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Capital Budgeting The IRR (internal rate of return) and the NPV (net present value) are the two most common and important indicators in investment decisions. These two indicators, however, have intrinsic differences between one another. The IRR is a financial indicator and the NPV an economic indicator of a capital investment. The former gives the private investor's point of view and the latter the society's point of view. The value of IRR varies with the change of financial arrangement of an investment. The NPV, however, does not but remains constant no matter how the financial arrangement changes.
Although IRR and NPV both are discounted cash flow methods, they have intrinsic differences from one another. Analysts indicate that the ranking of investment alternatives is not necessarily the same obtained by the two methods. Assessing the differences in rankings between NPV and IRR, Asquith and Bethel reported that IRR might be preferred to NPV under certain circumstances (Asquith, 287). Simultaneously, other investment specialists reckon that IRR is more cognitively efficient than NPV because IRR is expressed as a percentage (or a rate of return) while NPV is just a monetary value cognitively inefficient to decision makers, and hence the use of IRR should be promoted (Evans, 87). From theoretical and academic point of view, NPV is more conceptually correct despite the fact that the IRR is more popular than the NPV, and that NPV is more theoretically sound as the IRR may be too capricious or fickle and may not rank some projects in the same order as the NPV (Lefley, 321). Both IRR and NPV can be considered in terms of hurdle rate, which is a benchmark for the return company wants to achieve.
The minimum hurdle rate is equal to the cost of capital of the company. This is computed as a weighted average of the cost of the various capital components - debt, equity, and retained earnings. However, the actual hurdle rate management chooses will typically not be equal to the company's weighted average cost of capital. Some projects with low returns have to be done for various reasons. For example, projects necessary to comply with government regulations may have no return at all. Therefore, the actual hurdle rate chosen must be high enough to compensate for these low-return projects so that the overall portfolio of projects is either equal to or above the selected hurdle rate.
NPV is considered to be the excess of the present value of cash inflows generated by the project over the amount of the initial investment. The present value of future cash flows is computed by discounting them at the rate of the cost of capital or minimum required rate of return. From the practical point of view, if the NPV of a project or capital investment is positive, it should be undertaken and if capital is limited, management selects projects that yield the highest overall NPV. From the critical point of view, IRP is a reverse of NPV, which indicates the breakeven discount rate at which the value of cash outflows equals the value of cash inflows. Thus, on practice IRP is used as a threshold for investment approval, which consequently allows management to develop financial criteria for project assessments.
Although IRP has recommended itself to be a useful objective, though not absolute indicator for investment decision, some analysts consider IRP to be complicated in terms of computing and misleading when it comes to reinvestment. Therefore, some professionals criticize the utilization of IRP in regard to accurate reflection of investment performance and its ability to reveal absolute cost of capital. NPV of a capital investment is constant in all situations and is not affected by the variation of financial arrangements. From a society's point of view, NPV is a good economic indicator for projects, as the economic value of an investment does not change even if its financial arrangement does. The IRR, however, is suitable for use as a financial indicator from a private investors point of view, since private investors usually like to play around with financial arrangements to optimize the rate of return. As far as the society's viewpoint is concerned, the criterion of highest economic value (or the highest NPV), the value of which is not affected by differences of financial arrangements, should be the basis for the selection of capital investment alternatives.
From the private investors viewpoint, however, the criterion may be different. Under the circumstances of limited availability of funds, the highest IRR should be a suitable criterion for private investment decisions. Bibliography Asquith, D. and J. E.
Bethel. Using Heuristics to Evaluate Projects: The Case of Ranking Projects by IRR. The Engineering Economist, Vol. 40, No. 3, 1995 Lefley, F. Morgan, M.
A new pragmatic approach to capital investment appraisal: The financial appraisal profile (FAP) model. International Journal of Production Economics, Vol. 55, No. 3, 1998 Evans, D. A. and S. M. Forbes.
Decision Making and Display Methods: The Case of Prescription and Practice in Capital Budgeting. The Engineering Economist, Vol. 39, No. 1, 1993
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