Question

How do IRR and NPV interact to evaluate capital projects? What are some difficulties in estimating cash flows?

Answer 1

Part 1:

Net present Value (NPV) is calculated as: -initial cash out flow + Present value of the cash flows using discount rate

To calculate IRR (internal rate of return), we equate NPV=0 and then solve for discount rate. The value of this discount rate is the IRR

If NPV < 0, then IRR < Cost of Capital. In this case we need to reject the investment due to negative NPV and IRR less than cost of capital. Negative NPV reduces the value of a business.
If NPV = 0 , IRR = Cost of Capital: This provides the minimum return. A company can reject a capital project from cash flow perspective as it is not going to add value to the business due to zero NPV.
If NPV > 0, IRR > Cost of capital: Here a company can accept the capital project that would be most profitable.

Part 2

Cash flows cannot be estimated without reinvestment estimation.
If we are not able to identify the changes in working capital and the net capital expenditures, it will not be possible to estimate cash flows.
It becomes more difficult to estimate the future growth in a case in which the rate of reinvestment cannot be measured.