Analysis

The crucial test upon which the final acceptance of a project depends is whether or not the IRR compares favourably with the required rate of return. If the required rate of return is 20 per cent both projects qualify.

One of the problems of comparing rates of return on projects is that direct comparisons between two percentages are meaningless unless referred to the initial outlays, so that their true dimensions may be perceived. This problem should never be lost sight of when using IRR percentages.

With more complicated investment problems, for example, those which require that cash surpluses be set aside to meet an obligation arising at the end of the project's life, both methods assume that those cash surpluses are re-invested at the appropriate rate of return. Thus, where a loan has been raised to finance the project*, the IRR method envisages that the cash surpluses will be re-invested at the IRR discounting rate, whereas the NPV method envisages that they will be re-invested at the minimum acceptable rate of return used in that method. Thus, the advantage of the NPV method is that it makes more realistic assumptions about re-investment opportunities.

* The simplifying assumption which we are making for the purpose of illustrating the point is that the firm's finances are linked to specific investment projects, which in reality is not perhaps the case.

More complex problems arise when applying the IRR method to investment projects which do not have the simple pattern of cash flows of the above examples, but we regard these problems as beyond the scope of this text.


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Read on: The Net Present Value

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... see: The Net Present Value