Choosing The Best Investment Proposal: NPV Vs. IRR

Net Present Value (NPV)

Every organization faces dilemma condition in choosing 1 project from more than 2 projects. Companies choose the best project according to their needs and the requirements. These projects help the company to manage the operations and the process of the comapny. Projects must be chosen by the company after analyzing and evaluating the various requirements, demands and the problems in the process and the functions (Wright, Daugaard, Satrio and Brown, 2010). Basically, various techniques are available which could help a comapny to analyze and evaluate the best proposal on the basis of their needs and the requirements.

Net present values and internal rate of return is also one of the techniques which help a comapny to choose among 2 or more projects, the bets project. Both of this technique considers the different criteria to choose the best projects.

NPV stands for net present value. This technique depict that it is required for every business t identify the total profit according to the today’s worth of the invested amount. In this process, the cash inflow, cash outflow and the present value factors are considered to analyze the total profit which could be earned by the company if the investment is done in a particular project. This technique expresses that the profit making is the main aim of every business and every business is required to focus over it. Formula of NPV is as follows:

Net present value = present value of cash inflow – present value of cash outflow (Deegan, 2013)

IRR stands for internal rate of return. This technique depict that it is required for every business to identify the total return through the investment. In this process, the cash inflow, cash outflow, present value factors and cumulative frequencies are considered to analyze the total return which could be earned by the company if the investment is done in a particular project. This technique expresses that the analysis of return is requisite to identify the position of the proposal. Formula of IRR is as follows:

IRR  = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n

Where,

P0, P1…..Pn equals to the cash flow

IRR = internal rate of return (Du and Girma, 2009)

Garrison et al (2010) has depicted in his study that NPV is the total difference among the invested amount and the present value of all the cash inflows in the life of investment. Further, it has been reviewed that this method calculates and analyze the entire expected cash flows whether it is inflow or outflow through using the required rate of return. Further Damodaran (2011) has depicted that the internal rate of return is a technique of capital budgeting which is used by the firms to analyze the return in which the NPV of the investment would be zero. It depicts about a discount rate that leads the net present value of an investment towards a point where the total cash inflow and the cash outflow of a company is zero. It has been added by Burns and Walker (2015) that if 2 investments re compared than the investment with high IRR must be chosen as it would offer more returns to the company.

Internal Rate of Return (IRR)

Further, it has been found that the NPV is more approachable the the IRR by the companies on the basis of various advantaged of NPV techniques and various drawbacks of the IRR technique. In addition, it has been added that the performance and the position of the company also makes an impact over the capital budgeting techniques to choose the best investment proposal (Bodie, 2013). More, the factors and requirements of the investment and the organization also affect the decision of choosing the best technique to analyze and make a result about the best investment proposal method (Bierman and Smidt, 2012).

According to the various secondary sources, it has been found that organizations whose main motto is to make the profits and enjoy the growth, uses the net present value techniques to identify that the project must be accepted or not whereas the organizations who just want to look that on which discount rate the point of cash inflow and outflow would be similar uses the IRR technique to reach over a conclusion (Barlow, 2006).

Mainly, it has been found that the people go for the net present value technique for its simplicity and the best outcome whereas the IRR technique is complex to evaluate and reach over a conclusion. Further, this topic has been evaluated through analyzing a situation in which the following are the cash inflow and outflow of a company of two projects:

Cash Outflow	Cash Inflow
90,00,000
	3000000
	3000000
	3000000
	3000000
	3000000

Cash Outflow	Cash Inflow
24,00,000
	2000000
	800000
	200000
	200000
	200000

The investment would offer the return to the investors for five years and the above would be the cash inflow. Thus the following are the calculations of the NPV and IRR:

Calculation of Net Present Value
Years	Cash Outflow	Cash Inflow	Factors	P.V. of Cash Inflow	P.V. of Cash Outflow
0	90,00,000		1	0	9000000
1		3000000	0.869565	2608696	0
2		3000000	0.756144	2268431	0
3		3000000	0.657516	1972549	0
4		3000000	0.571753	1715260	0
5		3000000	0.497177	1491530	0
				10056465	9000000
NPV= Total Cash Inflow-Total cash outflow	1056465
Calculation of Net Present Value
Years	Cash Outflow	Cash Inflow	Factors	P.V. of Cash Inflow	P.V. of Cash Outflow
0	24,00,000		1	0	2400000
1		2000000	0.869565	1739130	0
2		800000	0.756144	604914.9	0
3		200000	0.657516	131503.2	0
4		200000	0.571753	114350.6	0
5		200000	0.497177	99435.35	0
				2689335	2400000
NPV= Total Cash Inflow-Total cash outflow	289334.6

Calculation Of IRR
Renovate
Years	Cash Inflow
0	-90,00,000
1	3000000
2	3000000
3	3000000
4	3000000
5	3000000
IRR	19.86%
Replacement
Years	Cash Inflow
0	-24,00,000
1	2000000
2	800000
3	200000
4	200000
5	200000
	23.69%

The above calculations depict that it is bit easy for the analyst and management to identify and evaluate the net present value whereas the calculations of the IRR is bit difficult and do not help the management to make a better decision about the performance and the evaluation of the business (Gitman and Zutter, 2012).

