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Corporate Financial Theory

Net Present Value approach to Investment Appraisal

Name: Mohammed Salman


Registration No: H00173156
Course Code: C38FN
Lecturer: Dr. Welcome Sibanda
Tutor: Ms. Rehnuma Shahid
Word Count: 2726

Table of Contents
Section A - Introduction.............................................................................................. 3
Section B 3 Methods of Capital Budgeting...............................................................4
Net Present Value (NPV).......................................................................................... 4
Payback Period (PBP)............................................................................................... 6
Internal rate of Return (IRR).................................................................................... 7
Section C Criticism, Pros & Cons..............................................................................9
Criticism.................................................................................................................. 9
Pros & Cons of NPV.................................................................................................. 9
Pros & Cons of PBP................................................................................................ 11
Pros & Cons of IRR................................................................................................. 12
Section D Conclusion............................................................................................. 13
Section E References............................................................................................. 14

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Net Present Value approach to investment


appraisal
Section A - Introduction
Net Present Value is one of the characteristics of speculation evaluation or capital budgeting.
Most enormous businesses make decision based on inventing activities that requires capital
budgeting technique. The most vital decision making for this technique is the projects NPV. This
helps an investor to analyze whether the firm should invest in a new equipment or project, which
shows if it is worth it to pump in the cash and it indeed results in fair long-term benefit.
Therefore the shareholders select those projects that will earn maximum future return from the
investment (Dayananda, 2002).
NPV is one of the aspects of capital budgeting and the basic concept in most of the course books.
Most focus will be given to NPV as it helps to analyze investment activity in a company which
determines if one should make invest in the activities of the company leading to a profit. The
basic rule for this determination is: if an NPV of a particular project is negative then you reject it
and accept the projects with a positive NPV (Ross, 1995).
This essay describes the importance of NPV, Payback Period (PBP) and Internal Rate of Return
(IRR) with the help of calculations and examples. Section A- will talk about introduction and the
roots of NPV. Section B will be divided into 3 parts, explaining one method for each part. In
section C- the best method chosen will be criticized and the Pros and Cons for NPV against the
respective methods. At last, section D and E will contain Conclusion and References.

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Section B 3 Methods of Capital Budgeting


Net Present Value (NPV)
The net present value is described as the sum of the present value of all the cash inflows and
outflows of a specific project which is discounted at the rate rational with the projects risk

(Megginson, 2008). NPV is calculated by the simple formula

i +

C
t
(1+r )

where i the initial

investment of a project, C is the cash flow, r is the discount rate and t is the time period. The
formula changes depending on the number of years for the cash outflow, that is

i+

NPV =

C1
C2
Ct
+

1
2
( 1+ r ) ( 1+ r )
( 1+r )t

NPV provides accurate information as the cash inflows are added to the negative initial
investment, divided by the discount rate which gives an exact value for a project and helps the
investor to decide if one should invest in the project based on the NPV, only if it is greater than
zero. With the help of it, maximum shareholder wealth can be achieved. Therefore, it is good, as
it is simple to use and it can be easily compared. There is no need for pitch research. It is the
easiest method compared to IRR and PBP. NPV takes into consideration the periodic value of
money and likewise it is the analysis that focuses on profitability over an investment made as a
main objective.
Example of NPV Assume that a manufacturing company manufactures wooden doors. They
want to expand and think about investing in 2 equipments, equipment A costs $10000 and
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equipment B costs $10000. Both equipments are mutually exclusive. The discount rate is 15%
and the cash flows are as follows:-

