NPV technique is a discounted cash flow method that considers the time value of money in evaluating capital investments. It is a method of calculating return on investment of a project by taking into consideration all the expected cash flows from the project and translating those into today’s rupees value (Gallo, 2014). In simple term, NPV is the difference between the present value of future cash inflows and initial investment. It represents the contribution of the investment to the value of the firm and the wealth of shareholders (Moyer, McGuigan, Rao, & Kretlow, 2012). The proposed project is selected if the NPV is equal to or greater than zero.
Assumptions
The NPV of a project is calculated based on the following assumptions:
A rupee in future will not worth as much as a rupee today. So all the future cash flows are translated to present value by discounting them at the cost of capital.
The inflow or outflow of cash other than the initial investment occur at the end of each period.
The discount rate or cost of capital remains same throughout the life of the project.
The cash generated by a project is immediately reinvested at the cost of capital.
Limitations
Some of the limitations of this method are:
The assumption about the immediate reinvestment of cash generated by the project may not be always reasonable due to changing economic conditions (Accounting for Management.Org 14).
It does not consider the non-cash benefits generated from a project into consideration while making decisions.
Since NPV is calculated on the basis of estimated cash flows and discount rate, there is room for error and accuracy cannot guaranteed.
The cost of capital may change over the life of period and NPV does not provide criteria for addressing the change in discount rate.
Internal Rate of Return (IRR)
IRR is the estimated rate of return offered by an investment that makes the present value of subsequent net cash inflows equal to the initial investment. It is the rate of return at which NPV of the investment will be zero. Thus it is the break even rate that equates the present value of cash inflows with present value of cash outflows (Gallo, A Refresher on Internal Rate of Return, 2016). Based on this criteria, the projects having IRR higher than the required rate of return are accepted.
Assumptions
The assumptions of IRR is similar to that of NPV except for the reinvestment rate of generated cash flow. It includes:
It considers both the magnitude and timing of cash flows.
The discount rate does not change over the life of the project.
The cash flows generated from the proposed project are reinvested at the calculated IRR.
Limitations
Some of the major limitations of IRR method are:
It does not address issues of scale or size of investment. It means if the IRR of a project is estimated to be 20%, it may be 20% of Rs. 100, Rs. 1000 or Rs. 100000.
IRR alone is not sufficient for decision making process. It need to be compared with the required rate of return.
The reinvestment of the generated cash flows at IRR is an unrealistic assumption. To generate the return equal to IRR, the firm should have multiple investment opportunities that is not always true in real market scenario.
There is chance of getting multiple IRRs in case of projects that require additional investment during the life time of the project or projects with unconventional cash flows that complicates the decision making process.
Which is Better: NPV or IRR
NPV and IRR are recurrently used methods for evaluating projects. In case of independent projects, the NPV and IRR both give similar results. The NPV is positive if the IRR is greater than cost of capital and vice-versa. But, in case of mutually exclusive projects, they might give contradictory results. Both NPV and IRR have their own significance but if we have to choose between these two, NPV is superior and beneficial because of the following reasons:
NPV assumes that the cash flows are reinvested at cost of capital which is more realistic and practical than the assumption of IRR where reinvestment rate is equal to the calculated IRR.
NPV shows the value addition to the company in rupee value which is easier to understand than the straight forward calculations shown in percentage by IRR. The actual amount by which the project adds value to the firm cannot be estimated easily by using IRR.
References
Accounting for Management.Org. (n.d.). Net Present Value Method. Retrieved from Capital Budgeting Techniques
Gallo, A. (2014, November 19). A Refresher on Net Present Value. Hravard Business Review .
Gallo, A. (2016, March 17). A Refresher on Internal Rate of Return. Harvard Business Review .
Moyer, R. C., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management (12th ed.). Oklahoma: Cengage Learning.
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Net Present Value (NPV)
NPV technique is a discounted cash flow method that considers the time value of money in evaluating capital investments. It is a method of calculating return on investment of a project by taking into consideration all the expected cash flows from the project and translating those into today’s rupees value (Gallo, 2014). In simple term, NPV is the difference between the present value of future cash inflows and initial investment. It represents the contribution of the investment to the value of the firm and the wealth of shareholders (Moyer, McGuigan, Rao, & Kretlow, 2012). The proposed project is selected if the NPV is equal to or greater than zero.
Assumptions
The NPV of a project is calculated based on the following assumptions:
Limitations
Some of the limitations of this method are:
Internal Rate of Return (IRR)
IRR is the estimated rate of return offered by an investment that makes the present value of subsequent net cash inflows equal to the initial investment. It is the rate of return at which NPV of the investment will be zero. Thus it is the break even rate that equates the present value of cash inflows with present value of cash outflows (Gallo, A Refresher on Internal Rate of Return, 2016). Based on this criteria, the projects having IRR higher than the required rate of return are accepted.
Assumptions
The assumptions of IRR is similar to that of NPV except for the reinvestment rate of generated cash flow. It includes:
Limitations
Some of the major limitations of IRR method are:
Which is Better: NPV or IRR
NPV and IRR are recurrently used methods for evaluating projects. In case of independent projects, the NPV and IRR both give similar results. The NPV is positive if the IRR is greater than cost of capital and vice-versa. But, in case of mutually exclusive projects, they might give contradictory results. Both NPV and IRR have their own significance but if we have to choose between these two, NPV is superior and beneficial because of the following reasons:
References
Accounting for Management.Org. (n.d.). Net Present Value Method. Retrieved from Capital Budgeting Techniques
Gallo, A. (2014, November 19). A Refresher on Net Present Value. Hravard Business Review .
Gallo, A. (2016, March 17). A Refresher on Internal Rate of Return. Harvard Business Review .
Moyer, R. C., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management (12th ed.). Oklahoma: Cengage Learning.