Suggested answers to review questionsmaximise the return on investment. Since this coincides, in most cases, with those
projects that will maximise shareholder wealth, using IRR will tend to give the right
signals, however.
IRR also has some anomalies, such as giving more than one IRR or no IRR, but
these tend not to occur with typical projects.4.6 Possibilities include:
lUsing only one method per decision, but using different methods for each type of
decision: for example, using NPV for projects involving an investment of more
than £100,000, but using payback period for smaller decisions.
lUsing more than one method for each decision so that a fuller picture of the deci-
sion data can be obtained.5.1 No, it is not illogical. Profit and NPV have two entirely different objectives. Profit
is concerned with assessing trading effectiveness for a period of time that is
shorter than the typical investment project’s life. If some allowance for the cost of
using non-current assets during that accounting period is to be made, deprecia-
tion must be calculated and charged. NPV has another objective, which is to look
at the effectiveness of an asset (or set of assets) over its full life. In a sense, NPV
assessments do take account of depreciation since the project is charged (cash
outflow) with the capital cost of the asset, normally at the beginning of the project,
and given credit (cash inflow) for any disposal proceeds, normally at the end of
the project.5.2 This is not logical as discounting takes account of the financing cost of the project.5.3 It is slightly more complicated than this. The relationship is:1 +‘money’ rate =(1 +‘real’ rate) ×(1 +inflation rate)5.4 The two approaches are:
lIdentify the‘money’ cash flow and discount this at the ‘money’ cost of capital.
lIdentify the ‘real’cash flow and discount this at the ‘real’ cost of capital.
These two approaches are both equally valid and will give precisely the same
NPV. In practice, the former tends to involve a more straightforward calculation,
particularly where such complications as tax and working capital are involved.5.5 Hard capital rationing arises where it is simply impossible to raise the funds to sup-
port all of the available projects. It can be argued that, in practice, funds can always
be raised provided that a high enough rate of return is offered to the providers of
the finance. This rate may well be too high to enable the project to be viable (that is,
it leads to a negative NPV), but this simply means that the project should not be
undertaken, not that capital rationing exists.5.6 The profitability index is a measure of a project’s NPV per £ of initial investment
required. It can be useful for solving single-period capital rationing problems.
It is not normally a helpful approach to dealing with multi-period capital
rationing problems. This is because the profitability index may suggest one project
as being the most beneficial in the context of one year’s capital shortage, but a dif-
ferent one in the context of that of another year.Chapter 5
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