Question

What is the relationship among present value, net present value, and internal rate of return? Is there a consistent relationship at all possible values for these measures?

Answer 1

1. Present Value=It is the discounted value of the cash flows.

2. Net present value.
NPV = present value of cash inflow- the present value of cash outflow.

Discounted at the cost of capital/required rate of return.

NPV must be positive to accept the project.

In case of a mutually exclusive project, The project with the highest net present value is given the priority.

Pros: provide absolute dollar Returns.

Cons: less insightful in terms of profitability and interest rates.

3.Internal rate of return (IRR)

IRR: It is the discount rate at which the present value of projects cash outflows (cost) is equal to the present value of projects cash inflow.

The IRR must be above the cost of capital/required rate of return to accept the project.

In case of a mutually exclusive project, The project with the highest internal rate of return given the first priority.

Pros: It provides the hurdle rate above which to accept the project.

Cons: IRR method reinvest the intermediate cash flow at IRR rate, which is not true and hence not a better technique.


All three of them help to make capital budgeting decisions. They are techniques which help to determine if the present consumption at a specific discount rate is desirable or not.