Question

Net present value (NPV) method and internal rate of return (IRR) are largely used by firms to assess financial feasibility of an investment. It is also not uncommon to find that these two methods provide conflicting signals on the viability of a project.

Explain how do these two methods differ from payback period and accounting rate of return methods, and discuss how NPV-IRR conflict can be remedied.

Answer 1

Net present value and Internal rate of return differs from the payback period and accounting rate of return in significant ways. Net present value considers all the cash flows and discounts it at the required rate to calculate the present value and then subtract the cash outflows. Payback period focuses on how quickly the invested capital can be recovered and it does not consider the later period cash flows. Accounting rate of return does not consider the time value of money which is done by the NPV and IRR, it simply calculates as to how much the net income is generated on an annual basis. The IRR simply calculates the rate at which the cash outflow is equal to the cash inflow that means the NPV is zero.

The NPV and IRR conflict can arise because the IRR assumes that reinvestment is being done at the IRR which is not a feasible assumptions, one way to reduce the conflict is to focus on projects where the IRR is greater than the required rate of return and then use the NPV method, NPV method is more reliable because it gives the value in dollar terms as to what value addition is being done the project so NPV should be more often used.