Advances in Economics, Business and Management Research, volume 219

Proceedings of the 2022 2nd International Conference on Enterprise Management and Economic Development (ICEMED 2022)

Better Ways to Make Investment Decisions

Ke Hua1,*
1
College of economics and management, Shanghai Ocean University, Shanghai, 201306, China
*
Corresponding author. Email: [email protected]

ABSTRACT
With the development of the economy, the focus of the company's development shifts to investment decision-making.
The indicators used in evaluating investment options are divided into discounted and non-discounted indicators.
Discounted indicators take the time value factor into account, including net present value, present value index, and
internal rate of return. On the other hand, the time value of money is not considered by non-discounted indicators, which
have payback period, accounting return period, etc. And the approaches of net present value and internal rate of return,
as the two methods with the largest range of applications, are often debated on which one is better. This paper will
analyse this issue, the advantages and disadvantages of these two methods, and whether the modified solutions have the
perfect answer for the company's investment decision.

Keyword: Net present value (NPV), Internal rate of return (IRR), Modified internal rate of return

1. INTRODUCTION
2. NET PRESENT VALUE
The investment decision of a corporation is the most
critical decision of all, so we often say that investment 2.1 Advantages of NPV
decision failure is the biggest mistake, which can lead to
so much trouble or even bankruptcy. Therefore, a As a widely used tool for investment decisions
fundamental function of financial management is to make through decades, NPV no doubt has provided that there is
good investment decisions. Capital investment usually no perfect replacement for this approach. When making
has a great impact on the company's future cash flow capital decisions, companies will still refer to the project's
because it ties up a large amount of capital. In a way, net present value to make choices. The net present value
investment decisions determine the future of a company, method converts the net cash flows of the project's period
and the right investment decision can reduce the risk and into a sum of equivalent present values calculated at a
gain profit, while a wrong investment decision can be target rate of return. And the algebraic sum of all cash
devastating to the company. inflows' present value is equal to the project's net present
value.
Therefore, these decisions require very careful
considerations because they are highly exposed to all Ross clarified his point that nobody says the NPV rule
kinds of financial and market risks. In order to maximize is wrong, it's just irrelevant in some way and must be
the profit, net present value (NPV) and internal rate of modified to be more helpful. NPV is good when it can do
return (IRR) are two of the most commonly used its job properly, which is reject the project when it is not
measurements among all the other financial valuation good enough for the company. However, NPV can also
methods such as payback period and average accounting be bad when it rejects the really good projects. To make
rate of return. The company makes strategic positioning things worse, NPV can sometime accept a project when
and industrial layout according to them, clarifies the it should be rejected [1].
corresponding investment direction, and looks for First, the cash flow of the project can be used instead
suitable investment targets. Screening investment of profit, meaning that profit is not equal to cash in the
projects, comparing investment alternatives, analysing capital budget; second, all cash flows of the project are
and evaluating their profitability and risks. included by NPV, unlike some other capital budgeting
methods that ignore cash flows after a specific time;
finally, another reason why NPV is better than methods

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such as payback period is that the NPV rule takes the time need a more dynamic approach to investment decision-
value of money into account. making. Systematic evaluation of various investment
decision methods shows that weighted average cost of
Naturally, companies will use the NPV approach to
capital (WACC) and mean-variance method can be
make capital decisions. They accept projects with a
combined to form the NPV-at-risk method, which
positive NPV because today's received money equals the
incorporates money's time value into mean-variance
NPV, and rejecting projects with a negative NPV will not
method and uses WACC as discount rate [4].
create any cost loss. Apart from this obvious use, NPV
projects can also reflect the firm's current stock price. And The NPV maximization model may still have several
it also has an impact on Shareholders' Wealth and different representations, which means it is not perfect.
Implications for Capital Budgeting Theory [2]. And the use of the particular form depends on the specific
situation. For example, if the market is incomplete, then
2.2 Drawbacks of NPV the arbitrage NPV cannot be used. Some of these forms
are usually not applicable or consistent with universal
As we all know, optionality is inevitable everywhere standards. [5].
when evaluating investments. Thus, the NPV method is
not perfect which means it also has many defects. When There are two ways to make investment decisions
the economy is not stable, it easily adds more uncertainty according to the decision-making rules' requirements:
with the changing capital market interest rate, making the one is to calculate the NPV at a given confidence level,
cost of capital harder to settle. In fact, NPV only uses cash and the other is to calculate the confidence level when the
flows to show the total capital gain and loss of an NPV is zero. And a systematic review of various
investment project but not the actual return on the project investment decision methods suggests that the weighted
itself. This leads to a tendency for decision-makers to average cost of capital method and the average variable
choose projects with massive returns on investment and method can be combined to form the net present value at
ignore the fact that a high return on investment is a better risk method, which can be used for decision making in
investment option in comparison [1]. privately financed infrastructure projects [4].

