MBA728 Advanced Corporate Finance Assignment Help

MBA728 Advanced Corporate Finance Assignment Help

MBA728 Advanced Corporate Finance Assignment Help

Introduction

This assignment aims to analyze the different investment appraisal methods that can be used by the management of an organization and how these appraisal methods differ from one another. The later part of the work tries to understand and disseminate the difference between the two widely used methods of investment appraisal namely IRR and NPV.

MBA728 Advanced Corporate Finance Assignment Help

(a) Discuss   whether   B&S Ltd   should   rationalise   and   end production in any of the factories producing the beverages. If so, suggest which factories should be closed and explain your answer fully. Explain what reservations you may have.

Beverage

Orange

Apple

Peach

Pear

Revenue

    60.00

  180.00

  100.00

  350.00

Material

    10.00

  130.00

    20.00

    85.00

Labor

      5.00

    25.00

    60.00

  225.00

Overheads

    25.00

    45.00

    20.00

  150.00

Revenue and per unit cost

Beverage

Orange

Apple

Peach

Pear

Revenue

     60.00

     180.00

     100.00

       350.00

Material

     10.00

     130.00

       20.00

         85.00

Labor

       5.00

       25.00

       60.00

       225.00

Overheads

     25.00

       45.00

       20.00

       150.00

Total Cost

     40.00

     200.00

     100.00

       460.00

Profit/(Loss)

     20.00

      -20.00

             -  

     -110.00

Per unit sold profit and loss

Factory Cost

 1,00,00,000.00

 1,50,00,000.00

 2,00,00,000.00

 3,00,00,000.00

Research

    20,00,000.00

    50,00,000.00

    10,00,000.00

    20,00,000.00

Total

 1,20,00,000.00

 2,00,00,000.00

 2,10,00,000.00

 3,20,00,000.00

Life of project

                  5.00

                  5.00

                  5.00

                  5.00

Depreciation per annum

    24,00,000.00

    40,00,000.00

    42,00,000.00

    64,00,000.00

Project Depreciation

Beverage

Orange

Apple

Peach

Pear

Revenue

                 60.00

               180.00

              100.00

                350.00

Material

                 10.00

               130.00

                20.00

                  85.00

Labor

                   5.00

                 25.00

                60.00

                225.00

Overheads

                 25.00

                 45.00

                20.00

                150.00

Total Cost

                 40.00

               200.00

              100.00

                460.00

Profit/(Loss)

                 20.00

               -20.00

                      -  

              -110.00

Factory Cost

  1,00,00,000.00

  1,50,00,000.00

 2,00,00,000.00

   3,00,00,000.00

Research

     20,00,000.00

     50,00,000.00

    10,00,000.00

      20,00,000.00

Total

  1,20,00,000.00

  2,00,00,000.00

 2,10,00,000.00

   3,20,00,000.00

Life of project

                   5.00

                   5.00

                  5.00

                    5.00

Depreciation per annum

     24,00,000.00

     40,00,000.00

    42,00,000.00

      64,00,000.00

Number of units sold

       1,00,000.00

       1,00,000.00

      1,00,000.00

        1,00,000.00

Total Profit

     20,00,000.00

   -20,00,000.00

                      -  

 -1,10,00,000.00

Cash Flow

     44,00,000.00

     20,00,000.00

    42,00,000.00

    -46,00,000.00

Before service charge cash flow of the factories

Beverage

Orange

Apple

Peach

Pear

Revenue

                 60.00

               180.00

              100.00

                350.00

Material

                 10.00

               130.00

                20.00

                  85.00

Labor

                   5.00

                 25.00

                60.00

                225.00

Overheads

                 25.00

                 45.00

                20.00

                150.00

Total Cost

                 40.00

               200.00

              100.00

                460.00

Profit/(Loss)

