Question

Compare and contrast NPV and IRR. Out of the six capital budgeting decision models which would you choose to measure a potential project and why?

Answer 1

Ans: NPV = Net Present Value, 1. it is the net value of the cash flows after discounting them with the given required rate of return or cost of capital to give an idea for project is giving positive net cash flows or not.

2. It is expressed in absolute value.

3. It shows surplus of cash flows.

4. Easy decision making in NPV method.

While IRR = internal rate of return ,1. is the rate at which the future cash flows discounted values equal to the initial cost involved.

2. It is calculated in percenage.

3. It shows no profit /no loss(breakeven)

4. Difficult in this case many times.

Six Capital budgeting Decision Models :

a) Payback period

b) Discounted payback period

c) NPV

d) IRR

e) Modified Internal rate of return

f) Profitability Index

As per me the NPV method is best among all, as it derives the cash flows time value of money at cost of capital consistently, It is again a drawback of this method that cost of capital is not changing over a period of time. But again deciding on cost of capital is the major challenge, else it makes very easier and accurate for the project seems viable or not.

Other methods like payback period is not giving the actual values of cash flows , discounted payback is comparing the inflows and outflows, better is to use NPV. IRR is giving breakeven analysis, which makes it difficult to decide with IRR only and MIRR is just its extension. Profitability index can be one method but preffered is NPV as it gives incremental value.