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4.3 Internal rate of return

without mentioning that the 8 is euros whereas the 5 is pounds sterling. To make

a sensible price comparison we should need to convert the euros to pounds sterling or

vice versa.

Similarly, it is necessary to undertake a conversion exercise to make the various

cash flows associated with the Zenith comparable. As we have seen, we usually con-

vert the future cash flows to their present value and then make the comparison. The

conversion exercise is, of course, achieved by discounting. This means multiplying

each of the cash flows by

NPV can thus be viewed as a time adjustedmeasure of financial benefit.

Conclusions on NPV

We have seen that NPV is a totally logical way of assessing investment opportunities.

It is logical, and, therefore, useful, because it possesses the following attributes:

l It is directly related to the objective of maximisation of shareholders’ wealth (value

of the business).

l It takes full account of the timing of the investment outlay and of the benefits; in

other words, the time value of money is properly reflected. Put yet another way,

NPV properly takes account of the cost of financing the investment.

l All relevant, measurable financial information concerning the decision is taken into

account.

l It is practical and easy to use (once the anticipated cash flows have been estimated),

and it gives clear and unambiguous signals to the decision maker. It should be

emphasised that accurately estimating future cash flows is usually difficult to do in

practice.

Despite NPV’s clear logic in appraising investments, research shows that there are

three other approaches that are widely used in the UK and elsewhere. These are:

l internal rate of return;

l payback period; and

4.5 Accounting (unadjusted) rate of return

We shall now consider these three in turn.

4.3 Internal rate of return

The internal rate of return(IRR) approach seeks to identify the rate of return that an

investment project yields on the basis of the amount of the original investment

remaining outstanding during any period, compounding interest annually. IRR is

sometimes known as ‘DCF (discounted cash flow) yield’. The IRR for a particular pro-

ject is the discount rate that gives the project a zero NPV. Identifying the IRR, at least

by hand, can be laborious.

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