Background: KingstonTech Co operates in an industry which is rapidly changing. You
are Assistant Management Accountant at KingstonTech Co. Your line manager, who is an
experienced Management Accountant and a Chartered Certified Accountant has delegated you
the duty to prepare a report presentable to the Board of Directors. Management Accountant will
be replacing the position of the Finance Director who has recently been nominated as the CEO
of KingstonTech Co. Therefore, your prospects of being promoted within KingstonTech Co can
be considerably enhanced if this report is of a quality that can convince the Management
Accountant of your understanding of Capital Investment Decisions and whether you can
articulate your argument in a manner that is comprehensible for the management within and
outside the teams of accountants. Proposal: KingstonTech Co are evaluating the purchase of a
new plant to manufacture product AAA, which has a short product life-cycle as it operates in an
industry with rapidly changing technology. The proposed plant is expected to cost $1 million.
Production and sales of product AAA are forecast to be as follows: Year 1 2 3 4 Production and
sales (units) 35,000 53,000 75,000 36,000 AAA will sell in the market for $20 per unit, while the
variable cost of the product will be $12 per unit. Both selling price and variable costs are in
current price terms. Selling price inflation is forecast to be 4% per year. Similarly it is expected
that variable cost inflation will be 5% per year. No increase in existing fixed costs is expected
since KingstonTech Co has spare capacity in its existing factory and existing employees can
handle this. Producing and selling product AAA will call for increased investment in working
capital. Analysis of historical levels of working capital within KingstonTech Co indicates that at
the start of each year, investment in working capital for product AAA will need to be 7% of sales
revenue for that year. KingstonTech Co pays tax of 30% per year in the year in which the
taxable profit occurs. Liability to tax is reduced by capital allowances on machinery (tax-
Essay on IRR VS NPV 2
allowable depreciation), which KingstonTech Co can claim on a straightline basis over the four-
year life of the proposed investment. The new machine is expected to have no scrap value at
the end of the four-year period. KingstonTech Co uses a nominal (money terms) after-tax cost
of capital of 12% for investment appraisal purposes. Required: Management Accountant has
asked you through a memo that the report must respond to the following requirements. (a)
Calculate the net present value of the proposed investment in product AAA. (15 % of total
marks) (b) Calculate the internal rate of return of the proposed investment in product AAA. (5 %
of total marks) (c) Advise on the acceptability of the proposed investment in product AAA and
discuss the limitations of the evaluations you have carried out. (10 % of total marks) (d) Using
acedamic theory and research present your understanding to compare the two approaches to
making capital budgeting decisions by means of discounted cash flows. You do not need to use
numbers to answer this question. (15 % of total marks) (e) You now plan to suggest the
Management Accountant the other two possible methods of investment appraisal. Explain to
him their uses and possible drawbacks. Although not necessary but if you so wish, you can do
some calculations to explain to him the ease of use of the other two methods. (10 % of total
marks) (f) Can all investments projects be described entirely in terms of monetary costs and
benefits? In light of your academic theory and research discuss in your own words if non-
monetary aspects are also relevant. If you argue that they are relevant then why should we
bother with numerical analysis? (10 % of total marks) (g) There is evidence (e.g., Arnold and
Hatzopoulos, 2000; Alkaraan and Northcott, 2006)1 showing that companies use more than one
of the four methods of investment appraisal thatyou have been taught in this module (net
present value, internal rate of return, payback method, simple rate of return). Discuss what
could be the reason for that? (10 % of total marks) (h) Your line manager has also asked you to
recommend various approaches to pricing. He has also sought your opinion regarding the most
suitable pricing approach that KingstonTech Co. can take with reasons for your
recommendation. (15 % of total marks) 1 Alkaraan, F. and Northcott, D.
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Essay on IRR VS NPV
To the Board of Directors
Essay on IRR VS NPV 4
Kingston Tech Co.
From Finance Director
Re: New Plant for Product AAA
Capital budgeting involves the use of modern techniques like NPV and IRR to determine the
investments or projects to be undertaken.
