Question

  Ranking is an important consideration when projects are mutually exclusive or when capital rationing is necessary. When projects are mutually exclusive, ranking enables the firm to determine which project is best from a financial standpoint. When capital rationing is necessary, ranking projects will provide a logical starting point for determining what group of projects to accept. However, there are instances wherein Financial Managers are faced with conflicting rankings using NPV and IRR. It is difficult to choose one approach over the other, because the theoretical and practical strengths of the approaches differ. Interpret both NPV and IRR techniques by highlighting its respective strengths and weaknesses in both theoretical and practical dimensions

Answer 1

NPV and IRR are both capital budget evaluation technique used by companies across the world in their project evaluation. Both techniques have their own strength and weakness. NPV is a more widely used approach than IRR. The focus of NPV is on finding how much value is being added to the firm, if the project has positive NPV then the project is said to be creating value for the company. The benefit of NPV is also that it does consider the time value of money concept and is sensitive to the change in the required rate. The NPV does consider all the cash flows occurring from the project. The weakness of the NV method lies in the fact that the cash flow and the required rate are estimated by the managers so the efficiency of the NPV lies in the input. The IRR method is quite simple to use and it is used in comparative way. We calculate the IRR of the project and then compare it with the required rate on the project, if the project IRR is greater than the required rate, we accept the project. The disadvantage of the IRR method is that with multiple cash inflows and outflows, the number of IRR will also increase and making it slightly complicated. It also assumes that the cash flow is being reinvested at the IRR which is not always a feasible thing.