Internal Rates Of Return Essay Example Pdf - Free Essay Example

Capital budgeting is the process of planning and evaluating investments in assets that have cash flows of periods greater than one year. These projects are classified as replacement decisions which are meant to maintain the profitability of a business and reduce costs. Capital budgeting is core to an organisation since the projects are always long-term. The Net Present Value (NPV) and Internal Rate of Return (IRR) approaches are commonly used in capital budgeting (Palepu, Healy Victor 2004). Comparison of NPV to IRR The NPV method uses cash flows estimated from each potential project. The present values of the cash flows are summed, to obtain the Net Present Value. The NPV decision rule is to accept projects with a positive NPV and to reject those projects with negative NPV, in an unlimited condition. In case the projects are mutually exclusive, the financial analyst accepts the project that has the highest NPV (CIMA, 2009). Internal Rate of Return (IRR) IRR is defined as the discount rate that equates the initial cost of a project to the expected net cash flows. In general, IRR is the discount rate that equates the net present value of a project to zero. IRR is generally calculated using trial and error method; formally it is calculated using financial calculators such as the BA TI Business calculator (Chanda, 2008). IRR decision rule First the financial analyst determines the required rate of return; which may be higher or lower than the firms cost of capital since it factors in the investment projects adjustments to financial risk. If IRR is greater than the required rate of return, finance managers accept the project. If IRR is less than the required rate of return, analysts will usually reject such projects since they reduce shareholders value (CIMA, 2009). The IRR approach advantage is that it clearly shows the return on capital. However, its main disadvantage is that, at times it may give contrasting results when compared to the net present value approach, especially for projects that are mutually exclusive. Another demerit of the IRR approach is the so called multiple Internal Rate of Return problem. This particular problem occurs when the investment projects lifetime cash flows are non-normal i.e. they are negative. This indicates that the project is running at a loss or the firm needs to invest more capital (Chanda 2008). Reason for NPV and IRR Methods giving conflicting appraisals When a project is classified as an autonomous project, i.e. the decision to invest in the project is independent of other projects, both the approaches of IRR and NPV will always give similar results, whether it is accepting or rejecting a project. In is true that NPV and IRR are resourceful methods for evaluating mutually exclusive projects. However, in cases where the decision favors one project to another, these metrics will not always give similar results, the reason being the timing of cash flows from each particular project. In addition, conflicting appraisals can be attributed to project sizes. Consider two projects, X and Y. Project X has an initial outlay of $1,000, and project Y has an initial capital outlay of $ 10,000. Project X (the smaller project) may give a higher IRR but a relatively lower NPV, but project Y may increase shareholders wealth (has a higher NPV) in as much as it will have a lower IRR (Chanda 2008). The NPV approach premises on the assumption that a projects cash flows can be reinvested to give a return on capital at the discount rate used in the calculation of NPV. In reality this assumption is rational since it is based on the notion that cash flows do actually reduce a firms investment capital needs. These funds allow firms to reduce capital requirements thus allowing firms to reduce their cost of capital. When a firm manages to reduce its equity and debt, it can actually earn on the cost of cash flow that are used to reduce its capital needs. On the contrary, if projects are to be ranked using IRRs, the analysts will be assuming that cash flows from the project could be reinvested at the IRR. This is not practical. If it were possible for a firm to earn the required rate on invested capital, then this rate should be used to discount the projects cash flows (Chanda 2008). Conclusion The above arguments proof that NPV and IRR are impeccable approaches used for appraising projects. However, in practice it is indicated t hat there are several other methods used for project appraisal. These include; the Payback period (PB) approach, the Average Accounting Rate of Return (ARR) approach and the discounted payback (DPB) method among several others. In fact the methods used by finance managers for capital budgeting vary due to four factors; Location- most European firms prefer the payback method to NPV and IRR; size-the firm-the larger the company the more likely it apply NPV and IRR methods; Managerial education-the higher their education level the more likely that they will use IRR and NPV methods; and finally, Private versus Public-Public firms- public firms are more likely to use NPV and IRR approaches while private firms prefer the pay back method.