Describe the Net Present Value (NPV) method for Investment appraisal and explain the arguments that suggest that NPV should be preferred to Internal Rate of Return (IRR) when choosing among mutually exclusive capital investment projects.
NPV method which is also known as Net Present Value Method and the Internal Rate of Return Method are popular methods of decision making. Investment proposal is analyzed with the help of these techniques and their future productivity. The investment proposal is selected after analyzing by these techniques. These methods are widely used by the business organization because of their accuracy in the projection but no method can provide an accurate projection of the future outcome. Therefore there is some limitation in these methods too.
The net present value is the technique of selecting best investment project from different investment projects available. The net present value of investment proposal is defined as the sum of present value of all future cash inflows less the sum of the [present value of all cash outflow associated with the proposal (accountingtools, 2017). The concept of selection of projects under net present value is simple. The present value of all the future cash flows received from the project is discounted at the discount rate prevailing in the market and from that the present value of all the future cash outflows that are going to arise in the future will be subtracted. The investment project whose net present value is higher from all will be selected before other projects.
The calculation of net present value is simple and effective. Following steps are followed by while calculating net present value:
The future survival and growth of a business organization depend on its capacity to make the right decisions. The management of the company should take a decision by applying their due diligence and professional skills and these decisions should result in the development of the company. The project evaluation decision is one of such major decision which contributes to the growth of the company. There are different methods available to evaluate projects that should be accepted (Jan). The two methods net present value method and the internal rate of return methods are used widely by different organization. There is some issue between the uses of such methods over other methods. Both of the investment analyzing technique uses the concept of present value of money (efinancemanagement, 2012). The result of both the techniques is same in most of the cases but in some case, they might have a conflict with each other. For example, in some case, the net present value of one project is higher but the internal rate of return is lower (efinancemanagement, 2012). The net present value method calculates the opportunity cost of the different projects over another project. This conflict between the projects arises due to the nature of the project whether they are independent or mutually exclusive.
The net present value method is considered best in the case of to be more useful in case of a mutually exclusive project than the internal rate of return. The meaning of mutually exclusive project is that one project’s consideration does not include some other project. The internal rate of return consider the reinvestment of the same project over the expiry of its life, but net present value focuses on the single project that is into consideration. The reinvestment of the project is not practical there can be some more option in the future and the demand of present situation to give judgment on the presently available option. Further, the internal rate of return considers discounting of the future reinvestment of the project with the same rate. The internal rate of return based on too much future assumption. This is not practical neither accepted in the present competitive market. In the case of the internal rate of return, the rates derived from the calculation are sometimes impractical and too good to be true such as 30% or 35%. In a practical market, this return is impossible to achieve. The net present value, on the other hand, is taken into consideration the practical lending or borrowing rate which are prevailing in the market at that time.
The internal rate of return simply calculates the rate at which the present value of cash inflow is equal to the present value of cash outflow arising from the project. The project with a higher rate of return will be selected from all the other projects. In the case of the mutually exclusive project, the net present value is best suitable than the internal rate of return. It gives more accurate result than the internal rate of return method and does not takes into account any assumption figures. The net present value always uses the true market rates. The internal rate of return is a relative method and ignores the total value added by acceptance of the project. Net present value is simpler than the internal rate of return and can be easily understood by the general public, it does not require any financial education on behalf of the user of information.
There are many pros and cons associated with NPV method utilization. Some of them are pointed as follows –
Advantages
The main advantage of net present value method is that it takes into consideration the future value of money(investopedia). Future value of money will always be less than it is now in the present Every year cash flow arising from the project is then discounted by the discount rate and converted into a present value which will be lower mainly.
The net present value states clearly the total benefit arising in the future year from a project. The total benefit is subtracted from the total expense on the project which will be income from the project.
It takes into account the inherent risk in making future projections. It also takes into account the cost of capital also.
While evaluating the projects the risk and profitability factors associated with the projects are taken into consideration.
The main concept of net present value is maximizing the value of the firm.
