An intern from DU at your firm is confused by the NPV and IRR rules in...

An intern from DU at your firm is confused by the NPV and IRR rules in the capital budgeting process. Please provide an overview of how these rules work. Your answer should cover not only situations where the firm’s projects are independent or if they are mutually exclusive, but also when the two rules will be in agreement or disagreement.

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Expert Solution

NPV (net present Value) is the difference between present value of inflows and initial outflow.The present value of the inflows is determined by discounting the cash flows to the year 0 using a given discount rate .It is used to asses the viability of a project.It helps determine the value addition that a project can bring to a firm.NPV assumes that the inflows are reinvested at the cost of capital.

IRR(Internal rate of return) is the discount rate at which the Present value of inflows becomes equal to the initial outflow.IRR is used to rank projects according to their computed IRR.Projects with IRR greater than the cost of capital are accepted.IRR makes an assumption that inflows are reinvested at the IRR itself.

When the projects being considered are mutually exclusive the project with higher NPV would be picked the NPV method is preferred under such a circumstance because ,NPV method assumes that inflows are reinvested at the cost of capital.this is amore realistic assumption than that of the IRR assumption that they are reinvested at the IRR itself.NPV method is more reliable than the IRR method when it comes to projects with several alternating periods ,because it can lead to maximizing of shareholder wealth.

When it comes to independent projects the projects with positive NPV or higher IRR than cost of capital are accpeted based on the criteria selected(NPV or IRR)

When the NPV is positive the IRR of the project would also be higher tan the discount rate.The NPV method and IRR method might be in disagreement due to the difference in initial outlay ,size or timing so inflows or the lie of the projects.In such cases the mangers go with the NPV method,and picks the project with the highest NPV.

In conclusion the NPV method is the most accepted project evaluation method among the two.

jeff jeffy answered 1 year ago

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