Page 136 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 6: Capital Budgeting

Advantages Notes

1. It possesses the advantages, which are offered by the NPV criterion such as it considers
time value of money, and takes into account the total cash inflows and outflows.
2. IRR is easier to understand. Business executives and non-technical people understand the
concept of IRR much more readily that they understand the concepts of NPV.
3. It does not use the concept of the required cost of return (or the cost of capital). It itself
provides a rate of return which is indicative of the profitability of the proposal. The cost of
capital enters the calculation, later on.

4. It is consistent with the overall objective of maximizing shareholders wealth since the
acceptance or otherwise of a project is based on comparison of the IRR with the required
rate of return.

Limitations

1. It involves tedious calculations.
2. It produces multiple rates, which can be confusing.
3. In evaluating mutually exclusive proposals, the project with the highest IRR would be
picked up to the exclusion of all others. However, in practice, it may not turn out to be one
that is the most profitable and consistent with the objectives of the firm i.e., maximization
of the wealth of the shareholders.
4. Under IRR method, it is assumed that, all intermediate cash flows are reinvested at the IRR
rate. It is not logical to think that the same firm has the ability to reinvest, the cash flows
at different rates. In order to have correct and reliable results it is obvious, therefore, that
they should be based on realistic estimates of the interest rate at which the income will be
reinvested.

5. The IRR rule requires comparing the projects IRR with the opportunity cost of capital. But,
sometimes, there is an opportunity cost of capital for 1 year cash flows, a different cost of
capital for 2-year cash flows and so on. In these cases, there is no simple yardstick for
evaluating the IRR of a project.

Self Assessment

Fill in the blanks:
5. Under Net Present Value (NPV) method, all cash inflows and outflow are discounted at a
………………… acceptable rate of return, usually the firm's cost of capital.

6. ………………… is the ratio of the present value of cash inflows to the present value of the
cash outflows.
7. ………………… is the interest rate that discounts an investment's future cash flows to the
present so that the present value of cash inflows exactly equals the present value of the
cash outflows.

6.4 Comparison – NPV and IRR Methods

Similarities: In respect of conventional and independent projects, the two methods give a
concurrent acceptance-reject decision. In case of conventional investment cash outflows are

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