Question 1

Which investment appraisal method is the best?

Accepted Answer

There is no single 'best' method; they each provide different insights. However, methods that use discounted cash flow (NPV and IRR) are generally considered superior because they account for the time value of money and consider all cash flows over the project's life. NPV is often preferred in academia and practice as it gives an absolute measure of value creation and avoids some of the technical problems of IRR. A comprehensive analysis should use a combination of methods.

Question 2

Why do we use cash flows instead of profits for NPV and Payback?

Accepted Answer

Cash flow is used because it represents the actual money moving in and out of the business. A company needs cash to pay its bills, employees, and investors. Profit is an accounting measure that includes non-cash items like depreciation and can be influenced by accounting policies. Cash flow provides a more objective measure of a project's ability to generate liquid resources for the business.

Question 3

What happens if IRR and NPV give conflicting advice?

Accepted Answer

This can happen, particularly when comparing mutually exclusive projects of different sizes or with different cash flow patterns. In such cases, the NPV method is generally considered more reliable. The NPV decision rule (accept all projects with a positive NPV) leads to decisions that maximise the value of the firm, which is the primary goal of financial management. The IRR's reinvestment assumption (that cash flows are reinvested at the IRR) can be unrealistic, whereas NPV assumes reinvestment at the cost of capital, which is often more achievable.

Investment Appraisal

What you need to know