Question

how do you answer a capital bugeting question ? NPV Profiles ? IRR?

Answer 1

IRR is used to estimate the profitability of any investments using a percentage value. The method is simple and frequently used in capital budgeting. But for a long-term project with several cash flows at varying discount rates, IRR does not provide an effective measurement and NPV method may be used.

In NPV method, we estimate the project's future cash flows and discount these cash flows into present value using a discount rate. The discount rate depends upon the riskiness of project, CoC etc. Finally, the project's future cash flows are then reduced to a final single present value figure which is then adjusted aginst the initial investment to get the final NPV value of project.

NPV method is superior to IRR method since it can handle multiple discount rates without any problems. Each year's cash flow can be discounted separately from the others in NPV method. However, at the same time, it may be noted that NPV method is more complex and we have to make assumptions at each stage.