Introduction
In every investment decision, it is necessary to scrutinize the benefits and cost before venturing into it. An investor should evaluate the benefits he or she would get if they invested their capital in the project rather than depositing the cash in the bank to accumulate annual interest. A project manager is solely responsible to decide on behalf of his clients on the best project to invest from a pool of several and closely related benefits on behalf of his client. The key factors that the manager would consider are rate of return on investment, period it would take the project to recover initial investment and the probability of risk. This task is usually very challenging and requires in depth evaluation. Several methods are used to determine the viability of a certain project. These methods include Pay Back Period (PB), Net Present Value (NPV), Internal Rate of Return (IRR) and Accounting Rate of Return (ARR). Each of these methods would give the investor or the project manager a platform to decide which project is the most viable to risk his capital. The most recommended approaches are the Net Present Value (NPV) and Internal Rate of Return (IRR).
Internal Rate of Return (IRR)
This discounted rate of cash flows equates net present value to zero. The difference between total present value of a project and the initial amount of invested should be zero .Internal rate of return provides the return of investment that an investor or a project manager anticipate from project. However, at the end of the investment period there is the actual return that will be generated. If IRR is greater than the require rate of return, the project is viable for investment. If IRR is less than required rate of return, the investor should not invest in the project. If IRR is equal to the prevailing rate of return, the investor is indifferent on whether to invest or not. He would be required to apply sensitivity analysis on risk.
When an investor is comparing two mutually exclusive projects, he should adopt the project with a higher rate of return.
Calculating IRR
Calculation of IRR uses the Net present value approach .This method can be used to calculate projects with a constant cash flow and the project with uneven cash flow returns.
NPV method
NPV=0
CF1/ (1+IRR) 1 + CF2/ (1+IRR) 2 +CF3/ (1+IRR) 3 +CFn/ (1+IRR) n –initial cash invested=0
Where:
IRR- internal rate of return, n-period, CF- annual cash flow
Since it is difficult and cumbersome to determine IRR that results in NPV equal to zero, prediction of IRR is appropriate. The following steps should be followed:
- Suggest a certain Internal rate of return and use it to calculate Net present Value(NPV).If NPV is greater or less than zero ,move to step2
- If NPV is greater than zero, suggest a lower IRR. if its lower than zero, suggest a higher IRR. Using the suggested IRR, calculate the new NPV.
- Continue with step 2 until NPV reduces significantly close to zero. The IRR that has its NPV close to zero is the Final IRR.
Decision criteria
If IRR is greater than the prevailing rate of return, the project manager should invest in the project. If it is less than the actual rate of return, the project is not viable for investment
Advantages
- It is simple to understand and interpret. This is because it provides mangers with a platform to compare mutually exclusive projects
- It considers the time value of money by depicting the period it would take for a certain project to recover the invested amount. For a rational investor , besides high returns ,time taken to recover initial outlay is essential
- It shields the investor from over/under-estimating required rate of return. Required rate of return is not required in calculating IRR.
Disadvantages
- If the discount rate of a project is not known, it is difficult to use IRR approach to determine the viability of a project.
- IRR approach only gives the percentage interpretation of a project viability.it does not further interpret other internal and external factors that could hamper the success of a project.
Net Present Value (NPV)
This is the most commonly method used in capital budgeting of a project. It refers to the present value of discounted cash inflows at a certain discount rate over a certain life period of a project. The initial cash invested is subtracted from the total present value to get Net Present Value.
Calculating NPV
This method can be used to calculate the NPV of projects with uneven cash inflows and those with uneven cash flows. To calculate NPV of a project with a constant cash inflow, the mangers us e present value of annuity formula. The following are formulas used to calculate projects with Uneven and constant cash inflow.
Projects with Uneven cash inflows
CF1/ (1+r) 1 + CF2/ (1+r) 2 +CF3/ (1+r) 3 +CFn / (1+r) n –initial cash invested=NPV
Where:
CF1, CF2, CF3 CFn – annual cash inflows over a certain period.
n- Number of period that the project is expected to take
r- Required rate of return
Projects with a constant flow of cash in all periods
Present value of annuity is used.
CF × {1-(1+r)-n/r} –initial cash invested= NPV
Where:
CF- cash inflow per period
{1-(1+r)-n/r} – Present value interest factor of annuity
r- Required rate of return
n -period when the useful life
Decision criteria
If NPV is greater than zero, then the project is viable for investment. If NPV is less than zero, the investor should not invest in the project. However if the NPV is equal to zero, the investor should be indifferent and engage in considering other factors before making final decision. When comparing a pool of possible investment projects, the project manager should choose the project with the highest NPV.
Advantages
- It considers the time value of money. Thus, discount rate and the useful life of a project are used to determine the viability of a project. Other approaches like the Payback and accounting rate of return do not account for time value of invested capital.
- It is easy to understand and enables a manger to compare different projects and their viability.
- It enables reconsideration of the current discount rate to adjust it to reflect uncertainties in the economy e.g. projected fluctuations in currency market.
Disadvantages
- It relies on estimated cash flows and the discount rate. In reality, it is difficult to determine the periodic earnings that a project is likely to yield. This is more difficult when a project is likely to last for a long period. Therefore, errors of estimation may affect the decision of a project manager or an investor.
- It does not account for the opportunity cost. There may be other projects with higher NPV that a project manager may have forego while evaluating the viability of other projects. Further, a new opportunity may arise shortly after the management has chosen the project to invest.
Which approach is the most appropriate?
According to Juhasz and other authors and financial experts, Internal Rate of Return method is the most appropriate method .Unlike NPV method, IRR indicates the efficiency of a project over its usable life. The IRR method uses estimation method that reduces the error of over /under estimation that mostly occurs in NPV method.
References
Juhasz, L. (2011). Net present value versus internal rate of return. Economics and Sociology, 4(1), 46-53,126.
Brealey, R. A., Myers, S. C., & Marcus, A. J. (2004). Fundamentals of corporate finance. Boston, Mass: McGraw-Hill Irwin.
Lumby, S., & Jones, C. (2001). Fundamentals of investment appraisal. London: Thomas Learning.