Equipment A
Year
0 (Initial Investment)
1
2
3
4

Cash flows
$-10000
$6000
$4000
$10500
$8500

Equipment B
Year
0 (Initial Investment)
1
2
3
4

Cash flows
$-10000
$6000
$400
$4000
$600

Solution
Equipment A =

Equipment B =

10000+

6000
4000 10500 8500
+
+
+
=$ 10005
1
( 1.15 ) ( 1.15 )2 ( 1.15 )3 ( 1.15 )4

10000+

6000
400
4000
600
+
+
+
=$1507
1
2
3
( 1.15 ) ( 1.15 ) ( 1.15 ) ( 1.15 )4

Equipment A gives a Positive NPV and Equipment B gives a negative NPV. The basic decision
rule suggests that NPV, which results in a positive value, should be selected. As a result

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Equipment A is higher and so it is advisable to select it, as compared to equipment B. When


decision is to be taken between mutually exclusive equipment then the criteria to be followed is
to choose either 1 equipment or none but certainly both equipment cannot be chosen.

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Payback Period (PBP)


Payback period is the time period that is required to retrieve the investment made for a project.
Unlike NPV it does not take into consideration the present value of money streams. It is an
important determination whether to accept the project or reject it because longer payback periods
are not preferably acceptable by any business owner as faster returns is what they look forward
to. It is the easiest approach of capital budgeting, very simple to understand and investment with
undersized payback period increases the liquidity position of the business so it is positively good
(Adams, 2003). PBP can be calculated with the formula: Payback period =

Investment required for a project


Net annual cash flow
However it can also be calculated with the help of cumulative like shown in the example below
using the same question as for the NPV.
Example of PBP
Equipment A
Year

Cash flow

Cumulative

0
1

$-10000
$6000

$-10000
$6000

$4000

$10000

$10500

$18500

$8500

$29000

Equipment B
Year

Cash flow

Cumulative

0
1
2

$-10000
$6000
$400

$-10000
$6000
$6400

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$4000

$10400

$600

$11000

The cumulative shows the negative initial investment made and keeps adding up the cash inflows
which add up in a straight line one after another. Once the cumulative chart is made we evaluate
which equipment gives a faster payback and hence choose the year which restores the investment
at the earliest. In this example we select equipment A as it restores the initial investment in the
2nd year which is $10000, compared to equipment B which recovers its investment in the 3rd year
that is $10400. It can be classified that a short payback period decreases the danger of misfortune
brought about by changing monetary conditions so a payback by the 2nd year is fairly very good.
Internal rate of Return (IRR)
IRR is the discount rate that is frequently used in capital budgeting, which makes the NPV of all
money streams from a specific investment equal to zero. It is utilized to assess the appeal of a
business activity (Adams, 2003). Usually greater the internal rate of return for a project, the
better it is to accept the project.
The discount rate in IRR plays an analytical role as a greater discount rate can result in either
zero or a NPV value less than zero, but we choose the one with a value that is equal to zero and
get that percentage which is used to calculate the NPV as the IRR (Adams 2003). The example
below will compute how to get the IRR with the help of excel, using the matching question used
for NPV.

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Example of IRR
Equipment A
Year
0 (Initial Investment)
1
2
3
4

Cash flows
$-10000
$6000
$4000
$10500
$8500

Equipment B
Year
0 (Initial Investment)
1
2
3
4

Cash flows
$-10000
$6000
$400
$4000
$600

Solution
Equipment A =

Equipment B =

10000+

6000
4000 10500 8500
+
+
+
=$ 10005
1
( 1.15 ) ( 1.15 )2 ( 1.15 )3 ( 1.15 )4

10000+

6000
400
4000
600
+
+
+
=$1507
1
2
3
( 1.15 ) ( 1.15 ) ( 1.15 ) ( 1.15 )4

To make the above NPV zero or nearest to the zero we have to try using a different discount rate
that can result to a zero, it is done by the following:

Equipment A =

Equipment B =

10000+

6000
4000 10500 8500
+
+
+
=$ 0
1
( 1.53 ) ( 1.53 )2 ( 1.53 )3 ( 1.53 )4

using 53.78%

10000+

6000
400
4000
600
+
+
+
=$ 0
1
2
3
( 1.05 ) ( 1.05 ) ( 1.05 ) ( 1.05 )4

using 5.15%
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The IRR for each equipment is 53.78% and 5.15%. These values are calculated using excel
spreadsheet and it can be evaluated that Equipment A gives a greater IRR, i.e. 53.78 when
compared to equipment B that gives an IRR of 5.15%. So equipment A will be chosen as the
final IRR.

