ACC640 Week 6 Discussion Forum 1 Capital Budgeting

Compare and contrast the Internal Rate-of-Return (IRR) method and the Net Present Value (NPV) 

The desirability of a particular investment opportunity is evaluated using the internal rate of return (IRR), a financial statistic. Calculating an investment’s internal rate of return (IRR) is essentially predicting the rate of return of that investment after taking the time value of money, and all anticipated cash flows into account. The investor will choose the investment with the highest IRR if it exceeds the investor’s minimal threshold while choosing between multiple alternative investments. The fundamental flaw with IRR is how strongly it depends on predictions of future cash flows, which are notoriously tricky to make (Bora, 2015).

On the other side, in net present value, an investment predicts future cash flows. The three essential pieces of information the investor needs to decide are the estimated cash flows, the years they will be paid over, and their discount rate. Conversely, when there are several discount rates or different cash flow directions over time, NPV is preferable compared to IRR (Bora, 2015). The other significant difference between the two methods is based on the cash flow. For instance, by discounting a project’s projected future cash flow at set or cut-off rates, the present value may be determined using the NPV methodology. However, employing a trial-and-error procedure that results in a current value, the IRR methodology discounts cash flow at appropriate rates.

Recommendation

My personal choice would be the IRR method.  The NPV method incorporates the time value of money and is a method considered to be signified by its simplicity in finding whether a particular project delivers value. Although the technique may be prioritized in certain instances, its accuracy depends on the quality of inputs. In addition, the NPV method may not help compare projects of different sizes since larger projects generate more returns.

References

Bora, B. (2015). Comparison between net present value and internal rate of return. International Journal of Research in Finance and Marketing, 5(12), 61–71.