Question

Discuss the NPV and the IRR. How do the two values differ? and provide an example for both.

Answer 1

NPV (Net Present Value):-

- The present value of a project's future cash flows less initial cost
- The discount rate takes into account the project's risk
- Provides an estimate of the change in shareholder wealth as a result of undertaking the project.

NPV > 0 (ie the return on the project is greater than the initial cost), ACCEPT
NPV < 0 (ie as the return on the project is less than initial cost), REJECT

IRR (Internal Rate of Return):-

- The discount rate that results in a zero NPV for the project.
- Represents the compound annual rate of return that the project earns over its life.
- Entities using IRR establish a hurdle discount rate that is market based, reflecting returns of other projects of similar risk.

IRR > Hurdle Rate, ACCEPT
IRR < Hurdle Rate, REJECT

The difference between NPV Decision Rule and the IRR Decision Rule is that with the NPV method, the discount rate is given and we find the NPV, versus with the IRR method, the NPV is equal to zero and we have to find the interest rate that provides this NPV.

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