Question

why is the NPV a better method than using the IRR for project rankings?

which would you rather use?

how can you apply the capital budgeting techniques to your purchase of a rental property?

Answer 1

Introduction

Whenever a long term asset is to be purchased by a company in which there is huge capital is being invested, the company plans the feasibility of the project by using some financial techniques called Capital budgeting Techniques. When the company takes any decision using these techniques then it is called as capital budgeting decision. In the question NPV (Net Present Value) and IRR (Internal Rate of Return) are two sort of techniques for taking capital budgeting decision.

NPV Method

Net Present Value Technique uses the difference of Present Value of Cash Inflows and Present Value of Cash Outflows. The decision taken by using NPV is when there is a positive NPV. A surplus NPV States that the project would be feasible for the company.

NPV= (Present Value of Cash Inflows) - (Present Value of Cash Outflows)

Decision:

Positive NPV: Accept The Project

Negative NPV : Reject the Project

IRR Method

It is also a Capital Budgeting Technique. It uses NPV. It is calculated on trial and error basis. IRR is that rate of return at which NPV is zero. It helps the company to choose profitable projects.

Decision using IRR

When the Project's IRR is greater than company's required rate of return then the project should be accepted.

Conclusion: NPV Versus IRR

There is a very common thing in both the techniques that both use time value of money or present value concept. But NPV is just a number stating the profit only fact but IRR Can be compared with company's required rate of return which provides a strong base to use IRR and proves it a better technique.

Using Capital Budgeting Technique to buy Rental Property:

One can use capital budgeting technique in the case of rental property when the rental property is to be used for any business related operations.

Example: Rental property means giving someone one's house/apartment or land for their personal/business purpose. One can compute the same by using NPV method. Here the inflows would be the monthly rent and that can be computed by taking a discount rate. One can also use other techniques of capital budgeting like payback method, which helps to let one know that when the investor would get the payback or the money of his initial investment. The investor can use any technique depending upon his requirements