contrast, the IRR rule necessitates calculating IRRs and differential cash flows for pairs of projects, resulting in a decision-making process that involves comparing each pair of projects until the optimal choice is identified.
Furthermore, it is highly unlikely that any company uses the modified IRR decision rule. Its use implies a belief in the accuracy of the NPV decision rule, as the modified IRR rule aims to provide the same advice as NPV. Therefore, it would be more straightforward to utilize the NPV rule itself. Another significant disparity between NPV and IRR lies in their reinvestment assumption. The NPV decision rule assumes that cash flows generated by the project are reinvested to earn a rate of return equivalent to the discount rate employed in NPV analysis.
The IRR method assumes that the cash flows generated by a project are reinvested at a rate of return equal to the project’s IRR. However, it is challenging because it implies that the project’s cash flow can yield a return equal to its own IRR, which may not always be true. The company may have other investment opportunities that can yield such returns regardless of whether or not the project is accepted. Conversely, the NPV model recognizes this argument by considering the market rate of interest as the opportunity cost of the project’s cash flows.
In a perfect capital market, the NPV model correctly assumes the opportunity cost of a project’s cash flow, thus providing accurate decision advice. However, the IRR decision rule encounters a problem when the investment time horizon is extended. The IRR of a project’s cash flow is determined by solving a polynomial equation, which can have multiple solutions or no solutions at all due to changes in sign. Hence, a specific investment project may have more than one internal rate of return or none at all.
It is possible to demonstrate that with the majority of project cash flows, the differences in the project’s NPV between the IRRs are typically quite small, and the actual NPV value is likely to be close to zero. However, the issue of multiple IRRs does pose challenges in the case of mutually exclusive investment decisions. This is because the differing cash flows may have multiple IRRs, which renders the decision rule invalid. The extended yield method (Lumby and Jones 94-116) offers a solution for dealing with multiple IRRs.
The problem is solved by this method through the elimination of the second sign change, achieved by discounting the unwanted cash flow back to the present value at the hurdle rate and then offsetting it against the year 0 outlay (Drury 298-302). However, this solution only circumvents the issue of multiple IRRs without resolving it. Another concern regarding the IRR is that it assesses projects based on a percentage rate of return, considering a project’s return rate in relation to its outlay rather than in absolute terms like NPV.
The NPV method automatically evaluates and compares the incremental cash flows with the cost of capital to determine the optimal level of investment. In contrast, the IRR method, expressed as a percentage, overlooks this crucial aspect of investment decision-making. Additionally, since most firms measure their goals in terms of absolute returns rather than percentages, the NPV method, which reflects absolute returns, ensures optimality in situations where mutually exclusive choices are involved.
It is more convenient to express a percentage rather than an absolute return when communicating with other managers and employees who may not be familiar with project appraisal techniques. This is because percentage terms are recognized and understood quickly. In conclusion, the Net Present Value and internal rate of return methods for selecting capital investment proposals are closely linked. They both involve time-adjusted profitability methods and have similar mathematical formulas.
Both criteria, although equivalent for independent conventional projects, do not rank projects in the same manner. Most managers prefer to use NPV due to its several advantages, including reflecting the absolute magnitude of the projects, unlike IRR. NPV assumes reinvestment proceeds at the cost of capital, whereas IRR assumes reinvestment at the project’s own rate of return. Assuming a changing cost of capital in the future years, the reinvestment assumption becomes crucial.
The IRR rule becomes ineffective when comparing a single-valued rate of return with a series of different short-term discount rates. NPV is not only theoretically superior to IRR but also offers important technical advantages. When dealing with non-conventional cash flows, it may be impossible to find a real solution for the project’s IRR or multiple IRRs may exist for a single project. Despite this, the IRR rule remains popular due to its appeal and ease of understanding for managers. The rate of return can be easily compared to the cost of funds to determine profit margins. However, it is important to recognize that when choosing between mutually exclusive decisions, the NPV method should be used. To address the limitations of IRR, a modified IRR has been developed. The modified IRR attempts to overcome theoretical difficulties while still providing an evaluation based on percentage returns, avoiding the complexity of NPV.
The modified internal rate of return (IRR) is based on the analysis of net present value (NPV), which is then transformed into a rate of return. There are two technical advantages to this modification: it solves the issue of multiple IRRs and ensures consistency with the NPV method for mutually exclusive projects. The modified IRR has emerged as the most effective technique for evaluating investments, leveraging the theoretical foundation of NPV while presenting a user-friendly percentage rate of return.
Works Cited
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