Question

The CEO and CFO of Marion Corporation have expressed dissatisfaction with the informal method they have used to select capital projects.

Prepare a memo to the CEO and CFO of Marion describing the net present value (NPV) and internal rate of return (IRR) methods. Include a discussion of the issues involved in selecting an appropriate hurdle rate for NPV analysis.

Answer 1

MEMO TO CEO and CFO

To: Marion Corporation’s CEO and CFO

Date: Jan 6. 2019

Subject: Description of the NPV and IRR methods

The Net Present Value and the Internal Rate of Return are methods that are closely related to each other and time- adjusted investment criteria for the purpose of analyzing and measuring the various investment proposals. The usage of these two methods does not lead to the same decision. The reason for this being that under the NPV, cash flows are converted into their present value with the help of a discount rate which depicts the firm’s cost of capital and, as such, those proposals which result in negative NPV are rejected.whereas under the IRR method it has to be selected in such a way that the present value of capital outlay must be equal to the present value of net cash flow (NCF). Here, there is no discount rate like NPV method. This method emphasizes the fact that the best investment will be one which will produce the highest rate of return at the time of equating the PV of capital outlay and PV of NCF

The NPV method assumes that cash flows will be reinvested close to or at the project’s current cost of capital, while the IRR method assumes that the firm can reinvest cash flows at the project’s IRR. The assumption that the firm will reinvest its cash flows at the current cost of capital is more realistic than the assumption that cash flows can be reinvested at the projects IRR. The reason being that the IRR may not reflect the true rate at which cash flows can be reinvested. To correct this problem, a modified IRR is used that includes the cost of capital as the reinvestment rate.

The NPV and IRR methods will give conflicting outcomes when mutually exclusive projects differ in size, or differences are there in the timing of cash flows. In most cases, utilizing either the NPV or IRR method will lead to the same accept-or-reject decision. An exception exists when evaluating mutually exclusive projects with crossing NPV profiles and the cost of capital is less than the crossover rate. When these conditions are present, the NPV and IRR outcomes will conflict in which project to accept or reject. Because the NPV method uses a reinvestment rate close to its current cost of capital, the reinvestment assumptions of the NPV method are more realistic than those associated with the IRR method.

NPV also has an advantage over IRR when a project has abnormal cash flows. Abnormal cash flows exist if there is a large cash outflow during or at the end of the project. The presence of abnormal cash flows will lead to multiple IRRs. Hence, the IRR method cannot be employed in the evaluation process. This problem will not occur if the NPV method is employed. The NPV method will always lead to a only one correct accept-or-reject decision.

In conclusion, NPV is a better method for evaluating mutually exclusive projects than the IRR method.   The NPV method employs more realistic reinvestment rate assumptions, is a better indicator of profitability and shareholder wealth, and in terms of actual arithmetic it will return the correct accept-or-reject decision irrespective of whether the project experiences abnormal cash flows or if differences in project size or timing of cash flows prevail.

The issue relating to the appropriate discount rate is that ,the choice of a discount rate can have a critical influence on the results or outcome of a comparison of discounted costs and benefits.

The first issue to resolve in discounting is whether it is the social or private discount rate that is used. In the context of evaluating public policies where the aim and objective of a benefit cost analysis is to consider the costs and benefits of a policy or project to society at large, then the social rate of discount is the appropriate choice.

A second issue that has been the focus of much recent academic and literature importance is the assumption of a constant discount (be it a social or private) rate.

Best Regards