Question 1: 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. (30 marks)

This first section of this paper will provide a brief explanation on theoretical rationale for the net present value (NPV) method of investment appraisal and then compare its strengths and weaknesses to two alternative methods of investment appraisal, those of internal rate of return (IRR) and pay-back.

Theoretical rationale for the NPV approach

The net present value rule or NPV devised by Hirshleifer (1958), is the fundamental model of how firms decide whether to invest in a project, commonly known as the ‘investment decision’, or
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G is also happy to invest because they can borrow against the future payoff of the investment. By investing G gets £20,000 more to spend today (£200,000 less £180,000). It would pay for either investor to borrow to invest in the opportunity due to the returns on offer.

Despite the reality of known imperfections in capital markets (e.g. taxation, transaction costs, asymmetric information), overall the use of NPV makes sense as a corporate objective. Certain ‘imperfections’ can be modelled into financials, providing a more realistic picture. Brealey et al (2008) state that the use of NPV for uncertain cash flows makes sense too, providing there is free access to competitive capital markets. This is due to when affirm chooses only positive-NPV projects, they will be meeting the shareholders and firms objective of maximising wealth. Instead of solely seeking a maximisation of wealth that might negatively impact in other areas (e.g. future profits, return on investment etc), NPV accounts for the time value of money, opportunity cost of capital and differences in project rates of return.

Comparison of the strengths and weaknesses of the NPV approach to two other commonly used approaches

This report will now focus on comparing the strengths and weaknesses of the NPV approach to two other investment appraisal approaches, internal rate of return (IRR) and pay-back.

Net present value (NPV)

The NPV approach asks

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