NPV Vs Internal Rate Of Return Method: A Comparative Study

Calculation of Net Present Value

Describe the Net Present Value (NPV) method for Investment appraisal and explain the arguments that suggest that NPV should be preferred to Internal Rate of Return (IRR) when choosing among mutually exclusive capital investment projects.

NPV method which is also known as Net Present Value Method and the Internal Rate of Return Method are popular methods of decision making. Investment proposal is analyzed with the help of these techniques and their future productivity. The investment proposal is selected after analyzing by these techniques. These methods are widely used by the business organization because of their accuracy in the projection but no method can provide an accurate projection of the future outcome. Therefore there is some limitation in these methods too.

The net present value is the technique of selecting best investment project from different investment projects available. The net present value of investment proposal is defined as the sum of present value of all future cash inflows less the sum of the [present value of all cash outflow associated with the proposal (accountingtools, 2017). The concept of selection of projects under net present value is simple. The present value of all the future cash flows received from the project is discounted at the discount rate prevailing in the market and from that the present value of all the future cash outflows that are going to arise in the future will be subtracted. The investment project whose net present value is higher from all will be selected before other projects.

The calculation of net present value is simple and effective. Following steps are followed by while calculating net present value:

1. Determine total cash outflow arising from the project and the year in which these cash flows are arising.
2. Then the total cash flow will be discounted with the discounted rate and converted into present value.
3. Now calculate the total cash flow derived from the projects in different years. The life of the projects can be more and the projection, in that case, is difficult to be assessed.
4. The total cash flows calculated in the above step will be discounted with the present value to derive the present value of cash inflow.
5. The net present value is calculated by subtracting the total net present value of cash outflow from the project from the total cash inflow of the project received throughout its life.
6. The project will be accepted if the project has positive or 0 Net Present Value. The project with higher Net Present Value will generate more profit for the company so they should be selected first.

The future survival and growth of a business organization depend on its capacity to make the right decisions. The management of the company should take a decision by applying their due diligence and professional skills and these decisions should result in the development of the company. The project evaluation decision is one of such major decision which contributes to the growth of the company. There are different methods available to evaluate projects that should be accepted (Jan). The two methods net present value method and the internal rate of return methods are used widely by different organization. There is some issue between the uses of such methods over other methods. Both of the investment analyzing technique uses the concept of present value of money (efinancemanagement, 2012). The result of both the techniques is same in most of the cases but in some case, they might have a conflict with each other. For example, in some case, the net present value of one project is higher but the internal rate of return is lower (efinancemanagement, 2012). The net present value method calculates the opportunity cost of the different projects over another project. This conflict between the projects arises due to the nature of the project whether they are independent or mutually exclusive.

NPV and IRR in Investment Analysis

The net present value method is considered best in the case of to be more useful in case of a mutually exclusive project than the internal rate of return. The meaning of mutually exclusive project is that one project’s consideration does not include some other project. The internal rate of return consider the reinvestment of the same project over the expiry of its life, but net present value focuses on the single project that is into consideration. The reinvestment of the project is not practical there can be some more option in the future and the demand of present situation to give judgment on the presently available option. Further, the internal rate of return considers discounting of the future reinvestment of the project with the same rate. The internal rate of return based on too much future assumption. This is not practical neither accepted in the present competitive market. In the case of the internal rate of return, the rates derived from the calculation are sometimes impractical and too good to be true such as 30% or 35%. In a practical market, this return is impossible to achieve. The net present value, on the other hand, is taken into consideration the practical lending or borrowing rate which are prevailing in the market at that time.

The internal rate of return simply calculates the rate at which the present value of cash inflow is equal to the present value of cash outflow arising from the project. The project with a higher rate of return will be selected from all the other projects.  In the case of the mutually exclusive project, the net present value is best suitable than the internal rate of return. It gives more accurate result than the internal rate of return method and does not takes into account any assumption figures. The net present value always uses the true market rates. The internal rate of return is a relative method and ignores the total value added by acceptance of the project. Net present value is simpler than the internal rate of return and can be easily understood by the general public, it does not require any financial education on behalf of the user of information.

There are many pros and cons associated with NPV method utilization. Some of them are pointed as follows –

Advantages

The net present value states clearly the total benefit arising in the future year from a project. The total benefit is subtracted from the total expense on the project which will be income from the project.

Suitable Scenarios for Mutually Exclusive Projects

It takes into account the inherent risk in making future projections. It also takes into account the cost of capital also.

While evaluating the projects the risk and profitability factors associated with the projects are taken into consideration.

The main concept of net present value is maximizing the value of the firm.

Disadvantages

The net present value cannot be used while comparing two projects of different life. The project should be assumed that it will be reinvested again if such comparison is to be made which is impractical.

Some people find the calculation of the net present value of the project very difficult because it contains some assumption on discounted The appropriate discounting rate cannot be calculated easily.

The internal rate of return as part of capital budgeting technique has certain advantages and limitations. Some of them are detailed as follows –

Advantages

The internal rate of return is simple to understand by the general It simply gives the rate of return of each project that is under evaluation(Kumar, 2010). These rates of returns are then evaluated and the project with a higher rate of return will be selected.

The internal rate of return can be used to evaluate two projects of different duration. For example, one project which has a life of 3 years can be compared with another project with 5-year

Disadvantages

The internal rate of return method makes the assumption the reinvestment of the project can be done at the same rate which is calculated now. But the future assumption cannot be used to achieve accuracy in business decision making.

The Internal Rate of Return specifies the result in percentage basis and does not give the total benefit or loss in the term of dollars.

The Internal Rate of Return calculation requires large formula. This formula can be hard to remember and even harder to execute in practical condition.

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efinancemanagement. (2012). Why Net Present Value is the Best Measure for Investment Appraisal? Retrieved July 30, 2017, from efinancemanagement: https://efinancemanagement.com/investment-decisions/why-net-present-value-is-the-best-measure-for-investment-appraisal

investopedia. (n.d.). Advantages and Disadvantages of the NPV and IRR Methods By Investopedia. Retrieved July 30, 2017, from investopedia: https://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/advantages-disadvantages-npv-net-present-value-irr-internal-rate-of-return.asp

Jan, O. (n.d.). NPV vs IRR. Retrieved July 30, 2017, from accountingexplained: https://accountingexplained.com/managerial/capital-budgeting/npv-vs-irr

Kumar, V. (2010). Advantages and Disadvantages of Internal Rate of Return. Retrieved July 30, 2017, from Accounting Education: https://www.svtuition.org/2010/05/advantages-and-disadvantages-of.html

Lanctot, P. (n.d.). The Advantages and Disadvantages of the Internal Rate of Return Method. Retrieved July 30, 2017, from chron: https://smallbusiness.chron.com/advantages-disadvantages-internal-rate-return-method-60935.html