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Where:
r = Discount rate
In addition to factoring all revenues and costs, it also takes into the account the timing of each
cash flow that can result in a large impact on the present value an investment. For example, it’s
better to have cash inflows sooner and cash outflows later, as opposed to the opposite of that
ADVANTAGES OF NPV
ASSUMPTION OF REINVESTMENT
Unlike IRR, using NPV makes sense because it does not assume that the cash flows will be
reinvested at IRR which is almost impossible. How can your cash flows get reinvested at the
project’s rate of return? Reinvesting the cash flows at IRR would mean you are investing back
the cash flows from your project into the market at the equivalent rate as that of your project’s
rate of return. You need to find another investment yielding same as your project for the
reinvestment. Well, that’s really difficult.
CONSIDERATION OF ALL CASH FLOWS
NPV takes into account each and every cash flow you define. It’s not like payback period
method or discounted payback period method which ignores cash flows beyond the payback
period.
GOOD MEASURE OF PROFITABILITY
If you wish to choose one single project from amongst many then NPV will be a good measure
of profitability. If you use IRR for mutually exclusive projects you might end up selecting small
projects with higher IRR and of a short-term nature at the expense of long-term (long-term value
creation is good for shareholders) and higher NPV projects.
FACTORS RISKS
Discount rates are used in calculating NPV; the risk of undertaking the project (Business risk,
financial risk, operating risk) gets factored into this method.
DISADVANTAGES OF NPV
OPTIMISTIC PROJECTIONS
Sometimes managers are too optimistic about the success of the project and since the corporate
finance team needs to sit with the management to take into account the business scenario of the
project; the cash flows considered might be too high. Hence, there can be an upward bias with
respect to this method.
CONCLUSION
Regardless of its disadvantages, finance managers widely use NPV and they consider it as a good
measure of profitability than IRR, discounted payback period and payback period
The internal rate of return (IRR) is a metric used in capital budgeting to estimate the
profitability of potential investments. The internal rate of return is a discount rate that makes
the net present value (NPV) of all cash flows from a particular project equal to zero. IRR
calculations rely on the same formula as NPV does.
Formula and Calculation for IRR
It is important for a business to look at the IRR as the plan for future growth and expansion. The
formula and calculation used to determine this figure follows.
IRR=NPV=t=1∑T(1+r)tCt−C0=0
where:
To calculate IRR using the formula, one would set NPV equal to zero and solve for the discount
rate (r), which is the IRR. Because of the nature of the formula, however, IRR cannot be
calculated analytically and must instead be calculated either through trial-and-error or using
software programmed to calculate IRR.
Generally speaking, the higher a project's internal rate of return, the more desirable it is to
undertake. IRR is uniform for investments of varying types and, as such, IRR can be used to rank
multiple prospective projects on a relatively even basis. Assuming the costs of investment are
equal among the various projects, the project with the highest IRR would probably be considered
the best and be undertaken first.
IRR is sometimes referred to as "economic rate of return" or "discounted cash flow rate of
return." The use of "internal" refers to the omission of external factors, such as the cost of
capital or inflation, from the calculation.
The first and the most important thing is that the internal rate of return considers the time value
of money when evaluating a project. This is a huge downfall in accounting rate of return, an
average rate of return and Pay Back period. One can measure IRR by calculating the interest rate
at which the PV of future cash flows is equal to the capital investment required.
SIMPLICITY
The most attractive thing about this method is that it is very simple to interpret after the IRR is
calculated. If the IRR exceeds the cost of capital, then accept the project, but not otherwise. This
is very easy to visualize for managers, which is why it’s preferable unless they come across
occasional outstanding situations, like mutually exclusive projects etc.
Advantages
Class: BBA(Hons)