Since an investor will not choose a project with a 3. IRR

negative NPV, it must have a positive net present value
when investing. The holder profits from a decline in the 3.1 Advantages of IRR
one-year interest rate and takes responsibility when the
interest rate rises. This results in the project being the As an expected return on investment, the internal rate
equivalent of a call option on a one-year bond. And just of return is also a discount rate that can make a project's
because the option is not cash today does not mean it is NPV equal to zero. The rate of return can be divided into
worthless. Conventional NPV indices do not allow the financial and economic internal rate of return in the
analysts to assign reinvestment rates that are independent project evaluation according to different levels of
of the NPV discount rate. As a result, it is not possible to analysis. Normally, the larger the exponent, the better.
make a fair comparison of competing projects in many Although many companies now choose to invest by using
capital budgeting situations because it is not possible to funds, stocks, or real estate, there are still many people
assign a common reinvestment rate [3]. who cannot get rid of investment's limitation to the
absolute value of returns. IRR provides a basis for
2.3 The modification of NPV judgment as an indispensable tool for this purpose.

Considering risks based on the NPV method yields Patrick and French explained what IRR is
two uncertainty decision methods: the certainty mathematically, and pointed out that a cash flow may not
equivalent method and the risk-adjusted discount rate even have a unique IRR. Besides, IRR can be misleading
method. However, a significant drawback of the positive- if the outcome is negative, and IRR may rank projects
equivalent method is that it is not easy to determine the incorrectly when considering the NPV at the same time.
positive-equivalent coefficients when it is poorly They drew the conclusion that the rate of return alone is
operationalized, while the latter combines time value with not enough to be the determined factor of the investment
risk and unreasonably discounts the cash flows. In decision, the timing of cash flows, is also important in
addition, it is not practical to apply a single risk-adjusted decision making [6].
discount rate made by the CAPM model. If there is some The project's life to its total investment can be related
flexibility in management decisions, calculating the NPV by the internal rate of return approach, indicating the rate
with a fixed discount rate would be even more inaccurate. of return for the project. Comparing the internal rate of
Therefore, there are ways to made NPV less limited, return to the investment rate of return benchmark, we can
just like Ye and Tiong discussed that some projects face easily get to know whether it is a project worth investing.
more risks like Build-Operate-Transfer projects. They The IRR approach will not be limited to the terms of
borrowing and can be seen as the borrowing rate cap

