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Advantages and Disadvantages of IRR and NPV

The term Capital Budgeting itself states that it is related with the capital issues of the business. It is the planning process by which it is decided whether the long term assets or the investments of the business such as machinery, products, plants and other research development programs are worth the funding out of the capital structure of the firm or not. The basic aim of the investment appraisal technique is to maximize the value of the firm for the shareholders because shareholders are interested in the maximization of their share.

There are various methods to study the Capital Budgeting and analyze the worth of the assets in which the amount is to be invested. These are:

  1. Accounting rate of return
  2. Average accounting return
  3. Payback period
  4. Net present value
  5. Profitability index
  6. Internal rate of return
  7. Modified internal rate of return
  8. Equivalent annual cost
  9. Real options valuation

Among these methods the most famous methods used for study are:

  1. Internal Rate of Return (IRR)
  2. Net Present Value (NPV)
assignment help with NPV and IRR

Internal Rate of Return: IRR is the discount rate used in the capital budgeting. This discount rate is used to bring the present value of all the cash flows of the project to zero. Thus higher the expected rate of return the higher will be the IRR. Higher IRR is always preferable to the one with a lower IRR. This IRR can be used to rank the proposed projects in the business. Therefore it shows that how much rate of growth a project can make. The actual result can be different from the estimated IRR. This could be due to unexpected market conditions. But the project with a higher IRR is always expected to have higher returns than the others.

Advantages of using IRR Method:

(i) Time Value of Money: The IRR Method gives due consideration to the Time Value of Money which makes it highly reliable. The time value of money considers the money on the basis of the time which makes it dependable. This feature is not available in many of the other projects which is a drawback.

(ii) Simplicity: The best thing about IRR is that it is easy to interpret. It is easy to use and the results of IRR can be easily studied and taken into consideration unlike other results in other methods. These results are highly reliable. Due to its easy accessibility the managers use this method unless any other peculiar situation arises in which other methods are suitable to be applied.

(iii) Hurdle Rate: Hurdle Rate is the Required Rate of Return. It is a difficult task to ascertain a hurdle rate that is reliable enough to draw the results. But the IRR method does not consider the Required Rate of Return while examining the results which gives this method a cover of any risk of wrong interpretations.

(iv) Required Rate of Return is a Rough Estimate: The required rate of return is a rough estimate and is not completely used by the IRR method. Once IRR is found then it can be compared with the Required Rate of Return. The managers can safely take the decision without any risk because the IRR is no where linked with the required rate of return.

Disadvantages of IRR:

1. Ignores Economies of Scale: The IRR method ignores the economies of scale completely. It ranks the projects on the basis of the returns they will produce. For example there are two projects: Project with investment of $5000 and earning 20% return and another is investing $ 1000 and earning 50% return. The project with $5000 will be given preference over $1000 just because it is earning a good amount i.e. $1000 as compared to $500. But IRR will Plan with $1000 before $5000 just because of the Rate of Return.

2. Mutually Exclusive Projects: Mutually Exclusive Projects means that if one project is accepted the other cannot be accepted. Thus it is a difficult task to ascertain which project gives a better return not just on the percentage basis but also the quantitative basis.

3. A mix of positive and negative future cash flows: The IRR is based on the project’s cash flows in future discounted at a rate to bring them to present value. The cash flows could be positive as well as negative. Thus IRR is based on a multiple IRR basis which renders it unreliable for results and interpretation.

Net Present Value: NPV is the difference between the present value of the cash inflows to the present value of the cash outflows. It is like the difference between the value of the dollar today to the value of the dollar in the future. The formula for NPV is:

formula for NPV

If the NPV of the project comes out to be positive then it is acceptable but of the value comes out to be negative then that project is not recommended as the cash flows will also be negative.

Advantages of NPV Method:

(i) Maximizes Company Value: Most of the methods undertake the requires rate of return as the basis to select the desired plan or project but NPV Method focuses on the Net present value derived. It could be possible to have a project giving a rate of return of 10% and NPV of $100,000 and similarly a project with a return of 20% but NPV of just $50,000. In this case the NPV method will give preference to the one with higher NPV. Thus it helps in increasing the value of the firm which is profitable for the shareholders.

(ii) Use of Time Value of Money: The time value of money shows the value of money today as compared to the one in future. Similarly NPV works in ascertaining the future cash flows of the projects in present. Thus it provides reliability in the taking up of this model.

Disadvantages of NPV Method:

(i) Prone to Forecasting Errors: There are estimates used in the NPV largely. The longer the tenure of the project the more will be the risk in the errors. The estimate for a short project can be fairer than the estimates for a longer tenured project. Therefore the forecasting errors may render the NPV Method inefficient.

(ii) Reliability on Discount Rate: The basis for the NPV Method is the Discounting factor. This discounting factor is basically the rate which is calculated on an estimation basis. If by any chance this rate s incorrect the whole result will be misleading.

Thus, we see how both of these models are of great importance for the proper planning in the business. NPV Model is better than IRR in terms of its reliability and correctness.

Thus a business’s functioning is highly reliable on the Capital Budgeting Process. The calculation and analysis of different plans available with the business for the investments in the assets can be a complicated task as it includes analyzing various fields and dimensions. But we are here to help you at where you can contact us at anytime and we will help you with your queries and helping you out with your assignments. We respect that you can’t lose on marks and that is why we are here to provide you with the best facilities and qualitative results. You can also take online classes from the best tutors. We believe in providing the best services for your satisfaction. We serve our clients with good and satisfying work and with complete dedication.

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