When the projects being evaluated are mutually inclusive

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Reference no: EM131822794

Assignment

Part 1

Respond to the following:

How is the NPV rule related to the goal of maximizing shareholder wealth, and under what conditions would you expect the NPV and IRR rules to return the same accept / reject decision? Identify one problem with using IRR as part of this decision-making process. What value might the financial decision maker gain by adding the profitability index to the decision-making process?

Part 2 Repond

The NPV being a discounted measure, is related to the goal of maximizing shareholder wealth in that it focuses on increasing the value of a firm by embracing projects that bring incremental cash flows in a firm. The condition of accepting a project using NPV is that it must be positive. The NPV rule is more accurate in discounting the future cash flows of an investment. From the findings of the NPV rule, the projects with positive NPV or returns are implemented implying that the investors will earn more hence the aspect of maximum shareholder wealth. Net Present Value Method (NPV): This is one of the Discounted Cash Flow strategies which unequivocally perceive the time estimation of cash. In this strategy all money inflows and outflows are changed over into display esteem (i.e., esteem right now) applying a fitting rate of premium (for the most part cost of capital). At the end of the day, Net Present Value Method discount inflows and outflows to their present an incentive at the suitable cost of capital and set the present estimation of money inflow against the present estimation of surge to compute Net Present Value.

The conditions we would expect the NPV and IRR rules to return the same accept / reject decision are

-When the projects being evaluated are mutually inclusive.

-When the total sum of present values of all the project cash flows using the rule are positive or negative

-When the rule uses time value of money

- When both the NPV and IRR values are positive, both results in the same accept decision. On the other hand, when the IRR and NPV have negative values, they would yield the same reject decision.

Problems with using IRR as part of this decision-making process is when a project yields uneven cash flows, it becomes a problem to use IRR as a capital budgeting measure. The problems associated with IRR in decision making process is that it ignores time value of money (TVOM), difficult to use and compute as well as can result in inaccurate decision if the cash flows are inconsistent, it also ignores economies of scale and can give conflicting answers when compared to NPV for mutually exclusive projects

The value that the financial decision maker might gain by adding the profitability index to the decision-making process is that profitability index can enable a firm to evaluate whether the implemented project is adding or decreasing the project value. The profitability index show the profit-investment ratio which estimates how much a project is likely to generate in terms of profit. The profitability index complements the other forms of capital budgeting in the decision making process.

Reference

Robison, L., & Barry, P., (2015). Consistent IRR and NPV rankings. Agricultural Finance Review, 75(4), 499-513.

Reference no: EM131822794

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