Question

Explain and illustrate net present value method and internal rate of return method. What are the limitations of using these methods?

29 Oct 2021
Answer :
Word Count : 1069

Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. By contrast, the internal rate of return (IRR) is a calculation used to estimate the profitability of potential investments.

NPV or otherwise known as Net Present Value method, reckons the present value of the flow of cash, of an investment project, that uses the cost of capital as a discounting rate. On the other hand, IRR, i.e. internal rate of return is a rate of interest which matches present value of future cash flows with the initial capital outflow.

In the lifespan of every company, there comes a situation of a dilemma, where it has to make a choice between different projects. NPV and IRR are the two most common parameters used by the companies to decide, which investment proposal is best. However, in a certain project, both the two criterion give contradictory results, i.e. one project is acceptable if we consider the NPV method, but at the same time, IRR method favors another _______ __________ _____ ___ ______ _________ __________ _______ ___ ___.
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