Question

Discuss: Evaluate the strengths and limitations of NPV and IRR methods. Also, compare NPV and IRR.

Answer 1

NPV - This is basically the net present value of future cash flows which company expects to receive over a period of time if they invest in some project. It is :

NPV = -PV of cash outflow + Present value of cash inflows

If NPV is positive, it means that the project is worth taking and it will add value to the shareholders. This is the biggest advantage of NPV. Also it takes into considration the cost of capital. So it means that if we are projecting the cash flows for longer period, the risk will be more which will increase the cost of capital.

Limitation is that it is very sensitive to the discount rate ( cost of capital ) we use to find the present value. If cost of capital is too low, it will lead to higher NPV but if the investment itself is suboptimal. Similarly if cost of capital is too high, we might have to forgo good investments due to negetive NPV.

Also it cannot be used to compare 2 projects of different sizes.

For example, if we have a project of $1 million, it has higher chances of giving +ve NPV than a $1000 project even if this small project provide us higher % returns.

IRR - This is the internal rate of return of a project and it is the minimum return which an investor should expect to achieve if he wants to invest in that project. This is basically the rate at which NPV = 0 or in other words. when cash inflow = cash outflow

This is very simple method and very easy to calculate. Also, it consider the timing of the cash flow i.e time value of money. We do not need cost of capital to calculate IRR

Limitation is that it does not consider the $ value of the profit which we are making. Suppose that we have IRR of 50% but the return itself is very small, on the other hand a different project with 20% have much higher actual return.

Also it has been assumed in this method that all the cash flows will be reinvested at IRR in future period which is impracticle. Market rates are not same as IRR always.

There can be multiple IRR if the project have unconventional cash flows. We generally assume the cash outflow will happen at starting and inflows will happen afterwards. This is conventional cash flows. But some times, we have to invest again during the project and in this case, Multiple IRRs can be possible

If we compare NPV and IRR, NPV should be choosen because it tells us the increase in investor's value. If there are 2 projects A and B, A has higher IRR than B but the NPV is -ve for A. We should not invest in A.