Through a study, it has been found that if the NPV of an investment proposal is positive than the project must be accepted by the comapny whereas if the result is negative than the project must not be accepted. 0 NPV depict that it depends over the organization to accept or not to accept the proposal (Gitman and Zutter, 2012). In case of IRR, if the internal rate of return of the project is more than the cost of capital of the comapny, than the project must be accepted whereas if the internal rate of return of the project is less than the cost of capital of the comapny, than the project must not be accepted (Garrison et al, 2010).

Comparison of NPV vs. IRR

According to this example and the study, it has been found that organizations could easily identify that from which investment they would be able to get the high return and how it would help the comapny to meet the objectives, and it also help the comapny to identify that the project must be accepted or not (Kaplan and Atkinson, 2015). At the same time, if the IRR techniques are taken into the context than it has been found that the it becomes tough for the organization to identify that from which investment they would be able to get the high return and how it would help the comapny to meet the objectives, and it is also tough to evaluate the result.

Advantages: 

Further, the advantages and disadvantages of NPV and IRR have been analyzed to identify the best capital budgeting technique for the business.

NPV:

In case of NPV, time value of money plays an important role. This technique depicts about the present value of all the future cash flows and put flows/ further, this technique shows its concern about the risk factor and the profitability factors. It takes the concern of cash flows in the investment life and after the investment as well (Gervais, Heaton and Odean, 2011).

IRR:

At the same time, IRR technique depicts the % of the required return from the investment. It offers the associated risk decision as well as guides the manager to make a better decision. It assists the organization to make a better decision about the actual return from the investment proposal.

NPV:

In case of NPV, it is not easy to reach over a conclusion when two projects must be evaluated with the different life of span. The calculations are very simple and that is why sometimes, it become tough to analyze the best result. Further, it is always not mandatory to reach over a good result through the NPV method as the assumptions could be wrong. The discount rate assumption is difficult (Lumby and Jones, 2007).

IRR:

At the same time, IRR technique depicts that if the % of cash flow changes every year than it becomes difficult for the comapny to reach over a better conclusion (Grant, 2016). It is also difficult to choose one projects from 2 or more than 2 projects than it becomes difficult due to the complexity in this technique.

The main objective of this report is as follows:

1. Identify and analyze the IRR and NPV
2. Evaluate the best technique
3. Make a decision about the technique

Advantages and Disadvantages

For primary sources, some projects have been evaluated and the numerical information has been analyzed through both the techniques so that the best idea and outcome could be got.

Secondary sources:

Further, various newspaper, journal, articles, books and the finance journals have been analyzed to accomplish this work.

Ms excel have been used to evaluate the numerical calculations.

Findings:

Through the above report, it has been analyzed that the NPV is the most using method due to its simplicity and the best results. This technique depict that it is required for every business to identify the total profit according to the today’s worth of the invested amount. In this process, the cash inflow, cash outflow and the present value factors are considered to analyze the total profit which could be earned by the company if the investment is done in a particular project (Moles, Parrino and Kidwekk, 2011).

Consequently, IRR technique depict that it is required for every business to identify the total return through the investment. In this process, the cash inflow, cash outflow, present value factors and cumulative frequencies are considered to analyze the total return which could be earned by the company if the investment is done in a particular project.

Conclusion:

Lastly, it has been analyzed through this report that the dilemma is faced by every comapny to analyze and evaluate the best result of investment proposals. Companies choose the best project according to their needs and the requirements. NPV technique and IRR technique help the company to manage the operations and the process of the comapny. Projects must be chosen by the company after analyzing and evaluating the various requirements, demands and the problems in the process and the functions.

Through the report, it has been found that the NPV and IRR techniques both are the techniques of the capital budgeting but the offered result of both the techniques depict about the different result so a comapny must be aware about the requirement and must choose the technique and the proposal on the basis of that.

NPV is more approachable the IRR by the companies on the basis of various advantaged of NPV techniques and various drawbacks of the IRR technique. In addition, it has been added that the performance and the position of the company also makes an impact over the capital budgeting techniques to choose the best investment proposal. More, the factors and requirements of the investment and the organization also affect the decision of choosing the best technique to analyze and make a result about the best investment proposal method.

To conclude, all the organizations which are performing and running their business in the international market are using the NPV technique due to its simplicity and the best evaluation methods.

References:

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Damodaran, A, 2011, Applied corporate finance,3rd edition, John Wiley & sons, USA

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Du, J. and Girma, S., 2009. Source of finance, growth and firm size: evidence from China (No. 2009.03). Research paper/UNU-WIDER.

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