Using the above assessments each may indicate which investment may be preferred. Using the payback period project a has a payback period of 4 years, whereas project B. has a payback period of 3 years 8 months. If the fastest payback period is preferred than project B. will be chosen.
The NPV which discounts the net revenues into a net present value shows that Project a has a loss of 1,576 and the loss for Project B. is 1,074. If assessed only on this basis, project a makes the greatest loss. However, the basic rule of NPV is that investments should only be made in projects where there is a new positive value, otherwise the firm is not earning the amount it is costing them in payments to support the capital used to fund the project (Weetman, 2010, p269).
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.
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.
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
discount rate discounted cash flow
Less initial investment
Table 8 NPV for project B. At 4% discount rate
discount rate discounted cash flow
Less initial investment
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.
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.
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 as a cost being applied. 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.
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.