                 20.00

               -20.00

                      -  

              -110.00

Factory Cost

  1,00,00,000.00

  1,50,00,000.00

 2,00,00,000.00

   3,00,00,000.00

Research

     20,00,000.00

     50,00,000.00

    10,00,000.00

      20,00,000.00

Total

  1,20,00,000.00

  2,00,00,000.00

 2,10,00,000.00

   3,20,00,000.00

Life of project

                   5.00

                   5.00

                  5.00

                    5.00

Depreciation per annum

     24,00,000.00

     40,00,000.00

    42,00,000.00

      64,00,000.00

Number  of units sold

       1,00,000.00

       1,00,000.00

      1,00,000.00

        1,00,000.00

Total Profit

     20,00,000.00

   -20,00,000.00

                      -  

 -1,10,00,000.00

Cash Flow

     44,00,000.00

     20,00,000.00

    42,00,000.00

    -46,00,000.00

Service Charge

  1,00,00,000.00

     20,00,000.00

    30,00,000.00

      60,00,000.00

Cash flow after service charge

   -56,00,000.00

                      -  

    12,00,000.00

 -1,06,00,000.00

After service charge cash flow of the factories

 

0

1

2

3

4

5

Discounted cash flow

Orange

-12000000

4400000

4400000

-5600000

4400000

4400000

 

Apple

-20000000

2000000

2000000

0

2000000

2000000

 

Peach

-21000000

4200000

4200000

1200000

4200000

4200000

 

Pear

-32000000

-4600000

-4600000

-10600000

-4600000

-4600000

 

Discounting values @13%

1

0.884956

0.783147

0.69305

0.613319

0.54276

 

Orange

-12000000

3893805.31

3445845.407

-3881080.909

2698602

2388143.7

-3454684.07

Apple

-20000000

1769911.504

1566293.367

0

1226637

1085519.9

-14351637.8

Peach

-21000000

3716814.159

3289216.07

831660.1947

2575939

2279591.7

-8306779.19

Pear

-32000000

-4070796.46

-3602474.744

-7346331.72

-2821266

-2496696

-52337564.8

Factorie’s NPV

Beverage

Orange

Apple

Peach

Pear

Revenue

                 60.00

               180.00

              100.00

                350.00

Material

                 10.00

               130.00

                20.00

                  85.00

Labor

                   5.00

                 25.00

                60.00

                225.00

Overheads

                 25.00

                 45.00

                20.00

                150.00

Total Cost

                 40.00

               200.00

              100.00

                460.00

Profit/(Loss)

                 20.00

               -20.00

                      -  

              -110.00

Factory Cost

  1,00,00,000.00

  1,50,00,000.00

 2,00,00,000.00

   3,00,00,000.00

Research

     20,00,000.00

     50,00,000.00

    10,00,000.00

      20,00,000.00

Total

  1,20,00,000.00

  2,00,00,000.00

 2,10,00,000.00

   3,20,00,000.00

Life of project

                   5.00

                   5.00

                  5.00

                    5.00

Depreciation per annum

     24,00,000.00

     40,00,000.00

    42,00,000.00

      64,00,000.00

Number of units sold

       1,00,000.00

       1,00,000.00

      1,00,000.00

        1,00,000.00

Total Profit

     20,00,000.00

   -20,00,000.00

                      -  

 -1,10,00,000.00

Cash Flow

     44,00,000.00

     20,00,000.00

    42,00,000.00

    -46,00,000.00

Service Charge

  1,00,00,000.00

     20,00,000.00

    30,00,000.00

      60,00,000.00

Cash flow after service charge

   -56,00,000.00

                      -  

    12,00,000.00

 -1,06,00,000.00

Resale Value

     40,00,000.00

     80,00,000.00

    30,00,000.00

      70,00,000.00

Cash Flow if Production Ceases for Year 3

     64,00,000.00

  1,20,00,000.00

    72,00,000.00

   1,34,00,000.00

Cash Flow if Production Ceases for Year 4 and 5

     24,00,000.00

     40,00,000.00

    42,00,000.00

      64,00,000.00

Cash position if the factory shuts down

 

                        -  

                   1.00

                   2.00

                    3.00

                                     4.00

                 5.00

 NPV

Orange

 -1,20,00,000.00

     44,00,000.00

     44,00,000.00

      64,00,000.00

                       24,00,000.00

   24,00,000.00

 

Apple

 -2,00,00,000.00

     20,00,000.00

     20,00,000.00

                        -  

                       20,00,000.00

   20,00,000.00

 

Peach

 -2,10,00,000.00

     42,00,000.00

     42,00,000.00

      12,00,000.00

                       42,00,000.00

   42,00,000.00

 

