Question

Explain FIVE conflicts between NPV and IRR

Answer 1

NPV or Net Present Value refers to the Present Value of net benefits which will be achieved throughout the life of the project. It is calculated on the basis of return required by the company.

IRR or Internal Rate of Return is the rate of return at which NPV becomes zero. It is the minimum return required by the company to recover its cost.

Differences between Net Present Value and Internal Rate of Return:

(i) Net present value method determines the PV by discounting the future cash flows of a project at a predetermined rate called the cut off rate based on cost of capital.

Internal rate of return method determines PV by discounting cash flows at a suitable rate which equates the present value to the amount of the investment.

(ii) NPV method recognizes the importance of cost of capital. It determines the amount to be invested in a given project by anticipating earnings that would recover the amount invested in the project at market rate.

IRR method does not consider the market rate of interest and determines the maximum rate of interest at which funds invested in any project could be repaid with the earnings generated by the project.

(iii) NPV method presumes that the intermediate cash inflows are reinvested at the cut off rate, whereas, in the case of IRR method, intermediate cash flows are presumed to be reinvested at the internal rate of return.

(iv) NPV method helps in decision making between two projects based on net benefit derived from them throughout the life of the project and makes decision making easy.

IRR method reduces the PV of cash flow to zero, thus, does not help in decision making.

(v) NPV is expressed in absolute numerical terms whereas IRR is expressed in percentage terms.