Net Present Value (NPV) is an indicator of how much value an investment or project adds to
Question:
Net Present Value (NPV) is an indicator of how much value an investment or project adds to the firm to help firm in making an investment decision. NPV rule is the most accurate and reliable rule, in practice, a wide variety of rules are applied. However, Graham and Harvey's study indicates that one-fourth of U.S. corporations do not use the NPV rule. Exactly why other capital budgeting techniques are used in practice is not always clear. Similar to NPV, the initial rate of return (IRR) investment rule, one of the capital budgeting tools is based on the concept that the return on the investment opportunity you are considering is greater than the return on other alternatives in the market with equivalent risk and maturity. In general, the IRR rule works for a stand-alone project if all of the project's negative cash flows precede its positive cash flows. In most cases, investments with high NPV will tend to have higher IRR. However, in other cases, the IRR rule may disagree with the NPV rule and thus be incorrect. The conflict happened when the mutually exclusive project has a higher NPV but has a lower IRR than the other project. This conflict can be solved by preparing an NPV profile. Figure 1 and Figure 2 illustrate two different NPV profiles.
Required:
(a) A survey found that a sizeable minority of firms(25%) in their study do not use the NPV rule at all. In addition, About 50% of firms surveyed used the payback rule. Furthermore, it appears that most firms use both the NPV rule and the IRR rule.
Explain this phenomenon on why do firms use rules other than NPV if they can lead to erroneous decisions?
Management Accounting Information for Decision-Making and Strategy Execution
ISBN: 978-0137024971
6th Edition
Authors: Anthony A. Atkinson, Robert S. Kaplan, Ella Mae Matsumura, S. Mark Young