Question

It is critical for businesses and investors to have an honest understanding of the value and risk involved in different investments. Professions related to accounting and finance have specific guidelines for performing these types of analysis and reporting their findings. Using the Payback Method, Internal Rate of Return, and Net Present Value.

Choose two of these three methods and compare and contrast them. Discuss the pros and cons of each. Determine which method is the better method and support your position.

we will explore why this is critical as well as some of the negative repercussions of dishonesty in this area.

Considering this please address the following prompts in your discussion:

·         Should these methods be detailed when projections, values and risks are presented?

·         Should it only be when these differ from the norm?

·         Who should decide?

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Answer 1

NPV or otherwise known as Net Present Value method, reckons the present value of the flow of cash, of an investment project, that uses the cost of capital as a discounting rate. On the other hand, IRR, i.e. internal rate of return is a rate of interest which matches present value of future cash flows with the initial capital outflow.

In the lifespan of every company, there comes a situation of a dilemma, where it has to make a choice between different projects. NPV and IRR are the two most common parameters used by the companies to decide, which investment proposal is best. However, in a certain project, both the two criterion give contradictory results, i.e. one project is acceptable if we consider the NPV method, but at the same time, IRR method favors another project.

The reasons of conflict amidst the two are due to the variance in the inflows, outflows, and life of the project.

Advantages of the Net Present Value Method

• The most important feature of the net present value method is that it is based on the idea that dollars received in the future are worth less than dollars in the bank today. Cash flow from future years is discounted back to the present to find their worth.
• The NPV method produces a dollar amount that indicates how much value the project will create for the company. Stockholders can see clearly how much a project will contribute to their value.
• The calculation of the NPV uses a company's cost of capital as the discount rate. This is the minimum rate of return that shareholders require for their investment in the company.

Disadvantages of Net Present Value

• The biggest problem with using the NPV is that it requires guessing about future cash flows and estimating a company's cost of capital.
• The NPV method is not applicable when comparing projects that have differing investment amounts. A larger project that requires more money should have a higher NPV, but that doesn't necessarily make it a better investment, compared to a smaller project. Frequently, a company has other qualitative factors to consider.

The NPV approach is difficult to apply when comparing projects that have different life spans.

Advantages of IRR

• This method is widely being used for its most attractive feature which is &ldquoSimplicity&rdquo. The tool gives a quick glance on the potential cash flow of the capital investment. It is also used for budgeting purpose.
• The tool considers the time value of money while assessing potentiality of capital investments.
• In IRR calculation, the required rate of return is not required to calculate the internal rate of interest.

Disadvantages of IRR

• The tool ignores the size of the project while comparing with other business projects. The cash flows are compared to the capital expenses which generates those cash flows. This can create huge problem while calculating IRR.
• The tool ignores future cost and reinvestment cost.
• While comparing the cash flow, when a project has negative cash flows in between positive cash flows, IRR equation will be solved with greater than one rate of return. Thereby getting trapped in multiple IRR.

I can conclude that if you are evaluating two or more mutually exclusive projects so better go for NPV method instead of IRR method. It is safe to depend on NPV method for selecting the best investment plan due to its realistic assumptions & better measure of profitability. Even you can make use of IRR method it is a great complement to NPV and will provide you accurate analysis for investment decisions. Also, NPV finds its usage in DCF Valuations to find the present value of Free Cash Flows to firm.

- These methods be detailed only when projections, values, and risks are presented.

- These may also be used even when these doesn't differ from the borm.

- The management of the organization should decide which of the methods to be followed for making a capital budget decision