NET PRESENT VALUE
Net present value is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.
INTERNAL RATE OF RETURN
The internal rate of return is used to assess and estimate the profitability of potential investments.
The above two methods are used by the companies in capital budgeting to determine the worthiness of the projects under consideration. The company considers the two methods to determine whether to undertake such investment in a specific project or not and which project is good for the wealth of the shareholder and which is not.
We will discuss the above two methods and how it is used by the company to determine the worthiness of the project.
NET PRESENT VALUE
In this method, the firms are used to determine the present value of the discounted cash flows over a period less than the expected cash flows for the specific project. If the NPV is positive means the value of the discounted value of the future cash flows is more than the expected cash flows of the project then the project is good for investment and the firm undertakes such projects.
Formula for NPV
Let us consider a simple example where a company XYZ company wants to undertake a project with a discount rate of 10% and the outflow of cash for the project is USD 18 million while the discounted future cash flows of the sales are USD 20 million so in this case, the NPV is USD 2 million. It means that this USD 2 million adds to the intrinsic value of XYZ company and would go for this project.
THE INTERNAL RATE OF RETURN (IRR)
Formula for IRR
In the above example of XYZ Company, it has a positive net present value of USD 2 million but the Company should also know the rate of return which is yielding by the project over its investment. For determining such return on investments the firm should recalculate the NPV equation and set the NPV factor to zero and solve for now the unknown discount rate. The rate which will be produced by such recalculation is the project's internal rate of return.
The internal rate of return is always expressed as a percentage. For a project that to be acceptable, the rate of return should be higher than the cost of capital. If the IRR is less than the cost of capital so the company shall not accept the project because it would lead to a reduction in shareholders' wealth. However, if the rate of return is higher than the cost of capital then the project should be accepted and the company should go for such a project.
In the NPV method, it is assumed that the cash flows will be invested or reinvested at the project's current cost or at the cost which is close to the current cost of the project while the IRR method assumes that the firm can reinvest cash flows at the project's IRR. The assumption of the firm that it will reinvest near or at the project's current cost is more realistic and beneficial than the reinvestment at the IRR.
Another benefit of NPV is that it is more suited when there are large normal cash flows. Normal cash flows occur when there are large cash flows involved in a project. The existence of non-normal cash flows will lead to multiple IRRs and then evaluation of the worthiness of a project became severely difficult but in the case of NPV this problem is overcome and the worthiness of the project can be easily evaluated no matter if there are large cash flows or multiple cash flows.
To clarify this concept a little bit let's consider an example by considering a new project that has the following cash flows;
Year 1: $ 25,000 (initial outlay)
Year 2: $45,000 (return on investment)
Year 3: $ 15,000 (incurred on marketing cost to present the project in a better way)
In the above example, a single IRR cannot be used because of the multiple cash flows and another point is that IRR cannot be used when the market conditions are changing. In such an example, the project has multiple IRRs and the same problems occur when the projects are long and thus leading to multiple cash flows and multiple IRRs that cannot be efficiently used for the project evaluation purpose.
The IRR method is not effective also when the discount rate is not known because the discount rate is a vital element to determine the worthiness of a project. If the discount rate is not known or cannot be applied to a specific project for whatever reason then IRR will be of limited value. In such cases, the NPV is better than IRR because if the project NPV is above zero then such a project is called to be financially viable.
Both the IRR and NPV methods can be used to determine the worthiness of a project. In IRR the rate of return is expressed in terms of percentage while in NPV the rate of return is expressed in the form of amount. Both methods can be used by the company as there are no hard and fast rules for this. However, the IRR method does not take into account the changing discount factor therefore using NPV is a better option to determine the worthiness of a project than using IRR.