Question

In an essay, discuss the advantages and disadvantages of using (1) NPV analysis and (2) IRR analysis to evaluate projects.

Answer 1

Advantages of using NPV ANALYSIS are as follows:

1) The primary advantage of using NPV ANALYSIS is that it considers the concept of THE TIME VALUE OF MONEY. The computation under NPV takes into account the discounted net cash flow of an investment in order to determine its viability.

2) Another advantage is that the NPV ANALYSIS is useful for the company in decision making. It helps in indentifying whether a particular investment is profit making or loss making that is it helps company to make decision that whether the project should be accepted or not.

DISADVANTAGES OF NPV ANALYSIS ARE:

1) The entire computation of NPV rests on discounting the future cashflows to its present value using the required rate of return. However there is no guidelines regarding determination of this rates. It is in the hands of the company to decide the percentage value and there could be instances wherein NPV was inaccurate due to an inaccurate rate of return.

2) Another disadvantage could be that it would be difficult to compare project of different sizes. NPV of larger projects would be higher then the NPV of the project of smaller size.

3) NPV considers only the cash inflows and outflows of a particular project. It doesn't take into account the sunk cost, hidden cost or other preliminary cost incurred in relation to a particular project.

ADVANTAGES OF IRR ANALYSIS ARE AS FOLLOWS:

1) This concept takes into account the time value of money concept.

2) The profitability of the project is considered over the entire economic life of the project.

3) In case of irr pre determination of cost of capital or cut off rate is not required.

4) The ranking of project proposal is very easy in case OF IRR

DISADVANTAGES ARE AS FOLLOWS:

1) In this method it is assumed that the earnings are reinvested at the internal rate of return for the remaining life of the project

2) In case of IRR , it focuses only on profitability but doesn't take into account the earliest recouping of capital expenditure.