A New Method to Estimate NPV and IRR from the Capital Amortization Schedule and an Insight into Why NPV Is Not the Appropriate Criterion for Capital Investment Decision
17 Pages Posted: 19 Jan 2017 Last revised: 30 Aug 2017
Date Written: January 15, 2017
This paper introduces a new method, different from the discounted cash flow (DCF) method, for the first time, to estimate NPV and IRR. This method makes use of the capital amortization schedule (CAS). The functional relationship between the closing balance in CAS and the NPV and IRR are derived and illustrated. Accordingly, the present value of the closing balance in a CAS is the NPV and the interest rate that makes the closing balance zero is the IRR. NPV and IRR are estimated using the new method for some selected normal and non-normal net cash flow (NCF) investment projects and presented here. The estimated NPV and IRR perfectly match with the NPV and IRR estimated by the DCF method. This method is more transparent and provides a better insight into the suitability of the NPV criterion. NPV represents the unutilized NCF and when it is fully utilized, the NPV will become zero and return on invested capital will be the highest, equivalent to IRR. Also, when the cost of capital is in percentage term, the return on invested capital (ROIC) must be in percentage term like the IRR and not in two parts viz. percentage term (hurdle rate) and the balance in absolute term (NPV). The CAS method exposes the weakness of the NPV and question about its validity as a criterion in capital investment. The CAS based method also makes it implicitly clear that there is no reinvestment of the intermediate income. Modified IRR (MIRR), which is based on the assumption of reinvestment, becomes redundant when there is no reinvestment. Authors of text books and other published works related to Corporate Finance, Investment Analysis, Capital Budgeting and cost-benefit analysis may wish to review these findings and consider updating the relevant chapters or sections accordingly.
Keywords: New Method to Estimate NPV from Capital Amortization Schedule, Problems with NPV Criterion, No Reinvestment of Income, MIRR Redundant
JEL Classification: D, D61, G, G31
Suggested Citation: Suggested Citation