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when the terms are not clear. However, the internal rate the project period, which is the maximum annual interest
of return is a ratio, not an absolute value. Because of its rate that we usually refer to as the loan investment.
size, a project with a low IRR may also have a high NPV.
For instance, the internal rate of return is 20 percent,
Hence, it is essential to think about the IRR along with
which means the maximum rate of depreciation that we
NPV when selecting the option for comparison.
can afford is 20% per year; and if we decide to borrow
money for this investment, the maximum annual interest
3.2 Drawbacks of IRR rate we can take is 20 percent, making this project is
As we mentioned above, IRR is a ratio indicator that worth invest. And when the currency devaluation rate is
cannot show the absolute level of return and can often only 5%, the remaining 15% is our profit. However, this
mislead investors' judgment. Unlike NPV, as a ratio, IRR seems to be talking about margin errors and resilience to
cannot be used independently. To use the IRR method for risk, but actually this can also be talking about marginal
investment analysis also have to know the company's profits and profitability. The other thing is that NPV is a
capital cost. If the final result is that the IRR is greater specific value in the investment project, while IRR is a
than the company's cost of capital, then the project can be ratio. To some extent, as a relative value, the IRR is
accepted; otherwise, the project should be rejected. definitely better than the absolute value because the latter
does not consider the investment's size. For example, the
Brown clearly listed the problems that IRR has and NPV of a $1 million project is $500,000, and the NPV of
summarized as four main problems. The first one was the a $10 million project can also be $500,000, but the
‘‘No Solution Problem’’, which means IRR may have no project's profitability is totally different.
result when the cash flow is not normal. The ‘‘Multiple
Solution Problem’’ indicates that the convex of IRR may 4. MIRR
come cross the x-axis twice. The ‘‘Ranking Problem’’
tells that the IRR may have different result with NPV, and 4.1 The modification of IRR
the ‘‘Scale Problem’’, which says the IRR cannot rank the
projects if they have different scale [7]. Magni then suggested to look at IRR in a new
Therefore, the disadvantages of IRR can be perspective, which is average internal rate of return
summarized as follows: (AIRR). This is quite different from the approach that
considers the concept of IRR as the centre, as it discards
 IRR cannot distinguish if the project is reinvested the IRR equation, guarantees the flexibility of description
or financed. and corrects decision making. The AIRR approach
addresses the long-standing problem of finding
 IRR cannot reflect the size of the funds, for
meaningful rates of return on the economic level that help
example, a 1% return on $100 investment and a
decision-makers make the right decisions [9].
50% return on $1 investment.
Lin proposes a substitute formula for IRR that
 IRR cannot distinguish the time series of funds.
maximizes the firm's value under specific conditions,
 IRR might have multiple answers or no solution. which is called the modified internal rate of return. The
advantage of MIRR over traditional IRR is that it
And the reliability of IRR depends on several
provides a unique solution making the NPV and benefit-
assumptions, an important one being the one mentioned
cost decisions result in the same outcome and does not
above that the reinvestment rate of return is equal to IRR.
make undue implicit assumptions about the impact of
intermediate cash flows as some other decisions do. [10].
3.3 IRR vs. NPV
IRR cash flows are also classified as positive or
Osborne discussed about a long exist question: NPV negative. Positive cash flow represents the cash the
or IRR, which is better and accurate when making investor receives during the investment period and how
investment decisions. Hence there is a new approach to the use of this cash affects the rate of return. For example,
understand this debate. One of the benefits of the new the money acquired during the investment period can be
approach is that it is very friendly to the solution proposed reinvested or used to purchase treasury or make stock
for this problem. Although this analysis still supports transactions. On the other hand, a negative cash flow is
NPV as an academic preference, it illustrates that IRR is reinvesting additional funds. The acquisition of these
also a fundamental concept. This is because the net funds is also considered a financing activity that has to
present value covers all internal rates of return that may consider the new interest rate. The MIRR can be
exceed the cost of capital. [8]. calculated as the final value of the FV under the
We can see that both of them consider money's time reinvestment rate of all cash inflows for the period, which
value, but the NPV method is the money that can be also means how much income will be generated after the
earned during the project period, while the IRR method is investment inflows for the period. All cash outflows for
the maximum depreciation rate that we can afford during

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these periods are to be calculated using the financing rate IRR, MIRR does not reflect project size. To solve this
of the present value PV. problem, Shull proposed a downloadable process to
adjust MIRR to mutually exclusive projects so that the
4.2 Pros and Cons of MIRR adjusted MIRR (ADDMIRS) could calculate the size of
projects. Thus, allowing direct and NPV-compatible
Kierulff believes that even though MIRR is more project ranking [13].
difficult to understand and calculate, it will gain public
acceptance over time, just like NPV. In fact, the idea 5．CONCLUSION
behind MIRR is easy to understand through the formula
but more challenging in reality because of the investment Compared with the traditional IRR, the modified IRR
rate to be estimated. The MIRR also effectively solves assumes that all investment returns are reinvested at a
some of the NPV and IRR problems. As with traditional certain discount rate for the investment, making its
IRR, an investment project is economically attractive reinvestment assumption more reasonable. The main
when the MIRR exceeds the hurdle rate, it provides a problem of multi-IRR is solved at the same time.
more accurate measure of which investment alternatives However, due to the different investment scales, the
is more attractive, which depends not only on the return modified index still cannot solve the problem of
of the investment itself but also on the expected return of contradicting the NPV index.
the cash flows it yields [11].
But after all, business is not natural science, and
Lefley observes that IRR remains the most popular efficiency is often more important than accuracy.
investment decision method despite all the flaws. The Although there are different voices on the need for the
newly researched modified internal rate of return can existence of MIRR, it is a more accurate indicator of the
address some of the weaknesses of IRR. If a company's profitability of future projects anyway. Therefore,
cost of capital is less than the reinvestment rate, then the decision-makers can use MIRR to check whether the
actual rate of return is underestimated by the MIRR. And forecast made by IRR is too optimistic. The modified
if the company's cost of capital and the project's MIRR is internal rate of return will undoubtedly prove its value
very different, then the determination of the project cycle over time, just like other approaches did.
can have a significant impact on the actual MIRR. Like
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