Net Present Value (NPV) Versus Internal Rate of Return (IRR)

Net Present Value (NPV) Versus Internal Rate of Return (IRR)

Contents

TOC o “1-3″ h z u The NPV approach to valuation is superior to the IRR approach. Suggest how you would approach getting buy-in from senior management. PAGEREF _Toc377396170 h 1Analyze the variation in the results of net present value and the internal rate of return for use in evaluating a combination of projects or portfolio of projects and how the variations should impact decision making. PAGEREF _Toc377396171 h 1Investments in Global Markets” Please respond to the following: (use article below) •From the e-Activity, analyze the factors that should be considered in determining the required rate of return for evaluating projects, in global markets and how this impacts decision making. PAGEREF _Toc377396172 h 3As CFO, discuss how you would defend the difference in the required rate of return for your company on similar projects in the Brazil and India PAGEREF _Toc377396173 h 4

The NPV approach to valuation is superior to the IRR approach. Suggest how you would approach getting buy-in from senior management.Net present value is equal to the sum of the present value of all cash flows associated with a project. The one outstanding feature of NPV is that it steadily decreases as the discount rate increases. Internal rate of return is the discount rate that equates the present value of cash inflows with the present value of cash outflows on investment. It is the rate of discount where the net present value is equal to zero (Siegel, 2008).

NPV is superior to IRR because it makes it easy to compare different projects. There is also the chance that consecutive projects can have their NPVs can be added together. This ensures that poor projects with a negative NPV will not be accepted just because it is paired with a project with a positive NPV. IRR is not reliable because it is possible for one to obtain more than one solution for the same project, this means that a project can be accepted and rejected on different times under same conditions. IRR also overstates the desirability of short life projects over those that are longer. IRR also discriminates against projects that have large capital outlays especially if the projects being compared are mutually exclusive (Siegel, 2008).

Analyze the variation in the results of net present value and the internal rate of return for use in evaluating a combination of projects or portfolio of projects and how the variations should impact decision making.Suppose the cash flows of different time periods of a project are as follows and the cost capital r= 10%, then the NPV would be

Year Cash Flows

0 1000000

1 200000

2 200000

3 300000

4 300000

5 550000

NPV = -1000000 + 200000 +200000 + 300000 + 300000 + 550000

(1.1)0 (1.1)1 (1.1)2 (1.1)3 (1.1)4 (1.1)5

= -1000000 + 181818.182 +165289.256 + 225394.440 + 204904.037 + 341506.720

= 118912.643

Generally NPV is calculated by

= ∑ Ci – Bi

(1 +r)i

Decision rule is if NPV >0 the project is viable, accept project

NPV<0 the project is not viable, reject project

NPV =0 the other factors apart from NPV should be considered.

In our case accept the project.

IRR = r + PV1 [ (r1 +r2)/ (PV1 + PV2)]

Given the following figures,

PV1 = 10000, r1 = 10, r2 = 20, PV2 = 5000

IRR = 10 + 10,000 (10/15000) = 16.7

There should be a predetermined discount rate that is r*= 15

Decision rule is

IRR >r* then the project is viable and it should be accepted.

IRR<r* the project is not viable and should be rejected

IRR=r* analyze other factors apart from IRR

In our case accept the project.

Investments in Global Markets” Please respond to the following: (use article below)•From the e-Activity, analyze the factors that should be considered in determining the required rate of return for evaluating projects, in global markets and how this impacts decision making.When it comes to global markets, the factors that currently influence the determination of the required rate of return is the rate at which the market is currently growing at. The other factor is the future expectations of the market in its physical situation. When it comes to a company going international the question that most shareholders usually ask is what are the risks associated with such an investment? At what growth rate is it? In a nutshell they always want to know how stable a market is and when they will get their initial invested capital back.

When it comes to developing countries, the share holders always make the mistake of setting a higher international rate of investment return (Gregory, 2012). This is because they work under the assumption that developing countries are not stable enough and are more likely not to experience the always projected growth. Well contemporary studies are showing that is not true, this is because companies that invest in developing countries are more likely to experience increase in revenues and profits earned than those who invest in already developed countries.

The other factor considered is the weighted average cost of capital, most companies view that the risks in emerging global markets are higher and that the cost of capital will increase with increase in the risk of any specific market, this makes most firms to simply invest very little in the emerging markets and end up getting little revenue as well (Gregory 2012).

As CFO, discuss how you would defend the difference in the required rate of return for your company on similar projects in the Brazil and IndiaLet us assume that a company has invested in a developed country like the United Kingdom and decides to franchise in Brazil and in India as well. These two are developing countries that most probably do not have the many competing firms. This means that there is a chance of controlling a greater market share in the developing countries than it is possible in the mother country of the firm.

The difference in the required rate of return from a developed country to a developing country is 12 – 15%, this difference is brought on by the fact that the emerging markets offer a great potential of growth and much more is expected. This is as opposed to the developed markets that are already structured and any more investment in the firm leads to diseconomies of scale.

Due to fear of the risks involved investors set high investment hurdles in emerging markets as opposed to the established markets, this makes the investment to be minimal and so is the pay off. A decrease in the hurdles to as low as the ones placed in the mother country will increase the return earned from investment in countries like Brazil and India. This will open more and more opportunities for further investment that will lead to increase the revenue earned as there will be more opportunities to exploit.

References

Siegel, Joel, (2008), Financial Concepts and Tools for Managers, Delta Publishing Company

Gregory V. Milano and Jeffrey L. Routh – CFO.com | US February 15, 2012