NPV gives a profit (discounted revenues minus discounted costs) for a project. IRR gives the rate...

NPV gives a profit (discounted revenues minus discounted costs) for a project. IRR gives the rate of return on the initial investment a project produces. Both are rational criteria, but depending on the situation one may give a clearer picture of the opportunities of a project compared to the other. Discuss with examples to support your arguments.

Expert Solution

Answer :-

Net Present Value (NPV) and IRR both are the measures to evaluate the economic viability of any project. NPV gives the present value of the expected profit from the project while IRR gives the rate of return that the project might yield.
However, depending upon the situation the and facts of the case, one of these two measures might be preferable over the other. Detailed discussion and explanation is given as follow:

IRR might be more useful when we want to compare the project's profitability with the cost of capital, as it gives the return from the project in the percentage form, which makes it easy for comparison with the required cost of capital.
It is might also be very preferable for the project with short period of life.
However, NPV is a better tool compared to IRR as it can also be used for long term projects.
While discount rates and the market conditions change during the lifetime of the project, IRR cannot be more useful.However, NPV gives a clear picture in such situations also.
For example, if rate of return on a bond is changed in range of 5% to 30% during the 25 years of the project life, then in that situation NPV can give a clear picture whereas IRR can also give more than one IRRs, but it would not be effective. Rather it would create confusion only.
Also the assumptions used in the NPV approach are more realistic as compared to the assumptions used in IRR approach.
Hence, NPV method is more realistic and preferable approach to evaluate the project.

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