April 2010 Q2 (Presentation)

[edcvfr]

We're asked to explain NPV and IRR to a board of directors. In the examiners' report, the slide says

NPV = value of project at a certain rate of return (the "discount rate")
IRR = discount rate at which NPV = 0

Is this sufficient as an explanation for NPV and IRR? I would've thought it would make no sense to someone who has never encountered discount rates before. How else would you explain it?

 

[David Wilmot]

I would agree with you edcvfr that what is on the slide is likely to be hard for some of the audience to understand. Of course, the presenter would also be narrating during the slide & that would also form part of the explanation.

We cover this particular question (and other past exam questions) in ActEd's Preparation Day tutorials and our Online Classroom. In these we avoid explaining the calculation itself. For example, for NPV we simply refer to NPV as being a way of placing a value on a project, which reflects the size and incidence of the expected future cashflows and the cost of financing the project (eg interest, or borrowing, rates). This ensures the audience (directors) can understand what the measure means and what it is affected by, so that they can make an informed decision as to which project to undertake. They don't need to know the detail of how NPV is calculated in order to make that decision.

 

[edcvfr]

I would agree with you edcvfr that what is on the slide is likely to be hard for some of the audience to understand. Of course, the presenter would also be narrating during the slide & that would also form part of the explanation.

We cover this particular question (and other past exam questions) in ActEd's Preparation Day tutorials and our Online Classroom. In these we avoid explaining the calculation itself. For example, for NPV we simply refer to NPV as being a way of placing a value on a project, which reflects the size and incidence of the expected future cashflows and the cost of financing the project (eg interest, or borrowing, rates). This ensures the audience (directors) can understand what the measure means and what it is affected by, so that they can make an informed decision as to which project to undertake. They don't need to know the detail of how NPV is calculated in order to make that decision.

Thanks for the quick reply David! How about IRR? Having explained NPV, if I say that IRR is the rate of return that sets NPV to 0, would that make sense? Or should I say IRR is a measure of the rate of return on the project. If it is greater than the cost of borrowing, then it is considered profitable?

 

[David Wilmot]

Thanks for the quick reply David! How about IRR? Having explained NPV, if I say that IRR is the rate of return that sets NPV to 0, would that make sense? Or should I say IRR is a measure of the rate of return on the project. If it is greater than the cost of borrowing, then it is considered profitable?

What do you think the audience would find most useful (from their perspective as directors looking to choose between two projects) and most easy to understand?