Which of the following situations suggests the acceptance of an investment proposal?

Under which of the following situations the decision outcome on evaluation of investment opportunities vary under NPV and IRR methods per se?a) Time disparityb) Cost disparityc) Life disparityd) Volume disparityChoose the correct combination of situations:

1. a and d only
2. b and d only
3. a, b and c only
4. b, c and d only

Answer (Detailed Solution Below)

Option 3 : a, b and c only

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Net Present Value (NPV) Method: In this method, all cash flows attributable to a capital investment project are discounted by a chosen percentage e.g., the firms weighted average cost of capital to obtain the present value of the future cash flows. If the present value of the future cash flows is higher than the present value of the investments the proposal is accepted else rejected. In order to arrive at the net present value the present value of the future cash flows is deducted from the initial investment. 

Internal Rate of Return (IRR) Method: Internal rate of return is a percentage discount rate used in capital investment appraisals which makes the present value of the cost of the project equal to the future cash flows of the project. It is the rate of return that equates the present value of anticipated net cash flows with the initial outlay. The IRR is also defined as the rate at which the net present value is Zero. The test of profitability of a project is the relationship between the internal rate of return (%) of the project and the minimum acceptable rate of return.

Conflicts between NPV and IRR: When analyzing a single conventional project, both NPV and IRR will provide the same indicator about whether to accept the project or not. However, when comparing two projects, the NPV and IRR may provide conflicting results. Conflicting results arise because of the following reasons:

1. A significant difference in the size (amount) of cash outlays of various proposals under consideration.
2. The problem of difference in the cash flow patterns or timings of the various proposals, and
3. The difference in service life or unequal expected lives of the projects.

In such cases, while choosing among mutually exclusive projects, one should always select the project giving the largest positive net present value using the appropriate cost of capital or predetermined cut-off rate. The reason for the same lies in the fact that the objective of a firm is to maximize shareholder wealth and the project with the largest NPV has the most beneficial effect on share prices and shareholder’s wealth. Thus, the NPV method is more reliable as compared to the IRR method in ranking the mutually exclusive projects. In fact, NPV is the best operational criterion for ranking mutually exclusive investment proposals. 

Volume Disparity does not lead to conflict between NPV and IRR decisions. Thus, option 3 is the correct answer.

Last updated on Dec 17, 2022

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