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The successful management of a project extends beyond project delivery – it includes applying sound principles to assessing project feasibility within the context of related risks to maximise your return on investment and ensure strategic alignment.
Many appraisal methodologies are applied across industries to assess the feasibility of projects and support capital investment decisions. These assessments are based on both quantitative and qualitative aspects, with quantitative assessments including the use of NPV and IRR calculations.
This webinar focuses on an approach to address conflicting results in NPV and IRR calculations where capital investments span differing periods. The webinar starts with an overview of differing techniques applied in capital investment decision making and provides the basis of the NPV and IRR calculation methodologies. This is followed by a practical example using an assessment technique that addresses conflicting results between NPV and IRR calculations. A Q&A session concludes the webinar.
About the Presenter:
Peter Hofmann is an Executive Director of MFX Options and Solutions (Pty) Ltd, specialising in business management and corporate strategic and operational management consulting. The platform for his current business focus was established through his exposure to the holistic corporate business environment where he built a successful career over two decades, having established and built up successful departments focused on operational and executive management and board liaison. His integral involvement with a range of international clients includes projects undertaken by MFX such as:
- Strategic business plans, functional plans and processes, supply chain management, strategic planning and process analysis for implementation of ERP systems
- The assessment of economic, social and environmental impacts and development of systems and processes to drive performance management and reporting and compliance within an organisational context
2. Overview
• Using NPV in capital investment decisions
• Using IRR in capital investment decisions
• Conflicts between NPV and IRR
• Example – addressing the problem of unequal lives
4. Internal Rate of Return (IRR)
• IRR – also termed:
– ERR (economic rate of return)
– DCFROR (discounted cash flow rate of return)
• Measure and compare profitability of investments
• Higher IRR more desirable
• IRR should exceed cost of capital / hurdle rate (MARR –
minimum acceptable rate of return + risk premium)
• MARR used as discount rate for NPV calculation
• NPV indicator of value of investment
• IRR indicator of investment quality or yield
• IRR < cost of capital – reject investment
• IRR > cost of capital – accept investment
5. Internal Rate of Return (IRR)
• IRR = rate of return that makes
the NPV of all cash flows
(positive and negative) from an
investment = ZERO
n=0
Cn
(1 + r)n
= 0ΣNPV =
N
Year (n) Cash flow (Cn)
0 (today) (123,400)
1 36,200
2 54,800
3 48,100
• IRR (r) = NPV = –123,400 + + + = 0
• r = 0.0596
• IRR = 5.96%
36,200
(1 + r)1
54,800
(1 + r)2
48,100
(1 + r)3
6. • NPV
– Absolute measure
– $ amount of value added
• IRR
– Relative measure
– Rate of return over lifespan
• NPV and IRR most widely used tools
• Both discounting models (time-value of money)
• Conflict between NPV and IRR:
– Independent projects
– Mutually exclusive projects (size and different cash flows distributions)
– Projects of differing duration
Conflict between NPV / IRR
7. Conflict between
NPV and IRR due to
the differences in
size of the two
projects
Conflict between NPV / IRR
Project A Project B
Investment $10m $1m
Y1 $10m $2m
Y2 $10m $1m
Discount rate 10% 10%
NPV $7.4m $1.6m
IRR 61.8% 141.4%
Investment $10m $10m
Y1 $15m -
Y2 $10m $30m
Discount rate 10% 10%
NPV $11.9m $14.8m
IRR 100.0% 73.2%
Conflict between
NPV and IRR due to
the differences in
cash flow
distributions of the
two projects
8. The problem of unequal lives
• NPV and IRR do not provide true reflection
• Adjustment necessary
• Two approaches:
• Replacement chain approach
– Each project “repeated” to achieve equivalent life span
– NPVs over life span compared
– Project with higher NPV chosen
• Equivalent annual annuity (EAA) method
– Calculates annual payments provided by a project as if it were an
annuity
– Project with higher equivalent annual annuity chosen
9. Unequal lives example
Year 0 1 7.8% 2 3 4 5 6
Cash flow – project A -10 000 2 000 3 500 3 250 3 000 2 750 2 500
Discounted cash flow -10 000 1 845 2 979 2 552 2 173 1 837 1 541
Cumulative cash flow -10 000 -8 155 -5 176 -2 625 -452 1 385 2 926
Cash flow – project B -5 000 1 750 3 250 3 000
Discounted cash flow -5 000 1 614 2 766 2 355
Cumulative cash flow -5 000 -3 386 -620 1 735
A: NPV = $2 926 A: IRR = 8.30%
B: NPV = $1 735 B: IRR = 15.50%
Based on NPV project A is a better option
Based on IRR project B is a better option
Influenced by unequal lifespan
