Accounting Business Reporting for Decision Making

CHAPTER 12 Capital investment 515

so-called unconventional patterns of cash flows. In mining investment projects, the restoration expenses

at the completion of a mining project may mean that the final year has net cash outflows rather than net

cash inflows. Thus, there will be two years of net cash outflows.

Comparing the NPV and IRR for a project

The NPVs and IRRs for projects that have conventional cash flows always bear the same relationship to

each other. When the IRR is zero, the NPV will be at a maximum and positive if the sum of the net cash

inflows exceeds the original cost. Think about that. If there is no discounting (i.e. r = 0), then the cash

flows will have their full undiscounted values. As the value of r increases, the value of the NPV must

decrease. At some point, the value of r will be such that the NPV is zero, and this is the IRR for the pro-

ject. Beyond that point, if the value of r increases still further, the NPV for the project will be negative.

Figure 12.1 shows this situation graphically.

NPV

$

for a given

project

0

Positive NPV — accept

(NPV decreases as r increases)

IRR for project

r (%)

Negative NPV — reject

(r is so large that

NPV is negative)

FIGU R E 12 .1 Relationship of NPV and IRR for a project

Suppose the IRR of the project in figure 12.1 was 15 per cent. Is this acceptable to us as investors?

If 15 per cent is above our RRR, then we would accept the project on this basis. Similarly, if we had

discounted the expected cash flows at any rate less than 15 per cent, we would have calculated positive

NPVs, and these values would also support our decision to make the investment. Thus, the two measures

in this case have given us the same advice. This is the normal situation with conventional cash flow pat-

terns; but, as noted earlier, it is possible for the two measures to be in conflict.

VALUE TO BUSINESS

•   There are two discounted cash-flow measures that overcome the time value of money problem,

which is a major defect of both the ARR and PP tools.

•   Discounted cash-flow techniques specifically recognise that $1 received some time in the future is

worth less than $1 received now.

•   The NPV measure compares the sum of the present values (PVs) of all of the expected cash inflows

from the project with the PVs of the expected cash outflows. The NPV is the net outcome.