Section C Criticism, Pros & Cons


Criticism
NPV is by far the best method correlated to PBP and IRR. Firstly, when NPV is compared to
PBP it is the most beneficial as it takes into account the time value of money invested as well as
the cash flows till the end of a projects life whereas PBP evaluates the period of years until a
particular investment is recovered through repayments and ignores the cash flows after the
investment is recovered. Taking NPV against IRR into consideration, IRR method disregards the
monetary value of money and it does not consider economies of scale.
It is impossible to differentiate two projects with the same IRR and so a big difference occurs in
the investment value return however NPV proves values in exact figures as well as take time
factor into account. Furthermore, the pros and cons for each method will describe the above in
detail.
Pros & Cons of NPV
Pros- NPV majorly considers the time value of money which helps in keeping
in mind as the cost of capital, i.e. the amount of capital to be required in
investing in an organization, the varying interest rates and the opportunity
costs of investment. This method is likely to be used for projects that are
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expected to last long. When the net present value of a firm is calculated it
gives an assumption that the value of money is higher than received at a
later note. For example, the value of a dollar earned today would be greater
than the value of it received a year later and thus is describes the concept of
time value of money.
This measure also helps in realizing the risks involved with the cash flow to
be done in the future. Strength of this measure is that if analyzed properly it
provides accurate information about the projects future value. The final
output makes it easy to interpret how the expected return will vary, if the
project is well accepted. The npv is accurate in reflecting the amount of
income that the project would be able to produce at a predicted rate of
return. It states the progress of a project, i.e. how a project will start how far
it will generate the required income and how efficient it will be in the future.
Cons- The ranking investments estimated by the npv do no compare the absolute levels of the
particular investments made. The npv does not consider the profits and losses incurred by the
firm but it rather focuses on the cash flows that take place. The percentage of discount that is
done in the net present value is sometimes difficult to determine depending on the varying
interest rates. The problem in the net present value method appears when it considers the capital
to be unlimited and which in turn causes a fault in the capital rationing.
If the required resources are not enough the researcher has to analyze the net present value as
well as the investment he is making in each of the projects that are taken. The npv requires a
proper research to be done as to know what amount of the finance is needed in the investing. If
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the net present value analysis appears too defective it may result in wrong decisions of selecting
the particular projects. The net present value is helpful mainly in comparing the different projects
taken at the same time it does not completely rely on the opportunity cost.

If a firm decides on which investment to take under consideration based on the NPV, there may
be chances of discovering new options that offer a high NPV. The investors do not make quick
decisions in choosing the option that has the highest NPV instead they look for more comfortable
options available.
Pros & Cons of PBP
Pros- The financial analysts prefer the PBP for various reasons. When the
firms evaluate the capital projects they select employees in different fields
and backgrounds. By using the PBP method the evaluation is reduced to a
simple number of years which are easy to calculate and it is considered to be
an easily understood concept. Companies that have limited cash should be
capable of recognizing projects that provide the fastest return on the
invested amount so that the firm can recover whatever investment it had
made.
The pbp method is of great help to the financial managers of an organization
as it helps making quick evaluations that have a small investment. The small
projects usually do not require too many employees or detailed economic