Pear

 -3,20,00,000.00

   -46,00,000.00

   -46,00,000.00

  -1,06,00,000.00

                      -46,00,000.00

 -46,00,000.00

 

Discounting values @13%

                    1.00

                   0.88

                   0.78

                    0.69

                                     0.61

                 0.54

 

Orange

 -1,20,00,000.00

     38,93,805.31

     34,45,845.41

      44,35,521.04

                       14,71,964.95

   13,02,623.85

      25,49,760.55

Apple

 -2,00,00,000.00

     17,69,911.50

     15,66,293.37

                        -  

                       12,26,637.46

   10,85,519.87

 -1,43,51,637.80

Peach

 -2,10,00,000.00

     37,16,814.16

     32,89,216.07

        8,31,660.19

                       25,75,938.66

   22,79,591.73

    -83,06,779.19

Pear

 -3,20,00,000.00

   -40,70,796.46

   -36,02,474.74

     -73,46,331.72

                      -28,21,266.15

 -24,96,695.71

 -5,23,37,564.78

Combined NPV

 -7,24,46,221.00

      

NPV if the Orange Factory is shuts down

 

0

1

2

3

4

5

NPV

Orange

 -1,20,00,000.00

     44,00,000.00

     44,00,000.00

     -56,00,000.00

                       44,00,000.00

   44,00,000.00

 

Apple

 -2,00,00,000.00

     20,00,000.00

     20,00,000.00

                        -  

                       20,00,000.00

   20,00,000.00

 

Peach

 -2,10,00,000.00

     42,00,000.00

     42,00,000.00

      12,00,000.00

                       42,00,000.00

   42,00,000.00

 

Pear

 -3,20,00,000.00

   -46,00,000.00

   -46,00,000.00

   1,34,00,000.00

                       64,00,000.00

   64,00,000.00

 

Discounting values @13%

                    1.00

                   0.88

                   0.78

                    0.69

                                     0.61

                 0.54

 

Orange

 -1,20,00,000.00

     38,93,805.31

     34,45,845.41

     -38,81,080.91

                       26,98,602.40

   23,88,143.72

    -34,54,684.07

Apple

 -2,00,00,000.00

     17,69,911.50

     15,66,293.37

                        -  

                       12,26,637.46

   10,85,519.87

 -1,43,51,637.80

Peach

 -2,10,00,000.00

     37,16,814.16

     32,89,216.07

        8,31,660.19

                       25,75,938.66

   22,79,591.73

    -83,06,779.19

Pear

 -3,20,00,000.00

   -40,70,796.46

   -36,02,474.74

      92,86,872.18

                       39,25,239.86

   34,73,663.59

 -2,29,87,495.58

Combined NPV

 -4,91,00,597.00

      

NPV when Pear factory is shut down

 

                        -  

                   1.00

                   2.00

                    3.00

                                     4.00

                 5.00

 NPV

Orange

 -1,20,00,000.00

     44,00,000.00

     44,00,000.00

     -56,00,000.00

                       44,00,000.00

   44,00,000.00

 

Apple

 -2,00,00,000.00

     20,00,000.00

     20,00,000.00

   1,20,00,000.00

                       40,00,000.00

   40,00,000.00

 

Peach

 -2,10,00,000.00

     42,00,000.00

     42,00,000.00

      12,00,000.00

                       42,00,000.00

   42,00,000.00

 

Pear

 -3,20,00,000.00

   -46,00,000.00

   -46,00,000.00

   1,34,00,000.00

                       64,00,000.00

   64,00,000.00

 

Discounting values @13%

                    1.00

                   0.88

                   0.78

                    0.69

                                     0.61

                 0.54

 

Orange

 -1,20,00,000.00

     38,93,805.31

     34,45,845.41

     -38,81,080.91

                       26,98,602.40

   23,88,143.72

    -34,54,684.07

Apple

 -2,00,00,000.00

     17,69,911.50

     15,66,293.37

      83,16,601.95

                       24,53,274.91

   21,71,039.74

    -37,22,878.53

Peach

 -2,10,00,000.00

     37,16,814.16

     32,89,216.07

        8,31,660.19

                       25,75,938.66

   22,79,591.73

    -83,06,779.19

Pear

 -3,20,00,000.00

   -40,70,796.46

   -36,02,474.74

      92,86,872.18

                       39,25,239.86

   34,73,663.59

 -2,29,87,495.58

Combined NPV

 -3,84,71,837.00

      

