IRRC To know whether a project is feasible in terms of returns on investment, a firm needs to evaluate it with a process called capital

budgeting and the tool which is commonly used for the purpose is called IRR. This method tells the company whether making investments on a project will generate the expected profits or not. As it is a rate that is in terms of percentage, unless its value is positive any company should not proceed ahead with a project. The higher the IRR, the more desirable a project becomes. This means that IRR is a parameter that can be used to rank several projects that a company is envisaging. IRR can be taken as the rate of growth of a project. While it is only estimation, and the real rates of return might be different, in general if a project has a higher IRR, it presents a chance of higher growth for a company. NPV This is another tool to calculate to find out the profitability of a project. It is the difference between the values of cash inflow and cash outflow of any company at present. For a layman, NPV tells the value of any project today and the estimated value of the same project after a few years taking into account inflation and some other factors. If this value is positive, the project can be undertaken, but if it is negative, it is better to discard the project. This tool is extremely helpful for a company when it is considering to buy or takeover any other company. For the same reason, NPV is the preferred choice to real estate dealers and also for brokers in a stock market. Limitations of the Internal Rate of Return (IRR) One problem with the IRR is that it ignores the initial investment amount. If youre comparing two alternative investments and your only decision criteria is the IRR, then which is better a 50% return on $1,000 investment, or a 10% return on a $50,000 investment? If IRR was your only decision criteria, then youd choose the first option, ignoring the the size of your initial investment, and therefore the actual cash youre able receive as a result of your investment. Another limitation of the IRR is that it assumes youll reinvest cash flows at the same rate of return. This of course may not always be possible. You might instead put that cash flow into a bank account with a much lower yield, which can be problematic when evaluating the true return for an investment. Limitations of the Net Present Value (NPV) One limitation of the NPV is that it doesnt take into account the timing or variability of cash flows. For example, which is better, a project that returns one lump sum in 10 years, or instead a project with even cash flows every year for ten years? These are two different investments and, depending on your needs, you might prefer one over the other, even if the NPV for both projects is the same. Another limitation of the NPV is that its often difficult to accurately estimate the discount rate. Because of this, it might also be difficult to accurately account for the riskiness of projected cash flows. For example, if youre evaluating a building with short term leases, then you might consider bumping up your discount rate to account for this rollover risk. But exactly how much higher should your discount rate be? This is often a subjective decision that an objective measure, like the NPV, cant easily account for.