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?
in most capital budgeting projects cash flow, rather than reported income, considered a valid financial indicator. Financial specialists prefer using NPV method, Payback Method and IRRmethod in order to assess the acceptance of the project. Within Payback Method, the time required to recoup the initial investment is computed; this method is considered easiest to understand and a key advantage of it is its focus on liquidity. However this method ..................................................................................
The conflicting situation you mentioned, where NPV indicates rejection while the IRR and Payback methods indicate acceptance, can occur due to the nature and assumptions of each method. Let's understand each method and their shortcomings:
1. Net Present Value (NPV): NPV calculates the present value of cash flows by discounting them back to the present using a specified rate of return, usually the company's cost of capital. The decision rule for NPV is that a project is accepted if the NPV is positive and rejected if it is negative. However, NPV has some limitations:
- It heavily relies on an accurate estimation of the discount rate, which can vary depending on the company's perceived risk and borrowing costs.
- It assumes that all cash flows generated by the project can be reinvested at the discount rate, which may not be realistic.
2. Internal Rate of Return (IRR): IRR is the discount rate that makes the present value of cash inflows equal to the present value of cash outflows for a project. The decision rule for IRR is that a project is accepted if the IRR is greater than the cost of capital and rejected if it is less. However, IRR has its own limitations:
- When evaluating mutually exclusive projects, IRR may lead to incorrect decisions as it assumes that any positive IRR project can be taken, which may not be optimal in reality.
- IRR does not consider the scale of investment or the project size and can favor smaller projects with higher IRRs.
3. Payback Period: The Payback method calculates the time it takes for the initial investment to be recovered by the project's net cash inflows. The decision rule is that a shorter payback period is preferred. However, Payback has limitations:
- It does not consider the time value of money, as it does not account for discounted cash flows.
- It ignores cash flows beyond the payback period, leading to a limited focus on short-term returns.
Given these limitations, NPV is considered the most accurate decision-making tool among the three. NPV considers the time value of money by discounting all cash flows at an appropriate rate and provides a more comprehensive evaluation of a project's profitability. It also accounts for the scale of investment and reinvestment assumptions. Thus, if the data is correct, analysts should rely on the NPV method and reject the project if the NPV is negative, despite the conflicting results from the IRR and Payback methods.