124 Financial Management
Comparison of Discounting Methods
In ordinary circumstances, the two discounting approaches will result in identical
investment decisions. However, there are differences between them that can result in
conflicting answers in terms of ranking projects according to their profitability.
In formal accept/reject decisions, both methods lead to the same decision, since all
projects having a yield in excess of the cost of capital will also have a positive net
present value.
Example
Project A and B both require an outlay of Rs 1000 now to obtain a return of Rs 1150 as
the end of year 1 in the case of A, and 1405 at the end of year 3 in the case of B. The
cost of capital is 8%.
Internal rate of return A = 15%
B = 12%
Net present value A = (1150 x 0.926) - 1000 = Rs.65
B = (1405 x 0.794) - 1000 = Rs.1 15
Both project have rates of return in excess of 8% and positive net present value; but on
the basis of the internal rate of return method, project A is superior, while on the basis
of the net present value method, project B is superior.
Confusion arises because the projects have different lengths of the life, and if only one
of the projects is to be undertaken, the internal rate of return can be seen to be unable
to discriminate satisfactorily between them. As with any rate of return, there is no
indication of either the amount of capital involved or the duration of the investment. The
choice must be made either on the basis of net present values, or on the return on the
incremental investment between projects.
The two methods make different implicit assumptions about the reinvesting of funds
received from projects-particularly during the "gaps" between the end of one and the
end of another.
The net present value approach assumes that cash receipts can be reinvested at the
company's cost of capital, thereby giving a bias in favour of long-lived projects. In
contrast, the internal rate of return approach assumes that cash receipts are reinvested
at the same rate, giving a bias in favour of short-lived projects.
It follows that the comparison of alternatives by either method must be made over a
common time period, with explicit assumptions being made about what happens to
funds between their receipt and the common terminal date.