Where the Apple and the Pear factory are shut down the NPV would be:

 

0

1

2

3

4

5

NPV

Orange

 -1,20,00,000.00

     44,00,000.00

     44,00,000.00

      64,00,000.00

                       24,00,000.00

   24,00,000.00

 

Apple

 -2,00,00,000.00

     20,00,000.00

     20,00,000.00

   1,20,00,000.00

                       40,00,000.00

   40,00,000.00

 

Peach

 -2,10,00,000.00

     42,00,000.00

     42,00,000.00

      12,00,000.00

                       42,00,000.00

   42,00,000.00

 

Pear

 -3,20,00,000.00

   -46,00,000.00

   -46,00,000.00

   1,34,00,000.00

                       64,00,000.00

   64,00,000.00

 

Discounting values @13%

                    1.00

                   0.88

                   0.78

                    0.69

                                     0.61

                 0.54

 

Orange

 -1,20,00,000.00

     38,93,805.31

     34,45,845.41

      44,35,521.04

                       14,71,964.95

   13,02,623.85

      25,49,760.55

Apple

 -2,00,00,000.00

     17,69,911.50

     15,66,293.37

      83,16,601.95

                       24,53,274.91

   21,71,039.74

    -37,22,878.53

Peach

 -2,10,00,000.00

     37,16,814.16

     32,89,216.07

        8,31,660.19

                       25,75,938.66

   22,79,591.73

    -83,06,779.19

Pear

 -3,20,00,000.00

   -40,70,796.46

   -36,02,474.74

      92,86,872.18

                       39,25,239.86

   34,73,663.59

 -2,29,87,495.58

Combined NPV

 -3,24,67,393.00

      

Where the Apple, Orange and the Pear factory are shut down the NPV would be:

 

0

1

2

3

4

5

Irr

Orange

 -1,20,00,000.00

     44,00,000.00

     44,00,000.00

      64,00,000.00

                       24,00,000.00

   24,00,000.00

22.00%

Apple

 -2,00,00,000.00

     20,00,000.00

     20,00,000.00

   1,20,00,000.00

                       40,00,000.00

   40,00,000.00

6.00%

Peach

 -2,10,00,000.00

     42,00,000.00

     42,00,000.00

      72,00,000.00

                       42,00,000.00

   42,00,000.00

5.00%

Pear

 -3,20,00,000.00

   -46,00,000.00

   -46,00,000.00

  -1,06,00,000.00

                      -46,00,000.00

 -46,00,000.00

 

Discounting values @13%

                    1.00

                   0.88

                   0.78

                    0.69

                                     0.61

                 0.54

 

Orange

 -1,20,00,000.00

     38,93,805.31

     34,45,845.41

      44,35,521.04

                       14,71,964.95

   13,02,623.85

      25,49,760.55

Apple

 -2,00,00,000.00

     17,69,911.50

     15,66,293.37

      83,16,601.95

                       24,53,274.91

   21,71,039.74

    -37,22,878.53

Peach

 -2,10,00,000.00

     37,16,814.16

     32,89,216.07

      49,89,961.17

                       25,75,938.66

   22,79,591.73

    -41,48,478.21

Pear

 -3,20,00,000.00

   -40,70,796.46

   -36,02,474.74

     -73,46,331.72

                      -28,21,266.15

 -24,96,695.71

 -5,23,37,564.78

Combined NPV

 -5,76,59,161.00

      

Where the Apple, Orange and the Peach factory are shut down the NPV would be:

 

0

1

2

3

4

5

NPV

Orange

-12000000

4400000

4400000

6400000

2400000

2400000

 

Apple

-20000000

2000000

2000000

12000000

4000000

4000000

 

Peach

-21000000

4200000

4200000

7200000

4200000

4200000

 

Pear

-32000000

-4600000

-4600000

13400000

6400000

6400000

 

Discounting values @13%

1

0.884956

0.783147

0.69305

0.613319

0.54276

 

Orange

-12000000

3893805.31

3445845.407

4435521.039

1471964.946

1302623.846

2549760.548

Apple

-20000000

1769911.504

1566293.367

8316601.947

2453274.911

2171039.744

-3722878.53

Peach

-21000000

3716814.159

3289216.07

4989961.168

2575938.656

2279591.731

-4148478.21

Pear

-32000000

-4070796.46

-3602474.744

9286872.175

3925239.857

3473663.59

-22987495.58

Combined NPV

-28309092

      

NPV if all the factories are shut down

If all the factories are closed the loss of the concern is minimized which is the best option the organization can opt for.

