Compare and contrast the internal rate of return (IRR) and the net present value (NPV) criteria for evaluating investment proposals.
The internal rate of return (IRR) and the net present value (NPV) techniques are 2 investment decision tools that satisfy the 2 major criteria for the correct evaluation of capital projects. This criterion is that the techniques should incorporate the use of cash flows and the use of the time value of money. This makes them viable techniques for evaluating investment proposals.
The Net Present Value is one of the techniques that are used by firms when evaluating which investment proposals to take on board and which ones to reject. The net present value is calculated by discounting all flows to the present and subtracting the present value of all inflows.
As cited by Petrochilos G 2004, the Net Present Value principle advises us to invest in the project as long as its Net Present Value is positive, and reject the investment suggestion if its Net Present Value is negative.
The reason given by Petrochilos G, 2004, is that when the flow of future returns is discounted at the cost of capital, and gives a positive NPV, the project can cover both interest and depreciation charges, and thus, the positive NPV represents a clear profit, which increases the wealth of the firm.
In the case of a negative NPV, the condition as referred to by Petrochilos, tells us that we shall lay yourself open to a loss in our internal venture opportunity, thus, should not invest, but consider, instead, using the outer opportunities by lending any money in the capital market.
Formula:Wheret - The time of the cash flowN - The total time of the projectr - The discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.)Ct - the net cash flow (the amount of cash) at time t (for educational purposes, C0 is commonly placed to the left of the sum to emphasize its role as the initial investment.).
The net present value of an investment tells you how this investment compares either with your alternative investment or with borrowing, whichever
The Net Present Value is one of the techniques that are used by firms when evaluating which investment proposals to take on board and which ones to reject. The net present value is calculated by discounting all flows to the present and subtracting the present value of all inflows.
As cited by Petrochilos G 2004, the Net Present Value principle advises us to invest in the project as long as its Net Present Value is positive, and reject the investment suggestion if its Net Present Value is negative.
The reason given by Petrochilos G, 2004, is that when the flow of future returns is discounted at the cost of capital, and gives a positive NPV, the project can cover both interest and depreciation charges, and thus, the positive NPV represents a clear profit, which increases the wealth of the firm.
In the case of a negative NPV, the condition as referred to by Petrochilos, tells us that we shall lay yourself open to a loss in our internal venture opportunity, thus, should not invest, but consider, instead, using the outer opportunities by lending any money in the capital market.
Formula:Wheret - The time of the cash flowN - The total time of the projectr - The discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.)Ct - the net cash flow (the amount of cash) at time t (for educational purposes, C0 is commonly placed to the left of the sum to emphasize its role as the initial investment.).
The net present value of an investment tells you how this investment compares either with your alternative investment or with borrowing, whichever
Bibliography: hris Mulhearn, Howard. R. Vane, James Eden, (2001), 慐conomics for business�, Palgrave Foundations, London: pages 127-131. Joseph.G.Nellis and David Parker, (1992), 慐ssence of business economics�, prentice hall, London: page 150-151. Evan, Dorla A and Shawn. Forbes, 1993, 揇ecision making and Display Methods. The case of prescription and practice in capital budgeting�, the engineering Economist, page 87-92. Petrochilos. A. George, (2004), 慚anagerial Economics� A European Text, Palgrave Macmillan, pg 315McGuigan et al. 2002, Managerial Economics: Applications, Strategy and TacticsSalvator, e D. 2003, Managerial Economics in a Global Economyhttp://en.wikipedia.org/wiki/Net_present_valuehttp://www.investopedia.com/terms/n/npv.asp