Question

There are various investment decision rules, which financial managers may select. Choose one of the alternatives to the NPV, and compare and contrast one of the selected alternatives with NPV (payback period, discounted payback period, IRR or profitability index. Provide a real world example.

Answer 1

NPV or the Net Present Value is the difference between the present value of the cash inflow and the present value of cash outflow. IRR or the Internal Rate of Return is calculated to measure the profitability of potential investment.

Both NPV and IRR are basically used in Capital Budgeting , which is the process by which the company decide whether the investment will generate net economic profits or losses for the company.

To determine NPV, suppose DBZ Comic company wants to buy a small publishing company. DGZ decides that the future cash flow generated by the publisher, when discounted at a 12% annual rate, yields a present valuen of $23.5 million. If the publishing company's owner is willing to sell for $20 million, then the NPV of the project would be $3.5 million ($23.5 - $20 = $3.5). The NPV of $3.5 million represents the intrinsic value that will be added to DBZ if it undertakes this acquisition.

So, DBZ's project has a positive NPV, but from a business poit of view, the company should also know what rate of return will be generated by this investment. For this, the firm would simply recalculate the NPV equation, this time setting the NPV factor to zero, and solve for the now unknown discount rate. The rate that is produced by the solution is the project's internal rate of return (IRR).

For this example, the project's IRR depending on the timing and proportions of cash flow distributions is to be equal to 17.15%. Thus, DBZ comics, given its projected cash flows, has a project with a 17.15% return. If there were a project that DBZ could undertake with a higher IRR, it would probably pursue the higher-yielding project instead.

Thus, you can see that the usefulness of the IRR measurement lies in its ability to represent any investment opportunity's possible return and compare it with other alternative investments.