Compare and contrast NPV with IRR as a method of investment appraisal
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Compare and contrast NPV with IRR as a method of investment appraisal Investment decisions are vitally important to a business because it involves making an outlay of something of economic value, usually cash, which the outlay precedes to benefits. If a wrong decision is made, the effects on the business could be significant and it might also mean closing down the activity and sell the premises at a significant loss. The Internal Rate of Return (IRR) and Net Present Value (NPV) are both methods used in practice by businesses to evaluate investment opportunities (long-term assets, i.e. machineries). The method of NPV uses the discounting cash flow which recognizes money coming in the firm in the future will be worth less value than the money equivalent they have today.
In NPV, we use the discount rate on the basis for the minimum return we will accept. If the NPV is positive, we accept the project, and if the NPV is negative, we reject the project. IRR is quite closely related to the NPV method since it also involves discounting future cash flows. When applied to its future cash flows, it will produce precisely zero NPV. It uses the iteration approach (trial and error) to be adopted. For any project to be acceptable, it must meet the minimum IRR, which tends to be the opportunity cost of finance. And where there are two or more projects involved, the one with the highest IRR should be chosen. IRR is in many ways similar to NPV. However, it does have some problems. It ignores the real world, which therefore could lead to wrong decisions being made.
In order to find out, we must do the NPV calculation. IRR is an average, in contrast to NPV, which can use a different discount rate for each year of the cash flow. NPV takes account of the time value of money. I have come to the conclusion that the NPV method is a better method of appraising investment opportunities than the IRR method. Reason being, although IRR has similar attributes to NPV, it has yet too many problems that could lead to a wrong decision being made, such as ignoring the real world and having multiple IRR's in a situation. Also, when coming to choose between two projects, the NPV method would be better and more reliable discriminator than to use IRR. So in my opinion, I think that the NPV is the best method and therefore it should be the only method used in the investment appraisal. Assignment by: Chi-Man Lam Student ID No.: 02040652 Course Pathway: CATF2
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