The following is the analysis for the Kingston Tech Co.’s New plant for product AAA.
1a) NPV calculations,
Year 1 2 3 4
Production 35,000 53,000 75,000 36,000
Sales 700000 1102400 1622400 809902.1
Variable costs 420000 667800 992250 500094
Depreciation 250,000 250,000 250,000 250,000
Cost of capital 5880 9260.16 13628.16 6803.18
Expenses 675880 927060.2 1255878 756897.2
Profit before tax 24120 175339.8 366521.8 53004.9
Taxes 30% 7236 52601.95 109956.6 15901.47
Net income 16884 122737.9 256565.3 37103.43
Total expenses 683116 979662.1 1365835 772798.6
Net Income 266,884 372,738 506,565 287,103
PV $1,078,456.24
Cost of Machine $
1,000,000.00
NPV $78,456.24
1b) IRR calculations,
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Year 0 1 2 3 4
Production 0 35000 53000 75000 36000
Sales 0 700000 1102400 1622400 809902.1
Variable costs 0 420000 667800 992250 500094
Depreciation 0 250000 250000 250000 250000
Cost of capital 0 5880 9260.16 13628.16 6803.177
Expenses 0 675880 927060.2 1255878 756897.2
Profit before
tax
0 24120 175339.8 366521.8 53004.9
Taxes 30% 0 7236 52601.95 109956.6 15901.47
Net income 0 16884 122737.9 256565.3 37103.43
Total expenses 0 683116 979662.1 1365835 772798.6
Net Income –
1,000,000
266884 372737.9 506565.3 287103.4
IRR 16%
c) The project AAA is viable as the NPV of the project is positive which means that its profitable
while the IRR is above the cost of capital. The IRR is 16% while the cost of capital is 12%.
The major limitation of the projects capital expenditure evaluations is that the internal rate of
return is different from the cost of capital. Absolute comparisons of the two methods of capital
budgeting is not possible hence the approach requires another capital evaluation method to
confirm the true position of the firms actual profitability. The firm will definitely register some
profits in future as confirmed by the NPV and also the higher rate of return for the IRR but the
actual amount of profit that the AAA project will make has been given under the cost of capital
in NPV and not under the IRR rate (Berk, DeMarzo and Stangeland, 2015).
1d) Capital budgeting is a financial term that applies to the decision whether a project or
investment should be undertaken or not. The two major concepts that are applied in capital
budgeting are the NPV (Net Present Value) and the IRR (Internal Rate of Return) which
Essay on IRR VS NPV 6
facilitate key decision making procedures in most companies. The NPV basic rule is to accept all
the projects that are NPV > 0 and reject all the projects with NPV < 0.
The NPV value is equal to CF0 +CF1/ (1+r) + CF2/ (1+r) ^2+ …CFN/ (1+r) ^n
While for all mutually exclusive projects its CFAO, CFA1, CFA2…CFAN and the other project
CFCO, CFC1, CFC2…..CFCN. Between the two alternatives the preferred choice should be
more or higher than the other alternative
The IRR (Internal rate of return) is basically a discount rate that gives a Zero NPV (Net Present
Value) The IRR is generally the compound return or result that one obtains from a given project.
Since r is the return rate, IRR should always be greater than r. The deciding rule for IRR between
two projects that are mutually exclusive for project B and C are CFBO, CFB1, CFB2, ….CFBN
and CFCO, CFC1, CFC2….CFCN. The rule is that the investment or project that has a greater
IRR is the best project i.e. IRR (B) > IRR (C).
1e) The following is an example that indicates the problem that may occur when only one
method is applicable i.e. either NPV or IRR. Project B costs US$1000 with a return of US$ 500
per annum at a return rate of 12 percent while the alternate project C costs $800 with a net return
of US$ 410 per year (Lin and Nagalingam, 2000). Using NPV, project A would be selected as its
NPV is higher than project B. A’s NPV is $802.39 against B’s $677.96. But the IRR and the pay
back evaluation methods would give different results. The payback method would put project C
as the best option as it would have a payback period of 1.95 years against project B that has a 2
year payback period while the IRR would also prefer project C that has a rate of 43% against B’s
IRR of 41%.
