Two Reasons For The Superiority Of The Npv Method In Evaluating Capital Investment Case Study

Register to read the introduction… Thus, the decision rules are similar for investment projects. The decision rule for NPV is to accept the project if the NPV is positive and reject the project if the NPV is NPV is negative. The decision rule for IRR is to accept the project if the IRR equals or is greater than the required rate of return and reject the project if the IRR is less than the required rate of return. Technically, the firm should be indifferent between accepting and rejecting a project with an NPV equal to zero or an IRR equal to the cost of capital because such an investment would not change shareholder wealth. The cost of capital is the discount rate for the NPV and the hurdle rate for the IRR.

The firm should accept the project because it has a positive NPV. However, the discounted payback method is inconsistent with shareholder wealth maximization because the method ignores some cash flows that contribute to the present value of investment.

What are two reasons for the superiority of the NPV method in evaluating capital investment projects? …show more content…
This is because the NPV is an absolute measure of a project’s worth. In addition, NPV has a more realistic reinvestment rate assumption than IRR. It implicitly assumes reinvestment of intermediate cash inflows at the required rate of return. Both reasons supporting the superiority of the NPV method assume that managers invest the cash flows from the investment for the benefit of shareholders. In summary, no other capital budgeting technique does a better job of measuring wealth creation than the NPV