Question

Give a real-life example of how each of the three calculations can be used in real life situations
Payback
NPV
IRR

Answer 1

1.Payback - It is used to find the period in which initial cash outlays will be equated with the discounted cash flows at present value. It is used in many capital budgeting decisions and the projects which have a low payback period are preferred as they tend to return the initial investment in quick period of time.

2.NPV- Net present value method is also used in capital budgeting decision of whether to invest into a particiular project or not .In this method, The cash inflows are discounted at the present value using a discounting rate of return.

Net present value is preferred when the net cash flows at present are greater than 0.

3.IRR- Internal rate of return is used to find a rate of return at which the cash inflows of a project will be equal to the cash initial outlays. Internal rate of return is an equilibrium rate of return at which the cash outflows at the begining are equated with the cash inflows at different future dates.

When the IRR is greater than WACC ,It means The required rate of return is greater than cost of capital and in such cases, the project is to be accepted.

IRR is used in mostly capital budgeting decisions when there is a huge capital investment to be made for longer periods.