Question

What is the NPV and IRR method for project valuation? In order to receive full credit for this answer, you should (1) Define NPV and IRR in your own words, (2) Provide the rules of acceptance/rejection, and (3) discuss at least one strength and one weakness in using this method.

Answer 1

1)NPV is the present value of all cash inflows subtracted by investment. It is the value added due to taking up a project.
IRR is the rate at which NPV of a project is 0. The discount rate of all cash flows which provides 0 NPV.

2. IF NPV is greater than 0 project should be accepted.
IF IRR is greater than cost of capital project should be accepted

3) NPV strengths:
1. it factors in time value of money
2. It includes risk involves in generating cash flow/.
3. It is good in evaluating project involving large investment is of large scale projects.
4. Here reinvestment rate is discount rate or WACC which is lower than IRR.
5. It helps in ranking between projects.
Weakness:
1. it is sensitive to discount rate. Faulty calculation of discount rate can distort the results.
2. Cash flow prediction is sometimes subjective leading to variance with actual NPV.

IRR:
Advantages:
1. Includes time value of money.
2. Good in accepting independent projects.

Disadvantages
1. Is not good for acceptability with large scale projects where it might be rejected when comparing with small scale project if IRR is higher.
2. IRR and NPV may conflict in certain case where NPV rule Prevails.
3. IRR rate is higher than WACC generally so reinvestment as higher than WACC may not be possible always.