Question

When the management team considers what projects to continue with, there are positive NPV projects and negative NPV projects. Based on the readings for this week, what are the differences between these two projects? What are some problems with the IRR methodology compared to the NPV methodology?

Answer 1

The NPV or net present value is found by subtracting a project's initial investment from the present value of its cash inflows discounted at arate equal to the firm's cost of capital. If NPV is positive, that means that the value of the revenues (cash inflows) is greater than the costs (cash outflows). If NPV is negative, that means that the value of the revenues (cash inflows) is less than the costs (cash outflows). If the NPV represents a positive value, the project would be a worthwhileinvestment to take on while a negative value would cause the opposite.

Internal rate of return is the rate that the firm will earn if it invests in the projectand receives the given cash flows. If the IRR percentage is greater than the cost of the capital the project would be worthwhile.If the percentage is less than the cost of the capital, the project could pose a risk.

IRR's major limitation is also its greatest strength: It uses one singel discount rate to evaluate every investment.IRRcan give varied accounts based on the changes in cash flow.When cash is inconsistent, the IRR may have multiple figures that can causeuncertainty.For any project that is long­term, that has multiple cash flows at different dicount rates, or uncertain cash flows ­ in fact foralmost any project at all ­ simple IRR isn't good for much more than presentation value.