NPV vs IRR
Every business comes across a number of decisions to be made on a daily basis regarding making investments in different projects. However, making these investments requires a huge analysis and consideration of a number of things. The projects are not definitely one off and are neither taken for a day or two; in fact the matter is of years. In a situation where there is a huge time period involved the time value of money takes the lead. However, apart from the time value of money there are numerous other matters as well that are required to be considered like risk, cash flows and discount rates.
When it comes to the project appraisals there a number of techniques to be used, however the two most commonly used techniques are Net Present Value and Internal Rate of Return.
Net Present Value
Net Present Value technique is a highly used technique for appraisal of the different business investments and projects. The Net Present Value is the difference between the initial investment made in the project and the present value of future cash flows being discounted at the required rate of return on investment. While computing the Net Present Value the initial investment, all cash inflows and outflows, and discount rate are being taken into consideration and the result generated by this technique the most reliable one.
Internal Rate of Return
Apart from the Net Present Value, the Internal Rate of Return is also a technique which is used to appraise the projects for investment. However, the Internal Rate of Return is the rate of interest at which the Net Present Value of the cash flows expected to be generated from the projects turns equal to 0.
Which one is a Better Choice: NPV or IRR
Both the techniques being discussed above are used very commonly for appraising different upcoming projects. However, both of them also have their own advantages as well as limitations. Considering the comparison of the Net Present Value and Internal Rate of Return we can see that the Net Present Value technique turn out to be more reliable as the discount rate used by Internal Rate of Return is constant for all projects. This limitation on the part of Internal Rate of Return where simplifies the calculation process turns out to be ineffective when it comes to evaluating two investment opportunities.
Every project you analyze is not always the one with similar cash flows and similar risks, whereas the discount rate needs to incorporate the changing trends and the risks and uncertainties as well. Therefore analyzing every investment opportunity with one single rate of discount is a vague approach. This limitation on the part of the Internal Rate of Return makes it a little weaker choice. Unless a number of modifications are being made to the Internal Rate of Return it does not tend to incorporate the changing discounts rates, moreover the projects with multiple mixture of positive as well as negative cash flows are also not evaluated appropriately with this technique.
However, the most preferable choice as well as the most commonly used is the Net Present Value technique that despite of having its own limitations offers reliable results due to its versatility.