Question

Explain how IRR, Net Present Value and payback period can be used to evaluate capital decisions. What are some problems with IRR? Explain what each metric actually measures and how those measurements can be used in decision making.

Answer 1

IRR	Internal rate of return is a capital budgeting techniques which is used to measure the performance of project. It is the rate of return at which NPV is zero. IRR is the minimum rate of return which a business or project should earn. IRR is compared to cost of capital and if IRR is less than cost of capital, project should be rejected
NPV	NPV is another method used for capital budgeting decisions, Is the excess value of present value of cash inflow over cash outflow. Project with higher value of NPV would be considered for selection. A negative NPV projects are always declined
PayBack period	It is a measure of recovery period of initial investment. It is used to calculate that how early investment in projects are recovered. A lower Payback period is always preferable
Problem with IRR	One major problem with IRR is that when projects of unequal life and investment, in that situation IRR often give contradictory results in comparison to IRR and One assumption of IRR, to reinvest the cash flow at a rate equal to IRR is a misleading assumption which leads to misleading results
IRR measures the rate of return on the project over the life and those projects with higher IRR will be seleted, NPV is used to measure the net benefits of investment over the initial investment and payback period is used to measure the time required to recover the initial investment. These tehniques can be used to decision making by taking the best project on the basis of IRR NPV and Payback period