Assignment 2: Capital-Budgeting Criteria The net present value (NPV) of a projec
ID: 2600986 • Letter: A
Question
Assignment 2: Capital-Budgeting Criteria
The net present value (NPV) of a project is a measure of the difference between the project's value and its cost. The internal rate of return (IRR) is another measure of the project's attractiveness. These are by far the two most widely used measures for evaluating the value of capital investment projects.
NPV and IRR are the focus of this discussion assignment. Your response should be one or two paragraphs in length for each of the following questions:
What is the logic behind the NPV capital-budgeting framework?
Would changes in the cost of capital ever cause a change in the IRR ranking of several projects?
When it is clear that a project will be profitable, why should it be rejected if it has a negative net present value?
Why should cash flow to be received at the end of six years be discounted more heavily than cash flow to be received at the end of five years?
Explanation / Answer
Answer
What is the logic behind the NPV capital-budgeting framework?
There are various method under the capital budgeting techniques which help the investor to take the right financicing decision. The same can be divided into traditional i.e non-time adjusted techniques & other the time adjusted (discounted cash flows).
Time Adjusted techniques are as below:
A) Net Present VAlue Method -NPV method helps in acheiving the objective of maximisation of the shareholder's wealth. The rationale behind this contention is the effect on the market price of the shares as a result of acceptance of a proposal having present value more than Zero. When NPV=0, the return on investment (IRR) just equals the expected rate of return by investors. There would therefore be no change in the market price of the shares. When NPV>0, the return on investment (IRR) would be higher than the return expected by the investor. It would therefore lead to increase in share price.Hence, the project with the NPV less than zero should be rejected and prject with NPV more than zero should be accepted.
IRR Method: In case of NPV method, the discount rate is the required rate of return, usually the cost of capital, its determination is external to the proposal under consideration. The IRR on the other hand is based on the facts which are internal to the proposal i.e cash otflows & cash inflows from the project being evaluated. The IRR is usually the rate of return that a project earns. It is a discount rate which equates the PV of Cash inflows with PV of cash outflows.
If IRR> the cost of capital the project may be accepted. If NPV>0, the IRR will be greater than the cost of capital.
The NPV and IRR gives the same result in case of conventional & independent investment projects, but may give contradictory results in case of mutually exclusive investment projects (disparity in investment size, time disparity of cash flows, project with unequal lives). The IRR method is not compatiable with the goal of wealth maximisation. Hence, NPV method is preferred. In case of projects with unequal lives, Annualised NPV method is more appropriate.
Would changes in the cost of capital ever cause a change in the IRR ranking of several projects?
As mentioned above, If IRR> the cost of capital the project may be accepted. If NPV>0, the IRR will be greater than the cost of capital. The changes in cost of capital will NOT change the IRR ranking of the projects because the expected rate of return is assumed to be same for all the projects being evaluated and if IRR > cost of capital the project may be undertaken. The IRR method is not compatiable with the goal of wealth maximisation. Hence, NPV method is preferred.
When it is clear that a project will be profitable, why should it be rejected if it has a negative net present value?
Net Present VAlue Method -NPV method helps in acheiving the objective of maximisation of the shareholder's wealth. The rationale behind this contention is the effect on the market price of the shares as a result of acceptance of a proposal having present value more than Zero. When NPV=0, the return on investment (IRR) just equals the expected rate of return by investors. There would therefore be no change in the market price of the shares. When NPV>0, the return on investment (IRR) would be higher than the return expected by the investor. It would therefore lead to increase in share price.Hence, the project with the NPV less than zero should be rejected and prject with NPV more than zero should be accepted.
Why should cash flow to be received at the end of six years be discounted more heavily than cash flow to be received at the end of five years?
The Cash flow to be received at the end of six years is to be discounted more heavily than cash flow to be received at the end of five years because of the time value of the money. The money received in year 5 will have a higher present value that cash floe received in six years as there is opportunity Interest loss to the extent of the discounting rate in case of the delayed cash flows by one year.