Calculation of internal rate of return, Financial Accounting

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Q. Calculation of internal rate of return?

The company is accurate in its belief that NPV measures the potential increase in company value of an investment project since theoretically the stock market value of a company increases by the total NPV of projects undertaken. This is accurate as long as the capital market is capable and information about new investment projects is made available to it.

It is probable that a high IRR offers a margin of safety for risky projects and it is able to be interpreted in this way. Nevertheless calculation of IRR is not a substitute for an assessment of project risk. Nespa's decision rule meant for ROCE is flawed in that if used continually it could eventually run out of investment projects that meet its hurdle rate its existing before-tax ROCE. This hurdle rate could enhance with each successive project accepted causing the company to reject projects that would have been acceptable in a previous period. But it is important to recognise that not all costs associated with the capital budgeting process are included in investment appraisal and that such costs will reduce the existing ROCE. The sunk cost of Nespa's market research is one example as well as another would be infrastructure costs that increase on a stepped basis as a result of cumulative project investment. The subsistence of such costs offers a partial justification for Nespa's ROCE decision rule.


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