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.
One of the key areas of long-term decision-making that firms must tackle is that of investment - the need to commit funds by purchasing land, buildings, machinery, etc., in anticipation of being able to earn an income greater than the funds committed. In order to handle these decisions, firms have to make an assessment of the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk attached and the cost of obtaining funds.
The main stages in the capital budgeting cycle can be summarised as follows:
Forecasting…show more content… If a project's NPV is positive, then its return exceeds the discount rate chosen for the economic evaluation. Thus, only those projects with a positive NPV require prioritisation.
NPV accounts for the time value of money as well as variable cash flow. NPV prioritises projects according to the total value earned during the project's evaluation period. NPV effectively identifies the best project in a set of competing projects. NPV also allows the best set of projects to be identified since the NPV of individual projects can be summed to determine the NPV for a set of projects. However, NPV does not provide a return rate for the project or an IRR. NPV cannot be used to prioritise projects with greatly different initial capital charges or expenses because it places more emphasis on the return period than on the cost or investment period. NPV does not consider the likelihood of actual results either.
IRR is based on the same assumptions used to calculate NPV, except it does not require knowledge of the firm's discount rate. IRR provides a method for determining whether a project meets the chosen required return rate.
IRR prioritises projects according to return rate rather than a monetary value. Using IRR, which is a percentage value, makes it difficult determine the value of a set of projects, since their individual IRR values cannot be summed. However, an IRR calculation can produce multiple answers, depending
