QUESTION

1. Introduction. 1

3. Net Present Value and Internal Rate of Return Comparison. 1

3.1 Net Present Value and IRR of Munster and Sikliboro. 1

3.2 Preference of NPV over IRR.. 2

3.2.1 Independent and Mutually Exclusive investments. 2

3.2.2 Inconsistent Cash flows. 2

3.2.3 Project Size and life. 3

3.2.4 Representation of the Results in Dollar Terms. 3

4. Conclusion. 3

5. References. 4

SOLUTION

1. Introduction

Flew ton Products is a highly profitable organization with, with a steady demand for steel faced by the organization over the years. The corporation is considering the replacement of its machines from 2 corporations namely Munster and Skiboros the company has evaluated the returns on the investment from both the corporations and obtained conflicting results in the calculations from NPV and IRR. The paper examines the firm’s decision making process and evaluates the better method to evaluate the return on investment. The decision would be felicitated by calculations of returns from both the projects and the eventual decision that would be undertaken.

3. Net Present Value and Internal Rate of Return Comparison

Below are given the NPV and IRR calculation for both corporations Munster and Sikliboro. The investment proposal is being considered by the corporation but however the CFO of the firm is encountered with the problem of obtaining conflicting results. This is evident from the tables below.

3.1 Net Present Value and IRR of Munster and Sikliboro

From the above calculations it is clearly evident that the NPV and the IRR methods produce conflicting results for the corporation. In such a case then the NPV method of evaluation is regarded as most suitable by the analysts and researchers. Therefore neither of the two methods i.e. is the Net Present Value method nor is the IRR method incorrect for evaluating the return on the project or investment but in the case of obtaining conflicting results it is advisable to use the NPV method.

3.2 Preference of NPV over IRR

3.2.1 Independent and Mutually Exclusive investments

The NPV and the IRR produce the same results if the investments are independent of each other. An independent investment implies that the cash flows from one project do not affect the cash flows of the other project or investment. Thus in such a case when the investments are independent of each other the cash flow remains the same they can be discounted eventually producing the same results or both NPV and IRR. This however does not seem to be the case with Flewton products.

The conflicting results are a clear indication of the investments being mutually exclusive. This is true as the machines would be eventually used to generate revenues for the organization. Thus, the IRR is not suitable to measure the projects of varying time length and investment value and the timing .As the investment may higher internal value may have a lower NPV and a lower IRR may have a higher NPV. In such a case the NPV is more useful because the investment under consideration is not a mutually exclusive investment.

(qfianance.com – accessed on 3/5/2012)

3.2.2 Inconsistent Cash flows

The IRR method may not be an applicable method in case the firm’s investments are faced with in consistent cash flows. A project is said to have normal cash flows if has more than one cash out flow and a series of cash inflows.  Non normal cash flows reflect in consistency in the cash flows received by the firm. For example the project may begin with negative cash flows and sown the line experience positive cash flows this causes the IRR to fluctuate and the IRR is not a consistent method for project evaluation. In the above case the IRR may fluctuate for Sikliboro Corp. because it has a negative cash flow and eventually a positive ones the IRR may not be in consistent therefore the NPV method should be used to calculate the investment decision on the project.

(Bringham et al, 2009)

3.2.3 Project Size and life

The NPV and the IRR may produce conflicting results if there is a variation in the investment size and time. In the above case this clearly seems to be the case , Munster has a project life of 7 years and a capital outlay of $ 8 million , On the other hand Sikiboro has an investment life on 10 years and the project has a capital outlay of 10 years. This variation has caused the conflict of the 2 methods to undertake the capital budgeting decision. Therefore in such a case the NPV is a better evaluator of the feasibility of the investment because it can take into account the long term costs and profitability associated with the investment. The IRR may produce in consistent results when evaluating a long term project.

(exinfm.com – accessed on 2/5/2012)

3.2.4 Representation of the Results in Dollar Terms

The Net present value analysis represents the present value of the project in dollar terms on the other hand the IRR is a percentage term. The dollar term provides a clear picture of the NPV being discounted and obtaining the real value of the investment. The IRR may prove to have certain inconsistencies and errors that may arise while calculating the IRR. In the case of the Munster and Sikiboro corporation the NPV is estimated at $ 2.4 million and $ 2.56 million, thus Sikiboro proves to be a better investment for the corporation. The margin for errors in percentage evaluations remains slightly higher.

(Bringham et al, 2009)

4. Conclusion

The capital budgeting decisions under take by the firm are crucial decisions as they determine the long term profitability and efficiency of the firm.Therefore the capital budgeting decision should be taken after a careful evaluation of the investment proposals. The investment proposals are evaluated using either the NPV or the IRR. The case of most capital budgeting decisions the NPV is a better measure to evaluate the present value of the investment as it accounts both time value of money and takes cares of long term goals and profitability considerations.

In the above the Flewton should evaluate the project returns using the NPV method as the project is firstly long term in nature as well as the investment is not mutually exclusive .Therefore the NPV is a better indicator of the investment value of the firm.

5. References

• Bierman, Harold Bierman. “Comparing Net Present Value and Internal Rate of Return.” www.qfinance.com. N.p., n.d. Web. 3 May 2012. <http://www.qfinance.com/contentFiles/QF02/g1xtn5q6/12/3/comparing-net-present-value-and-internal-rate-of-return.pdf>.
• Brigham, Eugene F., and Phillip R. Daves. Study guide: intermediate financial management, 9th ed.. Mason: Thomson Higher Education, 2007. Print.
• “Capital Budgeting.” www.exinfm.com/. N.p., n.d. Web. 3 May 2012. <www.exinfm.com/training/capitalbudgeti

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