Question

As finance manager of the company you should advise the manager about the best investment criteria to use in this situation. You should explain to the board of directors the pros and Cons of Npv method. In addition, in the meeting one of the managers claims that we should consider IRR for the project as well do you agree with hos opinion? explain your answer

Answer 1

Answer: NPV is the Net Present value method used to decide whether a company should Opt for a project or not. It Comes under the capital Budgeting in Finance.

Present Value Formula : Cash flow/(1+ discount rate)^(no of period)

Summation of all the present values gives us Net present value

Pros of using NPV:

1. It takes time value of Money in to consideration

2. It Can be applied to uneven cash flow patterns

3. Covers entire life of the project in the Calculation

Disadvantages of using NPV:

1. Not helpful in Comparing two projects. As most of the time Companies have to make a choice between projects of different periods

2. A lot Depends up on the Cost of Capital, Slight deviation or wrong assumption can give completely different results

IRR tells us the return rate at which NPV will be zero for the project.If IRR is greater than discount rate, project is good to go.

In majority cases, NPV and IRR gives us the same result but there could be variations in cases like

1.Where there is a mix of +ive and -ive cash flows, IRR becomes ineffective.

2. It is compared to discount rate, for longer period of projects it is very difficult to gauge the correct discount rate.

One can use IRR but NPV is a better method and suited more in deciding the projects with the above scenarios