Question

Two of the major capital budgeting decision methods are the Net Present Value (NPV) method and Internal Rate of Return (IRR) method. Compare those two methods, providing strengths and weaknesses. Further, under what circumstances would the NPV method work better than the IRR method? Provide examples

Answer 1

IRR is the rate at which NPV is zero

NPV is the difference betweeen cash inflow and cash outflow.

If discounting rrates are given in question we will use NPV method to arrive at a decision

if question specifically ask for IRR then only we calculate it, and in IRR also we calculate NPV of the project and then find IRR.

we have to do trial and hit error method to calculate IRR, for this we have to take 2 discounting factor rate and apply the figures in the formula to find the rate

Formula:-

Calculation of IRR

Lower Rate + NPV @ Higher Rate / Difference In NPV * (Higher rate - Lower rate)

example.

cost of machine=90000

Cash inflow 17000 every year for 8 years if we purchase this machine

IRR trial and hit error method using 2 rates

10% and 12 %

NPV @ 10%
Particulars	Amount
Cash Outflow
Cost of machine	90000
Cash Inflow
Note1	90693.75
Net Present Value	693.7453643
(Inflow - Outflow)
Year	Cash Flow	Present Value Factor@10%	Discounted Cash Flows
1	17000	0.909	15454.54545
2	17000	0.826	14049.58678
3	17000	0.751	12772.35162
4	17000	0.683	11611.22874
5	17000	0.621	10555.66249
6	17000	0.564	9596.056811
7	17000	0.513	8723.68801
8	17000	0.467	7930.625464
TOTAL		5.335	90693.75
NPV @ 12%
Particulars	Amount
Cash Outflow
Cost of machine	90000
Cash Inflow
Note1	84449.88
Net Present Value	-5550.123964
(Inflow - Outflow)
Year	Cash Flow	Present Value Factor @12%	Discounted Cash Flows
1	17000	0.893	15178.57143
2	17000	0.797	13552.29592
3	17000	0.712	12100.26421
4	17000	0.636	10803.80733
5	17000	0.567	9646.256547
6	17000	0.507	8612.72906
7	17000	0.452	7689.936661
8	17000	0.404	6866.014876
TOTAL		4.968	84449.88
Calculation of IRR	Lower Rate + NPV @ Higher Rate / Difference In NPV * (Higher rate - Lower rate)
	10 + (-5550.12/(-5550.12-693.75) * (12-10)
IRR	11.78%

I have explained everything step by step

Go through it once and everything will be cleared.

Hope you understand the concept

Please give positive feedback by giving thumsup

Thankyou