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analysis. Managers often use the PBP method for initially evaluating the
projects.
Cons- Irregular cash flows are to be expected from a project with a major amount of return not
occurring until the future. However a project may have an average rate of return but still wont
be able to fulfill the minimum time period provided by the company. The cash inflows from a
project are not considered by the payback method as they may occur after the initial investment
has been recovered. The PBP method majorly relies on the short term profits, which results in
loosing better projects.
Pros & Cons of IRR
Pros- The internal rate of return method is a very clear concept and is easy
to conceptualize. It helps the analysts and the financial managers of a firm to
understand its opportunity cost. In case the IRR exceeds the given rate, then
the project provides the financial funds if needed. However if the investment
rate is predicted to be below the IRR, then the investment would be of no use
to the firms value. The IRR method due to its clear structure is used by
many organizations to show their respective portfolios.
This method is also very popular because of it uncomplicated nature. The
NPV, IRR and PBP methods are the most commonly used in considering any
investment. The outputs of these measures are mostly included in the
analysis that are made in favor of the firm which in turn make the
managements decision making process easier when its the time to decide
whether to start a project or make a future investment. A major strength of
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this method is that it does not require a person to have advanced math skills,
i.e. it is comparatively easier to calculate and does not require professional
skills.
Cons- The IRR must assume the rate of discount or the cost of capital that is needed but it is
not possible at all times therefore making it as one of the key weakness of this method. The cost
of capital and the discount rate do not stay stable as they may change on a yearly basis with the
change in the market conditions. It mostly changes on a year to year period of time. The financial
analysts no matter how much research they do, it is likely not possible to measure the accurate
future rate of return.
It is sometimes possible that this method is not applicable because sometimes there is no singular
rate of return or multiple IRR are required for a project and in some of the cases the irr has to be
adjusted in accordance with the firms capital. As a result of poor assumptions it makes the
managements job difficult in making the required decisions. When the cash flow signs are
shown to vary in different years the output would be no IRR or multiple IRR. This method
mostly focuses only the projected cash flows that are brought into the business by a capital
investment and does not pay much attention towards the potentential future costs which are
likely to affect the future profits made by the organization.
The IRR allows the analyst to compute the future cash flows but at the same time it makes a false
assumption that the cash flows which are considered could be reinvested at the same rate as the
IRR. However the assumptions made are sometimes not applicable because the opportunities
turn out to be higher than expected.

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Section D Conclusion
To conclude with, this essay described how NPV is a better method for
investment appraisal in comparison to PBP and IRR. More stress was given on
NPV since it more accurate and reliable based on the time value and cash
flows it takes into consideration. Based on the contents and the structure of
this essay, it is critically discussed how each method is important and how to
make a choice built on the examples used. The discount rates used in NPV
are different from IRR as the whole point of IRR is to make the NPV value zero
which would result in a different discount rate. Moreover, it is proved that
NPV is the best method out of all as its advantages are more beneficial as
compared to the other 2 methods and the disadvantages of NPV are less
effective to investment rate of return.

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Section E References
Besley, S. and Brigham, E. (2008). Principles of Finance. 4th ed. Cengage Learning, pp.548550.
Brigham, E. and Ehrnhardt, M. (2013). Financial Mangement:Theory&Practise. 14th ed.
Cengage Learning, pp.25-28.
Dayananda, D., Irons, R., Harrison, S., Herbohn, J. and Rowland, P. (2002). Capital
Budgeting:Financial Appraisal of Investment Projects. Cambridge University Press.
Megginson, W. and Smart, S. (2008). Introduction to Coporate Finance. Cengage Leraning
EMEA, p.261.
Moyer, C., McGuigan, J., Rao, R. and Kretlow, W. (2011). Contemporary Financial
Management. 12th ed. Cengage Learning, pp.325-328.
Horne, J. V. Wachowicz, J. (2005). Fundamentals of Financial Management. Williams
Publishing House.
Damodaran, A. (2002). Investment Valuation. Tools and Techniques for Determinin the Value of
Any Assets. New York, John Wiley & Sons.
Brealey, R. A, Mayers S.C., Marcus A.J. (2001). Fundamentals of Corporate Finance. 3rd
edition. New Jersey: The McGraw-Hill Companies.
Graham JR, Harvey CR (2001). The theory and practice of corporate finance: evidence from the
field. J. Finance, pp187-188.

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