Independent Projects
Capital Budgeting projects are categorized as either Independent Projects or Mutually Exclusive Projects.
An Independent Project is a project of which cash flows are not regulated by the accept or reject decision for other projects. Therefore, all Independent Projects which meet the Capital Budgeting criterion should be accepted.
A project that is not dependent on any other project. Therefore, the financial support of an independent project does not depend on another project experiencing financial support first.
The internal rate of return is outlined as the discount rate that gives a net present value known as NPV, of zero. It is a commonly employed criterion of investment efficiency.
The internal rate of return method will result in the same decision as the net present value method for non-mutually exclusive projects in an unconstrained environment, in the common cases where a negative cash flow takes place at the start of the project, followed by all positive cash flows. In most of the realistic cases, all independent projects that have an internal rate of return higher than the hurdle rate should be accepted. However at the same time, for mutually exclusive projects, the decision rule of assuming the project with the highest internal rate of return which is often employed may select a project with a lower NPV.
In several cases, several zero net present value discount rates may exist, so there is no unique internal rate of return . The internal rate of return exists and is unique if one or more years of net investment are followed by years of net revenues. But if the signals of the cash flows change more than once, there may be several IRRs. The internal rate of return equation in general cannot be figured out analytically but only by way of iterations.
One deficiency of the internal rate of return method is that it is usually misinterpreted to impart the current annual profitability of an investment. However, this is not the case since intermediate cash flows are never invested again on the basis of the IRR of the same project and thus the actual rate of return is nearly going to be lower. Since of the reason given, a criterion known as Modified Internal Rate of Return (MIRR) is often employed.
Despite a strong academic preference for NPV, surveys indicate that executives opt internal rate of return over NPV, in spite of the fact that they should be employed in concert. In a budget-constrained environment, efficiency criteria should be employed to maximize the overall net present value of the firm. Some managers discover it more appealing, in an intuitive manner, to assess investments in terms of IRR percentage than dollars of NPV.
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