Question

Compare the merits between the Net Present Value (NPV) and Internal Rate of Return (IRR) methods of capital budgeting.

(600 WORDS)

Answer 1

NPV = PV of cash flows - Initial Investment. NPV is the best capital budgeting tool to identify a project between mutually exclusive projects and independent projects and to calculate the profitability of the investment. The discounting factor taken here is the WACC of the project which is calculated by weighted average of cost of equity, debt and preferred stock. Accuracy of NPV is dependent on prediction of future cash flows and WACC calculation. Any error in this calculation could lead to accepting of bad projects and rejecting of good projects.

NPV ignores tax savings in valuation.

NPV strengths:
1. it factors in time value of money
2. It includes risk involves in generating cash flow.
3. It is good in evaluating project involving large investment is of large scale projects.
4. Here reinvestment rate is discount rate or WACC which is lower than IRR.
5. It helps in ranking between projects.

Weakness:
1. it is sensitive to discount rate. Faulty calculation of discount rate can distort the results.
2. Cash flow prediction is sometimes subjective leading to variance with actual NPV.

Assumptions:
1. The reinvestment rate is same as WACC and is reinvested at higher or lower rate.
2. If two projects are equally risky, their reinvestment-rate is the same

Improvement:
1. It can be improved by adding extra risk premium on WACC and estimating cash flows meticulously.

IRR:
Advantages:
1. Includes time value of money.
2. Good in accepting independent projects.

Disadvantages
1. Is not good for acceptability with large scale projects where it might be rejected when comparing with small scale project if IRR is higher.
2. IRR and NPV may conflict in certain case where NPV rule Prevails.
3. IRR rate is higher than WACC generally so reinvestment as higher than WACC may not be possible always.
4. It gives multiple IRR when have more than one negative cash flows occur in the project

Assumptions:
1.Reinvestment rate is same as IRR which may not be practical.
2. Two different projects, even if equally risky, have two different reinvestment-rates