Purpose: The NPV method focuses on project surpluses, while IRR is focused on the breakeven cash flow level of a project. Decision support: The NPV method presents an outcome that forms the foundation for an investment decision, since it presents a dollar return. The IRR method does not help in making this decision, since its percentage return does not tell the investor how much money will be made. Reinvestment rate: The presumed rate of return for the reinvestment of intermediate cash flows is the firm's cost of capital when NPV is used, while it is the internal rate of return under the IRR method. Discount rate issues: The NPV method requires the use of a discount rate, which
can be difficult to derive, since management might want to adjust it based on perceived risk levels. The IRR method does not have this difficulty, since the rate of return is simply derived from the underlying cash flows. Generally, NPV is the more heavily-used method. IRR tends to be calculated as part of the capital budgeting process and supplied as additional information. The NPV and IRR methods sometimes gives contradictory results when used for selection of the most profitable investment project from among mutually exclusive projects. The contradictory results are due to the different assumptions underlying the two methods. The NPV method assumes that the cash inflows generated during the operational life of the project are reinvested at the discount rate. Whereas in the IRR method all future streams of cash inflows are reinvested at the yield rate over the life of the project. Since the objective is to maximize wealth, the NPV provides the correct criteria of investment decisions. A project with the maximum NPV makes maximum contribution to the present value of the firm. Hence NPV is better alternative than IRR. 4. A firm's after-tax cost of capital of the specific sources is as follows: Cost of debt: 7 per cent Cost of preference shares: 12 per cent Cost of equity funds: 17 per cent The following is the capital structure: Source Amount Debt Rs. 250,000 Preference capital Rs. 150,000 Equity capital Rs. 600,000 Total: Rs. 10,00,000 Calculate the weighted average cost of capital. In case the firm plans to raise additional capital of Rs. 5 Lacs through 100,000 Debt and remaining through Equity
Section B (10 Marks) Attempt the following questions 1. A company is planning to raise Rs. 50 Lacs. Given tax rate of 30%, please advise on the most optimum alternative: (i) Bank loan at 12% interest. Loan to be redeemed at the end of 10 years. Flotation cost is 5 % (ii) Raise Rs. 25 Lacs through issue of Preference shares for 10 years at 14%, with 3% flotation cost; and the remaining Rs. 25 Lacs through Bank Loan at 12% interest rate. Loan to be redeemed at the end of 10 years. Flotation cost is 5%.
- Fall '19
- Net Present Value, HPCL