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In spite of all the efforts to convince managers that the net present value (NPV) is the 'correct' method of investment appraisal to use, recent research shows that they continue to prefer the internal rate of return (IRR)."2 And, although a number of modified versions of the IRR have been developed, they too have been condemned by some academics even though such modifications are an improvement on the conventional IRR. No single investment-appraisal technique will give the right answer in all investment situations, however, and the NPV is no exception. This is reflected again in recent research which shows that companies now use a greater number of financial appraisal techniques than in the past, but with no consensus on the actual combination. This increase in usage has been attributed to the increase in computer software that is now readily available to perform the basic calculations of the various financial appraisal techniques such as payback (PB), accounting rate of return (ARR), IRR, and NPV.
Some weaknesses of the NPV
While the NPV will highlight those projects that increase shareholder value, this is normally based on the assumption that there is no restriction to the amount a company can invest and that it may therefore invest in all projects that show a positive NPV. As this is not a practical assumption, the NPV fails because it does not fully take into account the size of the capital expenditure required to produce this increased value; it may not identify the most advantageous combination of projects when there is a capital shortage. In reality, companies are faced with many types of capital investment situations and are also burdened with constraints such as liquidity, perception of risk and time factors, just to name a few. There is no doubt, however, that the NPV is conceptually more sound than the IRR, but on its own and in certain circumstances it too may not give the right signal to management.
If the discount rate used in the calculation of the NPV is based on a 'true' cost of capital, then the figure arrived at is the true return (expressed in present-value terms) on a project-it is the economic gain that a company can expect to achieve if it makes that investment. Often,...