**3.4 Conflicting advice of the net present value and the internal rate of return**

Sometimes it becomes necessary to compare two projects in practice. In such cases the net present value and the internal rate of return may give opposite advice. To understand why the results of both methods differ, it is necessary to present the lines of two projects in a diagram (Figure 2).

Fig. 2. Conflicting indication from net present value and internal rate of return (modified from Holmes, 1998).

Use of Discounted Cash Flow Methods for Evaluation of Engineering Projects 639

Pšunder and Cirman (2011) state that the discount rate is the rate at which future cash flows are converted into their present value. The differences between the discount rates have significant impact on the result of investment or project analysis. The contemporary theory of the determination of the discount rate favours a more precise definition of the discount rate. As the discount rate does not include a capital recovery premium, it can only be used for assessing an investment where we do not expect changes in the value of the investment, or where we can expect that changes in the value of the investment will be considered when selling property or at the termination of the investment (adopted from Friedman and Ordway, 1989, and The Appraisal of Real Estate, 2008). Ling and Archer (2008) emphasize that it is also necessary to take into account the cash flow from the sale of a property and not only the periodic investment inflows of cash. In such cases, it is important to include in the last projected cash flow any potential (marketable) residual value of an investment. The latter usually appears as a positive cash flow, but in some cases it can also be a negative one; for example, if we are dealing with the removal of a completely derelict property or of a property with a very low value, then the cash outflows for the removal are greater than the

By definition, the discount rate represents the rate of return that can be obtained in the financial market for a similar investment with comparable risk. What rate of return will be required for a certain investment depends on the risk associated with the specific investment and on the rate of return on investments with a comparable risk (Mramor, 1993). According to Pšunder and Cirman (2011), different risk premiums must be taken into account for different projects, enabling us to compare two quite different projects. Certainly, machinery and equipment investments are mostly subject to deterioration and obsolescence, which are the reasons an investment loses value in the long run. The loss of value can be included in cash flow from the residual value (the last cash flow in the equation when

Pšunder and Cirman (2011) write that the discount rate has a significant influence on the result of the present value method; that is why the correct choice of a discount rate is a

The above mentioned authors state that when analyzing a certain project, the size of the initial investment, expected cash flows and estimated duration of the project are known. The key factor that influences the result of the analysis is the discount rate. The discount rate is a decisive factor when evaluating whether projects are acceptable or not. The impact of the

Presuming a limited period until the end of the project and constant annual cash flow of the project, we can derive a present value of future annuities (PVFA). In the case of these

> 0 0 1 1

*n n*

*i i*

In equation 3, *CF* stands for the constant annual cash flow, *n* represents the number of

1 1

*r r*

*i i*

1

(3)

applied discount rate significantly increases with the duration of a project.

*CF NPV I I CF*

inflows from the liquidated asset.

individual cash flows can be considered).

precondition for an appropriate analysis.

presumptions, the equation 1 takes following form:

periods and *r* is the discount rate.

The two curves belonging to two projects cross at a certain discount rate. Above this rate, the full line belongs to the superior project, below this rate, the dotted line represent the better investment. Puxty and Dodds (1991) explain the reason: the bulk of cash inflows from the project with the dotted line arrives in the later years, and hence at higher rates of interest, they are discounted more heavily.

Holmes (1998) writes that the reason for conflicting advice is the two techniques make different assumptions regarding what will happen to cash inflows from investment projects. According to his findings, in such cases the net present value rule gives the correct advice.

According to their own opinion, only 37.5 percent of Slovenian projects managers with an education in mechanical engineering, 33.3 percent of Slovenian project managers with education in other technical sciences, and 43.8 percent of project managers with other education know the problem of conflicting advice from the net present value method and the internal rate of return method (see Table 1).
