Net Present Value and Internal Rate of Return Methods
These models follow the time value of money concept and also consider cash flows in their computation. After discounting future cash flows the net present value scheme outlines the total net present value that the project will provide to the organization. The Internal Rate of Return is determined by through trial and error, seeking the discount rate that gives a zero net present value. Such technique is often regarded as the determination of the break-even point of the capital project at hand.
Under capital projects that are not mutually exclusive and can be evaluated independently, both net present value and the internal rate of return will direct towards the same decision, since identical results are derived. However, the net present value model fully considers the scale of the project, because it is an absolute measure of the project’s financial return. While, the internal rate of return utilizes a relative measure to the size and cash flow timing in relation to opening capital costs.
Therefore under mutually exclusive projects, which require ranking in selection, these two methods can provide differing results and decisions. The net present value method highlights financial information of better quality in these instances, since it considers the project, which provides the greatest increase in financial wealth for the organization. In addition, the ranking exercise under such method is much easier to put in practice (Martin 1998). Further more, the internal rate of return model is subject provide erroneous financial information in instances of non-conventional cash flows.
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In such cast a nil or a vast number of internal rates of return are computed, which would confuse the people concerned. The net present value system does not have such problem (Martin 1998). Therefore, the net present value method is the best model that an organization can utilize for capital expenditure appraisal. Final Thought – Optimal Capital Project As outline above the Net Present Value Technique is the method that should be used. This favours Kips Project, which provides a positive net present value under the 20% discount rate.
References:
Martin R. (1998). Internal Rate of Return Revisited, Tripod. com (on line). Available from: http://members. tripod. com/~Ray_Martin/DCF/nr7aa003. html (Accessed 16th October 2008). Investopedia (2008). Time Value of Money (on line). Available from: http://www. investopedia. com/terms/t/timevalueofmoney. asp (Accessed 15th October 2008). RAI Foundation Colleges. Lesson 23: Capital Budgeting Techniques – Other Methods (on line). Available from: http://www. rocw. raifoundation. org/management/bba/IntroductCorporateFinance/lecture-notes/lecture-23. pdf (Accessed 15th October 2008).
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