Respond to classmates

FIN response m5

The finance department of a large corporation has evaluated a possible capital project using the NPV method, the Payback Method, and the IRR method. The analysts are puzzled, since the NPV indicated rejection, but the IRR and Payback methods both indicated acceptance. Explain why this conflicting situation might occur and what conclusions the analyst should accept, indicating the shortcomings and the advantages of each method. Assuming the data is correct, which method will most likely provide the most accurate decisions and why?

Jaquetta classmate 1

The financial evaluation methods are used to determine whether or not to accept or even reject a particular project. In mutually exclusive projects, the choice is usually made based on the possible ranking of the projects. The most commonly used methods include the Net Present Value (NPV), payback method as well as the Internal Rate of Return (IRR). All the above methods rank the projects regarding the present value of future cash flows. Generally, the NPV is variation between present values of inflows as compared to the present values of cash outflows in a given period. It is expected that an investment that has a negative NVP will result in a net loss while that with a positive NVP will be profitable (Bauer, 2014). However, the method highly relies on multiple assumptions as well as estimates hence there is the possibility of an error occurring. On the other hand, the payback method is involved in the determination of the time needed to recover the cost of any particular investment. It is fundamental in that the payback period is used to determine whether or not to undertake a project. The method, however, ignores the time value of money. The payback method is widely adopted for its simplicity as well as its ability to be used as a point of reference during capital budgeting. The IRR method may be used in capital budgeting to estimate the profitability brought about by potential investments effectively. The method is further seen to be a discount rate in that it makes the net present value of the entire firm’s cash flow equal to zero.

Keith Classmate 2

A large corporation has a small problem, they are trying to decide if an investment should be accepted or rejected. They are using net present value (NPV), internal rate of return (IRR), and the payback method to help in the decision. The problem that the NPV tells management to reject it but both the IRR and payback method gives the indication to accept the project. They have asked me to help sort things out. It is important to understand why NPV is rejecting the project when IRR and the payback method would accept the project. One reason that there can be a conflict is that NPV takes into consideration the cost of capital, while IRR does not. (Smirnov). This is important to note when deciding to accept or reject a project. When using the NPV method it is safe to assume that the capital generated can be reinvested at the same rate of capital cost. While the rate in which IRR gives is generally unrealistic to achieve. (Investopedia). Another reason for the conflict is that if the firm is comparing two different mutually exclusive projects that have different cash flows or the scale of the projects are different. The payback method is the general the most unreliable when making large investment decision, this method only looks at how quickly the company will recoup their initial investment. It does not take into consideration the time value of money. If this is an independent project and NPV and IRR are conflicted there is an error in the inputs that was used to figure each tool. However, if there is no error I would reject the project based on the NPV. Since NPV measures the current value of the project in dollars it gives the best indication of the success of the project. Since the IRR cannot realistically be invested at the same rate it would short the shareholders and lower the value of the company.