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NPV vs IRR Methods

Key differences between the most popular methods, the NPV (Net Present Value) Method and IRR (Internal Rate of Return) Method, include: NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return a firm expects the capital project to return; Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not; The IRR Method cannot be used to evaluate projects where there are changing cash flows (e.g., an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm); However, the IRR Method does have one significant advantage -- managers tend to better understand the concept of returns stated in percentages and find it easy to compare to the required cost of capital; and, finally, While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows, is preferable to a larger project that will generate more cash. Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recomendation.

Recent variations of these methods include: The Adjusted Present Value (APV) Method is a flexible DCF method that takes into account interest related tax shields; it is designed for firms with active debt and a consistent market value leverage ratio; The Profitability Index (PI) Method, which is modeled after the NPV Method, is measured as the total present value of future net cash inflows divided by the initial investment; this method tends to favor smaller projects and is best used by firms with limited resources and high costs of capital; The Bailout Payback Method, which is a variation of the Payback Method, includes the salvage value of any equipment purchased in its calculations;

The Real Options Approach allows for flexibility, encourages constant reassessment based on the riskiness of the project's cash flows and is based on the concept of creating a list of value-maximizing options to choose projects from; management can, and is encouraged, to react to changes that might affect the assumptions that were made about each project being considered prior to its commencement, including postponing the project if necessary; it is noteworthy that there is not a lot of support for this method among financial managers at this time.

Net Present Value (NPV) Method Versus Internal Rate of Return (IRR) Method:
Learning Objectives:

1. What is the difference between net present value (NPV) method and internal rate
of return (IRR) method? The net present value (NPV) method has several important advantages over the internal rate of return (IRR) method. First the net present value method is often simpler to use. As mentioned earlier, the internal rate of return method may require hunting for the discount rate that results in a net present value of zero. This can be a very laborious trial-and-error process, although it can be automated to some degree using a computer spreadsheet. Second, a key assumption made by the internal rate of return (IRR) method is questionable. Both methods assume that cash flows generated by a project during its useful life are immediately reinvested elsewhere. However, the two methods make different assumptions concerning the rate of return that is earned on those cash flow. The net present value method assumes the rate of return is the discount rate, whereas the internal rate of return method assumes the rate of return is the internal rate of return on the project. Specifically, it the internal rate of return of the project is high, this assumption may not be realistic. It is generally more realistic to assume that cash inflows can be reinvested at a rate of return equal to the discount rate - particularly if the discount rate is the company's cost of capital or an opportunity rate of return. For example, if the discount rate is the company's cost of capital, this rate of return can be actually realized by paying off the company's creditors and buying back the company's stock with cash flows from the project. In short, when the net present value method and the internal rate of return method do not agree concerning the attractiveness of a project, it is best to go with the net present value method. Of the two methods, it makes the more realistic assumption about the rate of return that can be earned on cash flows from the project.

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