The finance department of a large corporation has evaluated a possible capital p

Question

The finance department of a large corporation has evaluated a possible capital project using the NPV method, the Payback Method, and the IRR method. The analysts are puzzled, since the NPV indicated rejection, but the IRR and Payback methods both indicated acceptance. Explain why this conflicting situation might occur and what conclusions the analyst should accept, indicating the shortcomings and the advantages of each method. Assuming the data is correct, which method will most likely provide the most accurate decisions and why?

Explanation / Answer

NPV, IRR and Payback are the three most commonly used methods in calculation for the return that an organisation would receive from its capital projects. These three methods are explained in the following paragraphs:

Net Present Value Method:

NPV of cash flow technique is used to discount all cash flows, whether inflow or outflow, in a project using the opportunity cost of capital which might be the weighted average cost of capital for a company or the incremental rate of borrowing to a Company. NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. In case the NPV of a project is positive, the project is seen to be beneficial to shareholder's wealth and thus, is accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.

The limitation of NPV is that it does not factor in the variability of cash flows, i.e., timing of the cash flows into account. For example, a lump sum payment after a certain period of time might be more beneficial than a periodic receipt. Also, it does not give an idea as to how much time will be required to recover the initial investment made in a capital project.

IRR - Internal Rate of Return

IRR is the rate at which the NPV of the cash flows is equal to zero. Thus, higher the IRR, the higher is the profitability in a capital project. If the IRR of a project is higher than the Opportunity Cost of capital of a project, then the project is generally accepted.

The major issue with IRR is that it does not take into account the initial investment made in the project. Thus in a scenario even if the return is higher in % terms, the return in absolute terms may vary based on the amount of investment.

Payback

Payback period is the amount of time it would take for a project to realise its initial investment. Generally, all Companies have a standard payback period and if a project is expected to recover its investment cost within that limit, then the project might be accepted.

The major drawback of the payback period is that it does not take into account the time value of money and thus may lead to inaccurate decisions. Also, payback does not analyse the returns of the project beyond the payback period.

In the current situation, the NPV method suggests that the project should not be undetaken whereas the IRR and payback mehtod suggest that the project should be accepted. This could be due to the fact that Payback does not consider the time value of money and thus even if the returns on a project are more than the investment made, the real or discounted present value may not be higher than the investment made. Also, since IRR does not consider the initial investment made in the project, it might lead to a different decision when compared to NPV which considers the initial capital outflow.

Thus, in the current situation, the NPV would be most accurate method to anlayse the profitability of the project as it takes into account the initial capital outflow, the timing and variability of the inflows and a positive NPV would always lead to an increase in shareholder's wealth.

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