This method is based on an assumed minimum rate of return. Ideally, this rate should be the average cost of capital to the firm (see p. 461) and it is this rate which would be used to discount the net cash inflows to their present value. The net investment outlays are subtracted from the present value of the net cash inflows leaving a residual figure, which is the net present value. A decision is made in favour of a project if the NPV is a positive amount. This method may likewise be applied to the comparison of one project with another when considering mutually exclusive investments.

The internal rate of return

This method requires us to calculate that rate of interest which used in discounting will reduce the net present value of a project to zero. This enables us to compare the internal rate of return (IRR) with the required rate.

Net present value and internal rate of return compared

When dealing with simple investment appraisal projects, that is, those involving a once and for all investment outlay followed by a stream of cash inflows, both the NPV and the IRR methods produce the same YES or NO decisions.

But the advantage of the NPV method is the simplicity with which the results are stated. Our example shows that with the NPV method, the expected results are expressed in terms of £s which directly reflect the increased wealth position. The internal rate of return, on the other hand, produces a result which is shown as a percentage, and this result has to be compared with a minimum required rate of return before a decision may be made.

The methods of investment appraisal which we have just examined are generally regarded as producing misleading results. Discounted cash flow has gained widespread acceptance for it recognizes that the value of money is subject to a time-preference, that is, that £1 today is preferred to £1 in the future unless the delay in receiving £1 in the future is compensated by an interest factor. This interest factor is expressed as a discount rate.

In simple terms, the DCF method attempts to evaluate an investment proposal by comparing the net cash flows accruing over the life... see: Discounted Cash Flows