Explain the Theoretical Rationale for the Npv Approach to Investment Appraisal

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Explain the theoretical rationale for the NPV approach to investment appraisal and compare the strengths and weaknesses of the NPV approach to two other commonly used approaches. One of the key areas of long-term decision-making that firms must tackle is that of investment - the need to commit funds by purchasing land, buildings, machinery, etc., in anticipation of being able to earn an income greater than the funds committed. In order to handle these decisions, firms have to make an assessment of the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk attached and the cost of obtaining funds. The main stages in the capital budgeting cycle can be summarised as follows: • Forecasting…show more content…
It assumes that project cash flows are reinvested at the company's required rate of return. The IRR assumes that the project cash flows are reinvested at the IRR. Since IRR is higher than the required rate of return, in order for the IRR to be accurate, the company would have to keep finding projects that would reinvest the cash flow at this higher rate. It would be difficult for a company to keep this up forever, thus NPV is more accurate. NPV measures project value more directly than IRR. This is because NPV actually calculates the project's value. If there is more than one project lined up, the manager can simply add the values together to get a total. Often times, during the life of a project, cash flows must be reinvested to cover depreciation. This will give a negative cash flow for that period, thus leading to more than one IRR. If there is more than one IRR, than calculating only 1 IRR for the project is not reliable. NPV must be used for this type of project. When selecting mutually exclusive projects it is wise to use the NPV approach. The IRR approach may lead to a wrong decision. However, when evaluating independent projects, NPV and IRR give the same decision. Most firms use one or more of the measures of financial analysis to prioritise projects. Each of the financial analysis measures has its advantages and disadvantages.
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