Internal Rate Of Return (Irr) And Net Present Value (Npv) Are Both Powerful Tools Used In Business To Determine Whether Or Not To Invest In A Particular Project; Both Methods Have Its Pros And Cons

914 words - 4 pages

Internal Rate of Return (IRR) and Net Present Value (NPV) are both powerful tools used in business to determine whether or not to invest in a particular project; both methods have its pros and cons. If given a choice I would choose NPV, because of the potential to anticipate profitability.As it is assumed that the objective of a firm is to create as much shareholder wealth as possible for its owners through the efficient use of resources, the preferred method in determining whether or not to invest in a project is NPV. The reason for this is that NPV takes into account all the costs and benefits of an investment opportunity, making a logical allowance for the time factor. Generally speaking ...view middle of the document...

But this Cost of Capital can change and can be subject to disagreement. The NPV calculation is only valid for the interest rate that has been used. If an organization has appraised its capital investment proposals using one interest rate it will have a series of 'go' or 'no go' decisions which will only be valid for that interest rate. If the interest rate rises or falls, the decisions will no longer be valid; the calculations will have to be re-worked and new decisions taken.IRR is the flip side of NPV and is based on the same principles and the same math. NPV shows the value of a stream of future cash flows discounted back to the present by some percentage that represents the minimum desired rate of return, often your company's cost of capital. IRR, on the other hand, computes a break-even rate of return. It shows the discount rate below which an investment results in a positive NPV (and should be made) and above which an investment results in a negative NPV (and should be avoided). It's the breakeven discount rate, the rate at which the value of cash outflows equals the value of cash inflows. One can appreciate the problems of this method when we consider appraising several projects alongside each other. IRR is the exposure of future earnings and capital to interest rate changes. Interest rate fluctuations affect earnings by changing net interest income and other interest-sensitive income.Firstly, it is popular because of its simplicity. Research over the years has shown that firms favor it and...

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