1359 Words Aug 20th, 2011 6 Pages
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
Advantages: - It is a direct measure of the financial contribution to the investors / firm as it gives an absolute measure of return - Ensures a firm reaches an optimum scale of investment - Can handle multiple discount rates over different periods

Disadvantages: - There is no relative measure of project size, just the ultimate ‘net contribution’

Internal rate of return (IRR)

The IRR is the annual percentage return achieved by a project, at which the sum of the discounted cash inflows over the life of the project is equal to the sum of the capital invested. Or more simply put, the IRR is the rate of interest that reduces the NPV to zero. The IRR approach asks if the IRR on the project is greater than the borrowing rate.

Advantages: - It shows the return, or interest earned, on the original money invested - If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task

Disadvantages: - At times, it can give you conflicting answers when compared to NPV for mutually exclusive projects - Expresses return in percentage form, so no comparison on absolute returns - Ignores the scale of investment required - The 'multiple IRR problem' occurs when cash flows during the project lifetime are negative, where the project operates at a loss or the company needs to contribute more capital. This is known as a ‘non-normal cash flow’, and will give multiple IRRs

NPV vs

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