A.) The textbook seems to favor two techniques for two different reasons Net pre

Question

A.) The textbook seems to favor two techniques for two different reasons Net present value seems to be the most widely used technique because of its ability to predict the expected dollar amount of wealth that a project should produce. The other widely used technique is the internal rate of return. Both of these techniques can be used to make accept or reject decisions and sometimes IRR is used because of its focus on percentage rates of return as it pertains to the cost of capital of the firm. This way an analyst can identify any problems with the IRR before their bosses can implement the project. I am fairly new to this but can see why a combination of these two techniques could be very useful to decision makers especially IRR which can show if investment returns can exceed a company’s requirements. Personally my interest is in small business and I enjoyed learning about the payback period. Baby steps.

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B.)The textbook favors the net present value investment valuation technique. The reasoning is that it goes into deeper detail about the financial standing of a company, than other valuation methods. It subtracts the value of the initial investment from the firm's cash flows at a rate comparable to the firm's cost of capital, as a percentage. It demonstrates more than just the fact that a company can pay back their debts, but whether a company is profitable or not. An investment firm would be most interested in an investment that has a greater cash flow than that of the initial investment. It may seem obvious that someone would want to invest in a company that makes money, but our textbook has also shown us that investments do not always make money at the same pace. For example an investment could break even the first year, but then have accelerated growth year 2 and 3, or vice versa. This is a reason why, to me, NPV is a good way to value an investment. It leaves room for this information if you calculate the years separately (unlike you would an annuity).

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Explanation / Answer

(A) Therer are two popular techniques of project evaluation in Financial Management. They are

(1) Net Present Value   (NPV) and (2) Internal Rate of Return (IRR)

Every one can easily understand the Net Present Value ie. the net surplus generated by the project. That surplus is nothing but the positive difference between the present value of Cash Inflows and the present Value of Cash outflows. But NPV involves many assumptions and complex in calculation.

IRR is another capital budgeting technique of project evaluation. IRR is a rate at which Present value of cash inflows and present values of cash outflows are equal. Of course, Calcualtion of IRR is simple but many limitations are there, because of these limitations, generally preference will be given to NPV. LImitations of IRR as follows:

a. It uses one single discount rate to evaluate every investment, but this may not be desirable

b. If an analyst is ealuating two projects both of which share a common discount rate, predicatable cashflows, equal risk and shorter time Horizon, IRR will probably work. The point here is that discount rates usually changes substantially over time.

c. Without modificaiton, IRR doesn't account for changing discount rates, so its just nto adequate for a longer term projects with discount rates that are expected to vary.

d. For a project with a mixture of multiple positive and negative cash flows, IRR is ineffective as multiple rates of return of projects produce multiple rates of IRR. Hence, ther is a problem of decision making

e. Another limitaiton that causes problems for users of the IRR method is when the discoutn rate ofa project is not known. Generally, a project is selected if its IRR is more than company's discount rate, otherwise it is to be rejected, but the problem is that when we do not know the discount rate of the company,then no use of IRR.

Conclusion: Because of the above said limitations of IRR, generlly we prefer Net present Vaue technique as it clearly gives the net surplus of a project, so that we can decide whether we have to accept or reject based on NPV. These techniques generally we use for a big firms, but for small firms, it is better using discounted payback technique as it takes into account the time value of money and can easity unerstood by anyone.

(B). Definitely, NPV technique woudl evaluate the project desirability in terms of Cash flows generaled by the project every year. It prefers the project when Present value of Cash inflows are more than Present value of cash outflows. But it does not give accurate result in case of multiple porjects which have different lives, then comparision of NPV is not desirable. Another point is that as per NPV technique, a project is to be selected if its NPV is positive and in case of two projects we select a project which gives more NPV,but Cash inflows for both the project may differ, in case of a project that has been rejected due to low NPV may give higher cash flows in initial years

Another limitation of NPV is that it is very difficult to estimate the company's discount rate, only based on that we evaluate the project desirability.

Despite of abvoe limitations of NPV, it is good investment evaluation technique and really worthful in terrms of evaluation of a project based on how much surplus it will generate. So, any one can understand the logic in this technique, so I agree with your feedfack regarding NPV.

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