Investment decisions - Capital budgeting (NPV vs IRR)

 What is Capital Budgeting?

Capital budgeting is the process of allocating capital after determining project feasibility.

Determining project feasibility is a 3 step process:-

Step 1] Qualitative Analysis – Relationship/Branding feasibility, Socio-Cultural & Political feasibility

Step 2] Forecasting Performance – Financial Modelling & Structural analysis

Step 3] Quantitative Analysis –IRR (or MIRR), NPV, Payback period and other quantitative analysis

In capital budgeting, there are a number of different approaches that can be used to evaluate any given project, and each approach has its own distinct advantages and disadvantages.

What is NPV method?

The NPV method aims to capture the amount available after meeting the cost of all capital contributors (all claim holders).This method ‘discounts’ operating cash flows at a rate that captures the cost of capital (i.e. the capital used/contributed to generate cash flows). In fact, the NPV method is what leads to the concept of value creation through Economic Profit.

·         Net Present Value (NPV) = Total PV of future CF’s - Initial Investment

Estimating NPV:

1.      Estimate future cash flows: how much? and when?

2.      Estimate discount rate

3.      Estimate initial costs

·      Minimum Acceptance Criteria: Accept if NPV > 0

·      Ranking Criteria: Choose the highest NPV

In Short: A positive NPV is a must and the higher the better.

What is IRR method?

 Internal Rate of Return measures the return generated by an asset assuming that the reinvestment rate of cash flows thus generated, is the same as the IRR itself.

Limitation of IRR method - Major shortfall associated with the IRR method is the fact that it cannot be conclusively used in circumstances where the cash flow is inconsistent. While working out figures in such fluctuating circumstances may prove tricky for the IRR method, it would pose no challenge for the NPV method since all that it would take is the collection of all the inflows-outflows and finding an average over the entire period in focus.

IRR may not exist or there may be multiple IRR

The relationship between NPV and IRR is that “IRR is the rate at which NPV = Zero”

When Cost of Capital is more than IRR the NPV will be Negative

If we graph NPV versus discount rate, we can see the IRR as the x-axis intercept.

Difference between NPV vs. IRR

1.     NPV is calculated in cash, the IRR is a percentage value expected in return from a capital project.

2.    There may be conflicting results under NPV and IRR

NPV and IRR methods may give conflicting results in case of mutually exclusive projects, i.e., projects where acceptance of one would result in non-acceptance of the other.  Such conflict of result may be due to any one or more of the following reasons:

1.      The projects require different cash outlays.

2.      The projects have unequal lives.

3.      The projects have different patterns of cash flows.

In such a situation, the result given by the NPV method should be relied upon.  This is because the objective of a company is to maximize its shareholders' wealth.  IRR method is concerned with the rate of return on investment rather than total yield on investment hence it is not compatible with the goal of wealth maximization.  NPV method considers the total yield on investment.  Hence, in case of mutually exclusive projects, each having a positive NPV, the one, with the largest NPV will have the most beneficial effect on shareholders'

WHY NPV IS BETTER

Both the Net Present Value Method and Internal Rate of Return Method proceed on this presumption that cash inflows can be reinvested at the discounting rate in the new projects.  However, reinvestment of funds at the cut-off rate i.e cost of capita is more possible than at the internal rate of return.  Hence, Net Present Value Method is more reliable than the Internal Rate of Return Method for ranking two or more capital investment projects.

Similarities in results under NPV and IRR

Both NPV and IRR will give up the same result (i.e., acceptance or rejection) regarding an investment proposal in following cases:

                i.            Projects involving conventional cash flows, i.e., when an initial outflow is followed by a series of inflows.

                  ii.            Independent investment proposals, i.e., proposals the acceptance of which does not preclude the acceptance of others.

The reason for similarity in results in the above cases is simple.  In case of NPV method, a proposal is acceptable if its NPV is positive. NPV will be positive only when the actual return on investment is more than the cut-off rate.  In case of IRR method a proposal is acceptable only when the IRR is higher than the cut-off rate.  Thus, both methods will give consistent results since the acceptance or rejection of this proposal under both of them is based on the actual return being higher than the cut-off rate.

In case of projects requiring different cash outlays, the problem can also be resolved by adopting incremental approach, a modified form of IRR method.  According to this approach in case of two mutually exclusive projects requiring different cash outlays, the IRR of incremental outlay of the project requiring a higher investment is calculated.  In case this IRR is higher than the required rate of return, the project having greater non-discounted cash flows should be accepted otherwise it should be rejected.

Pay Back Period rule

·         How long does it take the project to “pay back” its initial investment?

·         Payback Period = number of years to recover initial costs

·         Disadvantages:

o   Ignores the time value of money

o   Ignores cash flows after the payback period

o   Biased against long-term projects

·         Advantages:

o   Easy to understand

o   Biased toward liquidity

Profitability Index

 PI =Total PV of future cash flows/Initial Investment or 1  +(NPV/Initial Investment)

• Minimum Acceptance Criteria:
• Accept if PI > 1
• Ranking Criteria:
• Select alternative with highest PI
• Disadvantages:
• Problems with mutually exclusive investments
• Advantages:
• May be useful when available investment funds are limited
• Easy to understand and communicate