Disadvantages
The biggest and main disadvantage of the net present value of the project evaluation is that the cost of capital taken into calculation requires some assumption on a personal basis which can differ on an individual
The net present value cannot be used while comparing two projects of different life. The project should be assumed that it will be reinvested again if such comparison is to be made which is impractical.
Some people find the calculation of the net present value of the project very difficult because it contains some assumption on discounted The appropriate discounting rate cannot be calculated easily.
The internal rate of return as part of capital budgeting technique has certain advantages and limitations. Some of them are detailed as follows –
Advantages
The internal rate takes into consideration the time value of money which one of the prominent factors to be considered while analyzing projects
The internal rate of return is simple to understand by the general It simply gives the rate of return of each project that is under evaluation(Kumar, 2010). These rates of returns are then evaluated and the project with a higher rate of return will be selected.
The internal rate of return can be used to evaluate two projects of different duration. For example, one project which has a life of 3 years can be compared with another project with 5-year
Disadvantages
The internal rate of return ignores all the future hidden cost which may arise. It only considers the time value of money but other changes in cost due to economic or political factors is ignored(Lanctot). This can affect the return received from the investment.
The internal rate of return method makes the assumption the reinvestment of the project can be done at the same rate which is calculated now. But the future assumption cannot be used to achieve accuracy in business decision making.
The Internal Rate of Return specifies the result in percentage basis and does not give the total benefit or loss in the term of dollars.
The Internal Rate of Return calculation requires large formula. This formula can be hard to remember and even harder to execute in practical condition.
accountingtools. (2017). net present value analysis. Retrieved July 30, 2017, from accountingtools: https://www.accountingtools.com/articles/2017/5/17/net-present-value-analysis
efinancemanagement. (2012). Why Net Present Value is the Best Measure for Investment Appraisal? Retrieved July 30, 2017, from efinancemanagement: https://efinancemanagement.com/investment-decisions/why-net-present-value-is-the-best-measure-for-investment-appraisal
investopedia. (n.d.). Advantages and Disadvantages of the NPV and IRR Methods By Investopedia. Retrieved July 30, 2017, from investopedia: https://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/advantages-disadvantages-npv-net-present-value-irr-internal-rate-of-return.asp
Jan, O. (n.d.). NPV vs IRR. Retrieved July 30, 2017, from accountingexplained: https://accountingexplained.com/managerial/capital-budgeting/npv-vs-irr
Kumar, V. (2010). Advantages and Disadvantages of Internal Rate of Return. Retrieved July 30, 2017, from Accounting Education: https://www.svtuition.org/2010/05/advantages-and-disadvantages-of.html
Lanctot, P. (n.d.). The Advantages and Disadvantages of the Internal Rate of Return Method. Retrieved July 30, 2017, from chron: https://smallbusiness.chron.com/advantages-disadvantages-internal-rate-return-method-60935.html
Essay Writing Service Features
Our Experience
No matter how complex your assignment is, we can find the right professional for your specific task. Contact Essay is an essay writing company that hires only the smartest minds to help you with your projects. Our expertise allows us to provide students with high-quality academic writing, editing & proofreading services.
Free Features
Free revision policy
$10Free bibliography & reference
$8Free title page
$8Free formatting
$8How Our Essay Writing Service Works
First, you will need to complete an order form. It's not difficult but, in case there is anything you find not to be clear, you may always call us so that we can guide you through it. On the order form, you will need to include some basic information concerning your order: subject, topic, number of pages, etc. We also encourage our clients to upload any relevant information or sources that will help.
Complete the order form
Once we have all the information and instructions that we need, we select the most suitable writer for your assignment. While everything seems to be clear, the writer, who has complete knowledge of the subject, may need clarification from you. It is at that point that you would receive a call or email from us.
Writer’s assignment
As soon as the writer has finished, it will be delivered both to the website and to your email address so that you will not miss it. If your deadline is close at hand, we will place a call to you to make sure that you receive the paper on time.
Completing the order and download