Question

What are the advantages and disadvantages of discounted cash flow methods such as NPV and IRR? Why is the NPV technique considered by many to be the superior method for evaluation.

Answer 1

What is IRR?

• Internal Rate of Return is discount rate in capital budgeting.This rate is used to bring present value of all cash flows of project.the higher expected rate of return ,higher the IRR. This is always preferable.this shows how much rate of growth a project can make.Actual result can be different reason being unexpected market conditions.

Advantages of IRR method:

• Time value of Money: This method gives really big consideration on time value of money,thus making it highly reliable.The time value of money is time dependent which makes it dependable.
• Simple:This is very easy to interpret.it is also very easy to use.The results are also very easy to study.This is also highly reliable.Due to this easy implementation many managers use this method.
• Hurdle Rate: This rate is the required rate of return.The IRR method does not consider this rate while checking the results which bypasses any possibilities of wrong interpretations.
• Rough Estimation:The required rate of return is a rough estimate .once IRR is found out ,it can be compared with rate of return.This also adds a safety measure.

Disadvantages of IRR method:

• Economies of Scale:The IRR method ignores economies of scale all together.the method ranks the projects on returns they produce.
• Mutually exclusive Projects:This means if one project is accepted then the other can't be accepted.This is very problematic because we can never tell which project will perform good and better than the other not on paper but in real life.
• Mix of positive and negative cash flows:This method is fully based on project's cash flow in future discounted at rate to bring to present.This flow might be positive or negative .In this situation the method tends to become unreliable.

What is NPV?

• NPV is difference between present cash inflow to the present cash outflow.For example we can say that it is the difference between dollar value today and the dollar value in future.

Advantages of NPV method:

• Maximize company value:Most of the current methods undertake rate of return as basis to select desired plan ,but this method focuses on net present value.It helps increasing value of firm ,profitable for shareholders.
• Use of time value of Money:Time value of money compares the value of money today with future amount.thus it can estimate future cash flow.This in turn provides reliability.

Disadvantages of NPV method:

• Forecasting Errors: NPV uses estimation largely.Longer the tenure the more is the risk.Therefore make the method inefficient.
• Reliability at Discount rate: The basis of this method is Discounting factor.This is the rate which is calculated on estimation.By any chance if the rate is not correct then the end result will be really misleading.

We can see that both of these models are important in proper business planning.

Why NPV is better?

• First let us clarify some pints.
  1. NVP uses cash flows,which is used for a number of purposes.
  2. NPV uses all cash flows unlike other methods which ignores cash flows.
  3. NPV discounts cash flows properly.
  4. All investments evaluated so that they can increase the share holder money.
• IRR does most things similar to NPV ,but IRR has unrealistic reinvestment rate assumption of cash flows.
• We have seen that all difficulties are bypassed by this method that is why this is the best method to analyze evaluate ,select big investment projects.But the estimation of cash flows needs to carefully done ,other wise the bound will be misleading.
• A problem with NPV is ,it considers the same discounting rate for inflow and out flows.Modified inter rate of return is a method more complex but improved which takes care of the problem.