Why use NPV?

1
Why use NPV?

• NPV approach is considered the best one for
  evaluating capital budgeting.
• NPV is easy to interpret and understand
• Positive NPV projects are accepted, negative NPV
  projects are rejected
• Accepting positive NPV projects benefits the
  stockholders.
• Three key attributes
• NPV uses cash flows
• NPV uses all the cash flows of the project
• NPV discounts the cash flows properly

NPV is used as a benchmark for evaluating other
alternative approaches to capital budgeting.
2
Managerial perspective - PBP

• Payback rule is often used by large companies
  when making relatively small investment
  decisions.
• Used for decisions made by lower-level
  management.
• Its simple to use and allows upper management to
  delegate responsibility.
• Important in terms of management control (short
  term verification of managers assessment of cash
  flows).
• For bigger investment decisions, the payback rule
  is seldom used (when questions of controlling and
  evaluating the manager become less important than
  making the right investment decision).

3
Internal rate of return (IRR)

• The IRR is very similar to the NPV approach.
• Basic rationale it tries to find a single number
  that summarizes the merits of a project.
• That number does not depend on the interest rate
  that prevails in the capital market.
• The number is internal or intrinsic to the
  project and does not depend on anything except
  the cash flows of the project.

4
IRR

• IRR rules
• The firm should accept the project if the
  discount rate is below 10 (IRR gt discount rate).
  
• The firms should reject the project if the
  discount rate is above 10 (IRR lt discount rate).

5
Advantages of the IRR

• Rule that summarizes the information about a
  project in a single rate of return.
• Simple way of discussing a project.
• However, in order to apply the IRR, you must
  compare it with r. So, the discount rate is
  needed for making a decision under both
  approaches.