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The IRR calculation also shows a loss for each project, with Project B. making the least loss, indicating that if one of these was to go ahead this would be the least damaging. However, we may argue the firm may be better taking either and not paying for the capital to support the projects.

Part D

It is essential that the assessment make use of a discounted cash flow in order to account for the erosion of the value of money over time. The concept is simple, 100 in cash today will not be worth the same amount buying the same goods in 5 years time. In terms of the firm there is the potential impact of inflation. However, it is usually the WACC which is used as the discount rate. This can be conceived by looking at 100 in capital, if this takes 11.5% to maintain, the value will fall by that amount after one year, and each subsequent year the value will decrease. Therefore, the discounting will mean that the projected revenues can be assessed in terms of their real value rather than numerical value.

Part E

The calculations would change if the cost of capital changed, if it increased the discount rate would increase. If the discount rate was to increase, this would mean the value for money would erode faster, so the NPV would show a greater loss. .

If the cost of capital dropped the discount rate would reduce, for example to 4% this would decrease the rate at which the value of the money erodes, and increase the value of the investment, this would result in the following calculations.

Table 7 NPV for project a at 4% discount rate

Year

Profit

discount rate discounted cash flow

Accumulative total

Year 1

4,500

0.96153846

4,327

4,327

Year 2

4,500

0.92455621

4,161

8,487

Year 3

4,500

0.88899636

4,000

12,488

Year 4

4,500

0.85480419

3,847

16,335

Year 5

4,500

0.82192711

3,699

20,033

Less initial investment

18,000

NPV

2,033

Table 8 NPV for project B. At 4% discount rate

Year

Profit

discount rate discounted cash flow

Accumulative total

Year 1

6,500

0.961538

6,250

6,250

Year 2

7,000

0.924556

6,472

12,722

Year 3

8,500

0.888996

7,556

20,278

Year 4

7,500

0.854804

6,411

26,689

Year 5

6,000

0.821927

4,932

31,621

Less initial investment

27,000

NPV

4,621

In both cases this increases the NPV turning a negative to a positive; this also impacts on the IRR as they become positive, 6.73% for project a and 7.94% for project B. This should be referred to in part g.

Part F

The NPV is a measure that is sensitive to changes. However, it may be argued that long-term projects are more sensitive than short-term projects due to the way in which discounting takes place. The discounting is undertaken on a compound basis, so as time goes by any errors that are present may compound and increase their impact on the result. In a short-term project there is less time for the error to increase as a result of compounding as the result from one year passes to the next. The NPV model is also one that favors higher early return due to the discounting, which also reduces the sensitivity of the model to errors in the earlier years.

Part G

Changes in the cost of capital will impact on the IRR. The cost of capital is used to reduce the net revenue created, so may be seen...

When this cost decreases more revenue is left, so the return increases, when the cost increases, there is less revenue left in the present value, reducing the IRR. The way this may impact on both the projects assessed if the cost of capital reduces to 4% has been assessed in part E. Looking at this another way, if the NPV moves from being negative to positive, the return must also change from being negative to positive.

Part I

NPV and IRR may be compared. There are some clear similarities between both methods, as both have the discounting of cash flows as their basis, which means both processes are likely to favor projects where there are higher shorter term returns (Favaro, 1996, p4). Both are also likely to show increased sensitivity on long-term projects, due to the compound impact discussed in part F.

However, there are some differences. In maybe argued that NPV provides some more useful information, as it presents an actual level of return, reflecting the shareholder wealth which may be created for a particular project at a set discount rate. As the process facilitates the comparison of different projects, with the potential to adjust the discount rate in up to allow for disparate levels of risk, NPV may also be seen as facilitating a greater level of realism. Within this model it should be noted that this calculation makes the assumption that cash flows generated by the project will continue to generate the discount rate or the cost of capital.

The underlying assumption of IRR is different; instead of assuming that the reinvested capital will continue to earn the discount rate, in this model it is assumed that the reinvested cash will continue to earn the same rate as the project it came from, which is inherently at a higher rate. Therefore, IRR may be seen as a more optimistic, which may lead to a greater level of diversions with actual results. Conversely, NPV may be seen as more pessimistic, as it is likely that companies will reinvest cash in other projects that achieve returns above the cost of capital.

While the net present value gives the numerical value, the internal rate of return gives a percentage value. It has been argued that by giving a single percentage measure there is a simpler concept for comparison, especially by individuals who are not fully aware of the way in which calculations take place and the meaning of a net present value (Evans and Forbes, 1993, p89). Therefore, IRR may be seen as conceptually more simple for use in presentations.

Overall, both have advantages and disadvantages, however, NPV has a greater potential for realism, and may also be seen as slightly more conservative, so this writer argues that NPV is superior.

Bennouna, Karim; Meredith, Geoffrey G; Marchant, Teresa, (2010), Improved capital budgeting decision making: evidence from Canada, Management Decision, 48(2), 225-247

Cooper DW; Cornick MF; Redmond a, (2011), Capital Budgeting: A 1990 Study of Fortune 500 Company Practices, Journal of Applied Business Research, 8(3), 20-23

Evans, Dorla a; Forbes, Shawn M, (1993, Fall), Decision Making and Display Methods:the Case of Prescription and Practice in Capital Budgeting, the Engineering Economist 39, No. 1, 87-92

Favaro J, (1996, April), a Comparison of Approaches to Reuse Investment Analysis, Proceedings of the Fourth International Conference on Software Reusability

Magni, Carlo Alberto, (2009), the use of NPV and CAPM for capital budgeting is not a good idea. A Reply to De Reyck (2005), retrieved 14th June 2012 from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1411221

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