Internal Rate of Return (IRR) is the discount rate that equates the NPV equivalent to zero. It helps in the decision making for selection of project as higher the IRR than the cost of capital positive signal for the selection of the project. (Moyer, McGuigan, Rao, & Kretlow, 2012)
Assumption of IRR
IRR is the discounted rate of also called an interest rate. This helps investors decide on which investment yields higher return. But on of its biggest assumption is that the cash flow generated each year is reinvested in the same project and its rate of return is the IRR. This may not be realistic as people may invest in other projects and the actual rate of return may be lower than the assumed IRR.
Limitation of IRR
IRR is basically just the interest rate that is used to calculate how much the project will earn at the end of the period when cash flow of each year is reinvested. However with varied cash flow which may be positive and negative in some years can generate multiple IRRs. This will make it impossible to choose which IRR to follow.
Net Present Value (NPV) is a tool used in capital budgeting for decision making of either selecting or rejecting a project. It calculates the positive or negative return from investment in the allocated period by calculating the discounted cash flows.
"The net present value–that is, the present value of the expected future cash flows minus the initial outlay–of an investment made by a firm represents the contribution of that investment to the value of the firm and, accordingly, to the wealth of the firm’s shareholders (Moyer, McGuigan, Rao, & Kretlow, 2012).”
Assumption of NPV
The discount rate at which NPV is calculated is assumed. We know that lower discount rate yield positive NPV while higher NPV yield negative and since we need positive NPV to select a project there is no concrete way to select a discount rate other than assuming.
Limitation of NPV
NPV only calculates up to the point of positive cash flow and does not review the profit made by the project. This is a limitation. As after the breakeven the cash flow goes negative in the NPV profile.
Reference
Moyer, C. R., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management. Natorp Boulevard: South-Western, Cengage Learning.
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Internal Rate of Return (IRR) is the discount rate that equates the NPV equivalent to zero. It helps in the decision making for selection of project as higher the IRR than the cost of capital positive signal for the selection of the project. (Moyer, McGuigan, Rao, & Kretlow, 2012)
Assumption of IRR
IRR is the discounted rate of also called an interest rate. This helps investors decide on which investment yields higher return. But on of its biggest assumption is that the cash flow generated each year is reinvested in the same project and its rate of return is the IRR. This may not be realistic as people may invest in other projects and the actual rate of return may be lower than the assumed IRR.
Limitation of IRR
IRR is basically just the interest rate that is used to calculate how much the project will earn at the end of the period when cash flow of each year is reinvested. However with varied cash flow which may be positive and negative in some years can generate multiple IRRs. This will make it impossible to choose which IRR to follow.
Net Present Value (NPV) is a tool used in capital budgeting for decision making of either selecting or rejecting a project. It calculates the positive or negative return from investment in the allocated period by calculating the discounted cash flows.
"The net present value–that is, the present value of the expected future cash flows minus the initial outlay–of an investment made by a firm represents the contribution of that investment to the value of the firm and, accordingly, to the wealth of the firm’s shareholders (Moyer, McGuigan, Rao, & Kretlow, 2012).”
Assumption of NPV
The discount rate at which NPV is calculated is assumed. We know that lower discount rate yield positive NPV while higher NPV yield negative and since we need positive NPV to select a project there is no concrete way to select a discount rate other than assuming.
Limitation of NPV
NPV only calculates up to the point of positive cash flow and does not review the profit made by the project. This is a limitation. As after the breakeven the cash flow goes negative in the NPV profile.
Reference
Moyer, C. R., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management. Natorp Boulevard: South-Western, Cengage Learning.