Question

1)the major differences between the NPV and IRR method for capital budgeting analysis. Also, explain the pros and cons of the IRR technique in the capital budgeting analysis.

2)What should be used as an appropriate discount rate for the project analysis of a division whose risk level is different from that of the company as a whole. Explain why.

Answer 1

Solution 1) :

The major difference between NPV and IRR is that the IRR is the internal rate of return which shows the percentage figure and it is the rate at which the net present value is zero. The net present value is in dollar amounts.

NPV focus on project surplus and IRR focus on breakeven cash flow.

NPV gives the amount as in how much the investor will get the cash benefits whereas IRR gives a percentage return expected from the project.

NPV we need the discount rate to be derived to discount the future cash flow and arrive at the net present value whereas IRR doesn't have that issue.

There are 2 major pros of using the IRR for capital budgeting:

1) Time value of money - it gives an accurate rate of return expected where the net present value is zero.

2) Simplicity :

The IRR is an easy measure to calculate and provides a simple means by which to compare the worth of various projects under consideration

Cons of IRR are :

1) It ignores the size of the project which leads to not an accurate expected rate of return.

2) It ignores the future cost.

3) It ignores the replacement rate as well.