Compare and contrast the internal rate of return (IRR) and the net present value (NPV) criteria for evaluating investment proposals.

2568 WordsApr 6, 200811 Pages
The internal rate of return (IRR) and the net present value (NPV) techniques are 2 investment decision tools that satisfy the 2 major criteria for the correct evaluation of capital projects. This criterion is that the techniques should incorporate the use of cash flows and the use of the time value of money. This makes them viable techniques for evaluating investment proposals. The Net Present Value is one of the techniques that are used by firms when evaluating which investment proposals to take on board and which ones to reject. The net present value is calculated by discounting all flows to the present and subtracting the present value of all inflows. As cited by Petrochilos G 2004, the Net Present Value principle advises us to invest…show more content…
Internal rate of return (IRR) is a rate of return on an investment. The IRR of an investment is the interest rate that will give it a net present value of zero. The IRR is calculated by a trial and error processStarting with a guess at the IRR, r, the process is as follows:The NPV is calculated using r. To find the internal rate of return, one needs to find the values of r that satisfies the following equation:YearCash Flow0-1001+302+353+404+45Internal Rate of Return (IRR)IRR = r,IRR = 17.09%Net Present Value (NPV)Thus using r = IRR = 17.09%,If the NPV is close to zero then r is the IRR. If the NPV is positive r is increased. If the NPV is negative r is decreased. This technique looks for the interest rate that equals the present value of inflows and outflows. The IRR technique use the accept/reject criteria of comparing the IRR with the cost of capital which is based on comparing the internal rate of return to the cost of the capital of the project. If the IRR is less than the capital then that project should be rejected because it is not very feasible. If the Internal Rate of Return is larger than the capital required for the project, it should be accepted while if the IRR is just equal to the capital then the project could be considered because it is at the very least earning its cost of capital and should therefore be accepted at the margin. When evaluating any investment proposals, the NPV technique and the IRR technique usually provide

More about Compare and contrast the internal rate of return (IRR) and the net present value (NPV) criteria for evaluating investment proposals.

Open Document