Notes:

1. It has been assumed the depreciation and cost of research have been included in the overhead calculations.

2. Even in closed condition depreciation expense can be claimed as tax deductible expense.

3. The projects initial investments have been taken into account to arrive at the NPV.

(b)  If B&S Ltd faced a shortage of cash [e.g. Bank Haircut] and was able to meet service charges up to a total value of only $10,000,000, which factories would B&S Ltd decide to keep open?

If the organization has only $10000000 as cash the same should be used to run the orange factory the same minimizes the negative net present value of the concern. If the organization choses to run the orang factory the NPV would be:

 

Orange

Apple

Peach

Pear

Discounting values @13%

Orange

Apple

Peach

Pear

0

-12000000

-20000000

-21000000

-32000000

1

-12000000

-20000000

-21000000

-32000000

1

4400000

2000000

4200000

-4600000

0.88496

3893806.4

1769912

3716815.2

-4070797.6

2

4400000

2000000

4200000

-4600000

0.78315

3445846.8

1566294

3289217.4

-3602476.2

3

-5600000

8000000

3000000

7000000

0.69305

-3881080

5544400

2079150

4851350

4

4400000

 

 

 

0.61332

2698603.6

0

0

0

5

4400000

   

0.54276

2388144

0

0

0

 

 

 

 

 

 

-3454679.2

-11119394

-11914817.4

-34821923.8

 

        

 

 

Combined NPV

-61310814

 

 

 

 

 

 

 

If the organization wishes to run the Apple and Peach Factory the NPV would be:

 

Orange

Apple

Peach

Pear

Discounting values @13%

Orange

Apple

Peach

Pear

0

-12000000

-20000000

-21000000

-32000000

1

-12000000

-20000000

-21000000

-32000000

1

4400000

2000000

4200000

-4600000

0.88496

3893806.4

1769912

3716815.2

-4070797.6

2

4400000

2000000

4200000

-4600000

0.78315

3445846.8

1566294

3289217.4

-3602476.2

3

4000000

0

1200000

7000000

0.69305

2772200

0

831660

4851350

4

0

2000000

4200000

0

0.61332

0

1226638

2575939.8

0

5

0

2000000

4200000

0

0.54276

0

1085520

2279592

0

 

 

 

 

 

 

-1888146.8

-14351636

-8306775.6

-34821923.8

 

        

 

 

Combined NPV

-59368482

 

 

 

 

 

 

 

  If the organization wishes to run the Pear Factory the NPV would be:

 

Orange

Apple

Peach

Pear

Discounting values @13%

Orange

Apple

Peach

Pear

0

-12000000

-20000000

-21000000

-32000000

1

-12000000

-20000000

-21000000

-32000000

1

4400000

2000000

4200000

-4600000

0.88496

3893806.4

1769912

3716815.2

-4070797.6

2

4400000

2000000

4200000

-4600000

0.78315

3445846.8

1566294

3289217.4

-3602476.2

3

4000000

8000000

3000000

13400000

0.69305

2772200

5544400

2079150

9286870

4

 

 

 

6400000

0.61332

0

0

0

3925241.6

5

   

6400000

0.54276

0

0

0

3473664

 

 

 

 

 

 

-1888146.8

-11119394

-11914817.4

-22987498.2

 

        

 

 

Combined NPV

-47909856

 

 

 

 

 

 

 

If the organization wishes to run the Pear & Apple Factory the NPV would be:

 

