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Capital Budgeting Some Issues
i. If NPV from a project is ZERO, it does not mean that return from project is NIL. If NPV is zero, it means that project is giving return equal to discount rate.
(ii) Whether financial cash flows should be considered as relevant cash flows or not? The answer is that if the discount rate is weighted average cost of capital, financial cash flows should not be considered as relevant cash flows. As it will result in double counting of cost of raising fund, First, in the cash inflow and second, in the weighted average cost of capital. This is also known as Interest Exclusion Principle.
However, if discount rate is Cost of Equity Capital, financial cash flows (except equity dividend) should be considered as relevant cash flows. As in such case, cash flow shall be residual value, which is available to equity shareholders only.
In the absence of any information, discount rate shall be assumed as Ke. The holding is that benefit of Trading on Equity shall be given to equity shareholders only. NPV is always viewed as net increase/decrease in the wealth of equity shareholders.
(iii) NPV method may not give satisfactory results where two projects having different effective lives are being compared. In such cases, Annual Equivalent Cash Flow may be used for decision-making purpose.
Annual Equivalent Cash Flow = P.V. of the sum total of cash flows or NPV / Cumulative P.V. factor
(iv) NPV Vs. IRR:
The NPV and the IRR methods are two closely related investment criteria. Both are time-adjusted methods of measuring investment worth. In case of independent projects, both methods lead to same decision. Both NPV and IRR would appear to be equally valid in the sense that they will both lead to accept or reject the same project.
However, the ranking of a set of projects obtained from IRR does not necessarily agree with that produced using NPV. The NPV and IRR will give conflicting ranking to the projects under the following conditions:
(a) The cash flow pattern of the projects may differ i.e. the cash flow of one project may increase over the time, while those of others may decrease and vice-versa.
(b) The initial investment of the projects may differ.
(c) The projects may have different expected lives.
When both NPV and IRR give conflicting result, which projects should we choose? The NPV rule is consistent with the objective of maximizing wealth. One always like to be richer rather earning a higher rate of return.
(v) Fisher's Intersection:
Fisher's intersection occurs at the discount rate where the NPVs of two projects are equal. It may be calculated with the help of trial & Error method.
F(i) NPVx = NPVy
Fisher's intersection rate also defines the relationship between NPV and IRR methods. It explains whether NPV & IRR will yield consistent results or not. If IRR & discount rate > F(i) or IRR & discount rate < F(i). ranking obtained from both IRR & NPV will be same otherwise different.