Capital Budgeting Decisions

When choosing between projects with acceptable IRRs, the one with the highest IRR should be chosen.

This essay will discuss the net present value (NPV), payback period (PBP) and internal rate of return (IRR) approaches for a project evaluation. It is often said that NPV is the best approach investment appraisal, which I why I will compare the strengths and weaknesses of NPV as well as the two others to se if the statement is actually true.

d. internal rate of return (IRR) the discount rate that forces a project’s NPV to equal zero. The project should be accepted if the IRR is greater than the cost of capital.

The Modified Internal Rate of Return is an underused measure for selection of projects that a company can choose because it is more effective at dealing effectively with periodic free cash flows that develop from the time that an asset is purchased through its life to the point where it is sold, ranking projects and variable rates of return through the project life. The Internal Rate of Return is an inefficient model to make decisions with because it lack the ability to account for the periodic free cash flows, proper ranking and variable returns from certain projects.

Using the IRR method will result in project Q being selected over P due to its higher rate of return. Using the NPV method would result in choosing project P because of its higher NPV. When there are mutually exclusive project, NPV method would be preferred.

A project may have more than one IRR, especially when returns of an investment yield negative cash flows following positive cash flows.

Under the base case scenario, the IRR of the project is 61%. Since the weighted average cost of capital is 14%, the project is acceptable. The estimated cash flows indicate that the project will provide a rate of return that far exceeds the hurdle rate. Even under the worst case scenario, the IRR of 51.73% far exceeds the cost of capital.

The IRR is generally the next best accepted method for determining the acceptance or declination of a project due to the fact that it also takes into account the time value of money, the risk associated with cash flows, and an the increased value of invested cash. Knowing that, it is generally accepted that IRR calculations lead to good decisions when it comes to accepting or declining a project. IRR is calculated either through trial and error with the aid of a financial calculator.

1. The cause to the conflict in the rankings is that while the IRR ranking shows a percentage so that you can see what percentage you are making on certain amount, it does not show the size of the project.

NPV and IRR: When examining the NPV and the IRR of the Merseyside project, the numbers were very attractive. It had a positive net present value and an IRR above 10 percent. By these numbers, along with others,

The rationale behind that assertion arises from the idea that all such projects add wealth, and that should be the overall goal of the manager in all respects. If strictly using the NPV method to evaluate two mutually exclusive projects, you would want to accept the project that adds the most value (i.e. the project with the higher NPV). Hence, if considering the above two projects, you would accept both projects if they are independent, and you would only accept Project S if they are mutually exclusive.

As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first ("Internal Rate Of Return - Irr", 2014).” When looking at both companies discount rates, they are within 1% of one another. The higher the discount rates the better the profit for that particular company. Corporation A has a discount rate of 10%, while Corporation B has a discount rate of 11%. Generally speaking, the higher the discount rate the more profitable that company will become.

Capital budgeting is the most important management tool that enables managers of the organization to select the investment option that yields comprehensive cash flows and rate of return. For managers availability of capital whether in form of debt or equity is very limited and thus it become imperative for them to invest their limited and most important resource in perfect option that could prove to beneficial for the organization in the long run (Hickman et al, 2013). However, while using capital budgeting tool managers must understand its quantitative and qualitative considerations that are discussed below.

The IRR technique use the accept/reject criteria of comparing the IRR with the cost of capital which is based on comparing the internal rate of return to the cost of the capital of the project.

Internal rate of return (IRR) is the discount rate that makes NPV equal to zero. It is also called the time-adjusted rate of return.