Orange

Apple

Peach

Pear

Discounting values @13%

Orange

Apple

Peach

Pear

0

-12000000

-20000000

-21000000

-32000000

1

-12000000

-20000000

-21000000

-32000000

1

4400000

2000000

4200000

-4600000

0.88496

3893806.4

1769912

3716815.2

-4070797.6

2

4400000

2000000

4200000

-4600000

0.78315

3445846.8

1566294

3289217.4

-3602476.2

3

4000000

0

3000000

13400000

0.69305

2772200

0

2079150

9286870

4

0

2000000

 

6400000

0.61332

0

1226638

0

3925241.6

5

0

2000000

 

6400000

0.54276

0

1085520

0

3473664

 

 

 

 

 

 

-1888146.8

-14351636

-11914817.4

-22987498.2

 

        

 

 

Combined NPV

-51142098

 

 

 

 

 

 

 

Considering all the propositions the organization should consider running the Pear factory.

(c) Discuss why the Internal Rate of Return method is used more often than NPV by financial directors.

The internal rate of return (IRR), alternatively termed as ERR is a capital budgeting technique and it measures and compares the profitability of several investments. The IRR is generally used for cost benefit analysis of the investment projects. IRR is generally calculated in a percentage format. Higher will be the IRR of a project, grater profit can be expected from that project and higher will be the acceptability of that project.

Internal Rate of Return (IRR)

The difference between the present value of cash inflows and the present value of cash outflows or initial cost of an investment project is termed as Net Present Value (NPV). This approach is followed in order to assess the profitability of a new investment venture. The formula of NPV is

Internal Rate of Return

Where, C? = net inflow of cash during‘t’

Co = total cost of the initial investment

r = rate of discount

t = time (in number).

If the calculated NPV of a project is positive then it signifies that the projected earnings from that investment project is higher than the projected cost that has to be incurred by the project management. Therefore the NPV signifies that the new investment project is profitable and therefore can be accepted. However if the value of NPV is negative then it signifies that this invent venture may lead to loss and therefore should not be accepted.

Net Present Value

The applicability of both IRR and NPV has been discussed below:

1. Both IRR and NPV serve the same purpose while assessing a new investment project

2. These two capital budgeting techniques appears to be complementary to each other while assessing a new investment project

3. Both the measures should be considered while apprising and investment project in order to derive better results as comparison between these two measures gives better analysis of the investment project

4. IRR appears to be more appropriate when we are trying to asses multiple investment projects

5. IRR appears to be the more effective tool in comparison to NPV while an investment project is assessed.

There are different tools and techniques that are used in capital budgeting for evaluating an investment project. Each of these tools and techniques has their own pros and cons. The Internal Rate of Return (IRR) and Net present value (NPV) are the two capital budgeting techniques that deliver almost similar results while assessing a new investment project. The IRR and NPV are also considered to be complementary to Discounted Cash Flow or DCF. Though the utility of both IRR and NPV are more or less same but IRR is considered to be more appropriate when an investment project has to be assessed by taking Time Value Of Money (TVM) under consideration. The major drawback of IRR as a tool of assessing investment project is the use of the single rate of discount. This on the other hand becomes an advantage for IRR and the financial decision makers of different management organizations often choose IRR over NPV for making investment decisions.

 Let us study the practicability of the above discussed statement with the help of the following example;

A Company X needs to buy a new machine for manufacturing unit. There are two machines between which Company X need to choose which will meet its criteria are Machine A and Machine B. Which of the analysis will be beneficial to the company while making its decision?

The finance manager of the company has selected two approaches for the purpose of making decision Net Present value and Internal Rate of Return.

Machines for Company X

Year

0

1

2

Cash Flow-Machine A

          -5,000.00

             3,000.00

                               3,000.00

Discounted Cash Flow

          -5,000.00

             2,768.00

                               2,533.00

Cumulative Cash Flow

          -5,000.00

            -2,232.00

                                  321.00

 

 

 

 

Cash Flow-Machine B

        -10,000.00

             5,800.00

                               6,000.00

Discounted Cash Flow

        -10,000.00

             5,350.00

                               5,106.00

Cumulative Cash Flow

        -10,000.00

             4,650.00

                                  456.00

Ist Case: Considering NPV

NPV (Machine A) = ($5,000)+$2,768+$2,553 = $321

NPV (Machine B) = ($10,000)+$5,350+$5,106 = $456

The result derived through this approach is that Machine B will be a better investment for Company X compared to Machine A.