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Year B C
0 -1000 -800
1 500 410
2 500 410
3 500 410
4 500 410
5 500 410
IRR 41% 43%
(=IRR(h4:h9)
12% 12%
Year B C
0 -1000 -800
1 500 410
2 500 410
3 500 410
4 500 410
5 500 410
NPV $802.39 $677.96
(=NPV(G12,G15:G19)+G14)
The NPV and IRR for both projects basically positive and acceptable as they both have Internal
rates of return which are above 12% and the NPV for both projects are also positive hence both
are also acceptable and qualify as good projects but the higher the NPV the better the ranking
just as much as the IRR rankings. Cases where the NPV and IRR give almost the same results
are easier to deal with. But like the in the case above, the two concepts provide contradicting
results. As per the NPV concept, project B should be selected as its NPV is US$802.39 while the
other project i.e. project C has also a positive NPV but its lower compared to project B as its
NPV is US$677.96. But according to IRR, the best option is project C as its IRR is 43%
compared to project’s B’s 41%. Such cases may present confusion but its recommended that the
NPV is the best alternative or concept to rely on incase of a conflict between the two capital
budgeting option as it also incorporates some aspects of IRR in its calculations. NPV is also
Essay on IRR VS NPV 8
widely used as it captures most of the investor’s targets of maximizing wealth as it measures the
total incremental wealth in all investments or projects.
1f) The non-monetary aspects mostly apply to the noncash expenses as it relates to the cash
flows. Accountants and tax agents mostly calculate earnings by deducting certain expenses from
the total sales even though these items or expenses are basically noncash expenses like
depreciation. When calculating the cash flow these expenses are added back like in question one
the net income after taxes for the first year was 16884 hence to get the cash flow, the amount of
depreciation amounting to 250,000 for that year, is added back to obtain a total of 266,884. The
same case applies to all the other years. These expenses that are also known as noncash expenses
create a tax shield which reduce the tax liability of the businesses. The tax shield has a big
impact on capital budgeting decisions as they are tax deductibles and they reduce the tax burden
for the company.
1g) The major reason why most companies use more than one method of the four capital
budgeting techniques is basically for comparison purposes. Wise companies use more than one
method for example most companies use IRR and NPV. IRR to measure the expected percentage
return to be generated by the project and NPV to determine the actual intrinsic value for the
future cash flows that the project is supposed to generate in future but have to be discounted to
present value.
1h) The two pricing policies that are popular are the flexible pricing policy and the uniform
pricing policy. Uniform pricing policy is favorable where the company prefers to maintain the
status quo. But in the case of AAA investments, the pricing policy is expected to change and it’s
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also expected to provide for inflation. The price of the products is expected to fluctuate with the
rate of inflation hence the best pricing is the flexible pricing policy (Jagpal, 2008).
To conclude, main advantage of applying the capital budgeting techniques to the evaluation of
projects ensures that all the projects undertaken are profitable, economical and also viable. The
payback period is very simple and easy to calculate and apply while the IRR is used to measure
the expected percentage return to be generated by the project while the NPV is used to determine
the actual intrinsic value for the future cash flows that the project is supposed to generate in
future but have to be discounted to present value. Most companies prefer to combine all the three
techniques to calculate the returns of an investment. Capital budgeting decisions need complex
and reliable information systems that can provide the basis for major decision making processes
that are economical and profitable.
Essay on IRR VS NPV
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References
Berk, J., DeMarzo, P. and Stangeland, D. (2015). Corporate Finance (3rd Canadian Edition
ed.). Toronto: Pearson Canada. p.64.
Jagpal, S. (2008) Fusion For Profit: How Marketing and Finance can Work Together To Create
Value, New York: Oxford University Press.
Lin, G. C. and Nagalingam, S. (2000). CIM Justification and Optimization, London: Taylor &
Francis. p. 36.
