Memorandum

MEMORANDUM

TO: John Doe

FROM: B123639

DATE: 14/10/18

SUBJECT: Appropriate Cash Budgeting Method

NPV can be used to analyse projects more effectively than IRR. NPV can be more effective than IRR as it doesn’t encounter pitfalls in relation to unconventional cash flows, mutually exclusive projects and reinvestment assumptions.

Unconventional cash flows

There will be conflict between the different decision rules when a project receives unconventional cash flows. In Example A NPV show different results. However, the IRR is calculating the same for both projects even though they clearly are receiving different flows of cash. This is because NPV measures profitability in absolute manner and IRR measures in relative manner (Arshad, 2012). IRR consequently does not take into account the direction of the cash flow. this therefore, makes it less reliable unless you look at the incremental expenditure.

Example A (£)

Year 0

Year 1

NPV (10%)

IRR

Project Y

-1,000

+1,500

+364

50%

Project W

+1,000

-1,500

-364

50%

This shows us that NPV is more appropriate at measuring relevant financial information concerning the decision is therefore taken into account which helps aid decision making.

Mutually exclusive projects

MEP’s are projects in which no one project can be pursued in conjunction with any of the other projects (Law, 2010). The IRR and the NPV in example B contains conflict. The NPV method it easy to use as we choose the project with the higher NPV because this will improve the firms value more. If we choose the IRR rule then we would be choosing project X which has a lower cash return which would therefore create an opportunity loss of £59 compared to project Z.

Example B (£)

Year 0

Year 1

Year 2

NPV (10%)

IRR (approx.)

Project Z

-10,000

6,000

6,000

413

13%

Project X

-6,000

3,650

3,650

354

14%

This conflict arises due to IRR not adjusting for the scale of different projects. The IRR gives us a rate of return for each unit of currency invested. (Moles, Parrino, Kidwell, 2011) This therefore makes it hard to meaningfully compare MEP with IRR alone (Cousins, 2018). However, NPV assess the total monetary value accumulated throughout the project. This therefore makes NPV a more suitable capital budgeting format when working with mutually exclusive projects as analysis is therefore more comprehensible. IRR can still be useful as it is easier for businesses to examine because it simplifies projects to a percentage. However, If IRR is going to be employed it shouldn’t be used as a standalone measurement and instead used in conjunction with NPV.

Reinvestment assumptions

IRR also encounters problems when assessing the rate at which cash flows generated by a capital project are reinvested (Moles, Parrino, Kidwell, 2011). The NPV method assumes reinvestment of cash flows and the IRR assumes that it is reinvested at the IRR. This therefore creates differences in results. It is generally believed that the cost of capital, which is often lower than the IRR, better reflects the rate that firms are likely to earn. “Using the IRR may thus involve overly optimistic assumptions” (Moles, Parrino, Kidwell, 2011).

If we were to use the IRR rule we would be accepting the project if the IRR is greater than the opportunity cost of capital. However, we would have to compute complex weighted averages of these rates to obtain a number comparable to IRR (Brealey, Myers, Allen, 2011) if there was changing rates of opportunity cost.

A business which therefore employs IRR instead of NPV is assuming that there will be no difference between short and long-term discount rates. A business may choose to use IRR as it therefore ensures simplicity. However, chances of successfully evaluating projects accurately is highly unlikely. I therefore believe that NPV would be more advantageous.

I believe a transition to NPV will ensure more accurate projections for all of our projects. IRR can be easier to understand as returns are stated in percentages. However, it doesn’t take into account additional shareholders wealth for calculating the profitability of the project as well as the aforementioned pitfalls. I therefore believe that NPV can be used to more effectively analyse projects than IRR.