2nd Case: Considering IRR

Machine A = 13%

Machine B = 11%.

Hence, by using IRR the finance manager finds if the company purchases Machine A instead of Machine B it will benefit more.

Thus we see that the findings that have been derived by following two different appraisal techniques contradict each other. The finance managers often opt for IRR over NPV as it seems to be more reliable and appropriate and also considers the concept of Time Value Of Money. Besides under IRR the result is calculated in percentage format and this format enables a much easier to comparison and understanding.

Thus if we consider the above example of two investment projects (Machine A and Machine B) then it will be required that equal amount of investment has to be made in these projects. If we are considering the multiple projects then the projects should be ranked as per the rate of return calculated under IRR. The projects with higher rate of return will be considered first compared to the others with low rate. However among the projects that are having higher rate of return, only those will be chosen whose IRR is greater than the projects’ initial cost of investment. If the opportunity cost of the selected projects are above their IRR, then it is expected that implementation of these projects may accelerate the financial momentum.

However if the rate of investment is lower than IRR then this investment venture should not be considered as implementation of this project may led to sharp decline in the value of the company. Most companies prefer to use IRR as a financial decision making tool as it can be applied with clarity and works as a very good indicator of the quality of return from an investment project

Thus the above example demonstrates that IRR is more acceptable to financial decision makers in comparison to NPV. The findings obtained under IRR are can be easily analyzed, where as findings derived under NPV are more based on assumptions and are difficult to analyze. The use of IRR method delivers a single simplified value to the finical managers on the basis of which they can easily choose those projects that will be beneficial for the company as well as economy.

However several financial directors find IRR is more suitable rather than NPV as a tool of assessing investment projects. The underlying reasons has been summarized below

1. The NPV assumption is based upon an incorrect assumption that cost of capital remains fixed throughout the life of the project. But in reality the cost of capital of an organization depends upon the expectation of the shareholders of that organization and therefore it changes with the change of risk perception of the shareholders. Thus the cost of capital of an organization varies from one year to another.

2. The unrealistic assumption under NPV is that cash flow only arises either at the beginning or at the end of a period under consideration. But actually cash flow may arise at any point of time of a period under consideration. When the calculation for NPV has been made assuming that cash inflow will take place at the end of the year, but actually the cash inflow is taking place by the end of 4 months or 6 months, then the calculated discounted value will be in accurate.

3. The financial decision making will be inaccurate if NPV method is used for assessing multiple investment projects that are having unequal life

4. It is difficult to understand  that for how long a project or investment will show a positive NPV due to simple calculation (Baum and Crosby, 2008);

5. As per the rules of NPV, the investment projects that give positive NPV must be considered but the method does not say anything regarding the time when positive NPV can be achieved.

6. It is complicated to calculate appropriate rate of discount for cash flows.

The reasons of preferring IRR over NPV has been below:

1. One reason for which financial directors  prefer IRR over NPV is the representation of IRR in percentage format which can be easily understood and compared with the cost of capital of the project;

2. The IRR approach also helps the directors to asses the possible  value and risk that are associated with the project ;

3. This approach also helps the finance directors to estimate the actual return of the investment to be achieved in future that has been calculated at today’s date.

However for mutually exclusive projects NPV is more appropriate for making investment decisions and choose the most appropriate among the available projects and IRR becomes irrelevant in this context.

It is the duty of the finance director will take the final decision regarding which appraisal technique will be most suitable for assessing the upcoming project. According to his decision calculations are to be done to reach to the desired result. After that he will carry out post audit process of capital budgeting.

Conclusion

The above discussion delivers a comprehensible idea regarding the two major capital budgeting techniques; namely Internal Rate of Return and Net Present Value. The discussion also signifies the usefulness of those tools in financial decision making. A good comparison has been made between NPV and IRR and it identifies the pros and cons of these two capital budgeting techniques. The discussion also identifies that which approach is better for financial decision making. A discussion is also made on the concept of “cost of capital” as this concept is going to be used for evaluating the upcoming projects of the organization. This discussion also clarifies that why IRR is considered to be more appropriate tool for financial decision making even if the utility of both IRR and NPV are more or less same as a tool of project assessment. Financial managers consider IRR to be more relevant where the concept of time value of money has to be utilized.