Question: What is the difference b/w NPV and IRR as techniques of capital budgeting and which one do you

think is a better alternative? Answer: There are two basic discounted cash flow techniques to evaluate capital budgeting proposals. These are Net Present Value method and Internal Rate of Return method. NET PRESENT VALUE (NPV) METHOD The NPV of an investment proposal is defined as the difference between the present value of cash inflows and the present value of cash outflows during a specific period of time. Formula:

Where, NPV= Net Present Value Ct = Cash flows occurring at time 0,1,2.n r = Discount rate t = Life of project in years Co= Initial cost of the proposal at time To (used only when the cost of the project is incurred at the beginning) Decision Rule: NPV > 0 (NPV is positive), accept the proposal & vice versa. NPV = 0, firm may be indifferent between its acceptance and rejection. In case of mutually exclusive proposals, the one with highest positive NPV is given the top priority. INTERNAL RATE OF RETURN (IRR) METHOD This is considered to be most important alternative to Net Present Value (NPV). It is defined as the discount rate at which the costs of investment equal to the benefits of the investment. Or in other words IRR is the required rate at which the NPV of an investment proposal equals zero. Formula:

Where, CFo = Cash outflow at time 0 CFt = Cash inflow at different point of time irr (r) = Internal rate of return n = Life of project in years Decision Rule: The firm has to first determine its own required rate of return, k (also known as hurdle rate or cut off rate) IRR>k, accept the proposal IRR=k, indifference between acceptance and rejection IRR<k, reject the proposal In case of mutually exclusive proposals, the one with highest IRR is given the top priority.

DIFFERENCE BETWEEN NPV AND IRR Key differences between the most popular methods, the NPV (Net Present Value) Method and IRR (Internal Rate of Return) Method, include: NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return a firm expects the capital project to earn; NPV is based on definite calculations but IRR is ascertained by trial and error method together with linear interpolation. The IRR Method cannot be used to evaluate projects where there are changing cash flows (e.g., an initial outflow followed by in-flows and a later out-flow); You can apply different discount rate in case of NPV method which is not possible for IRR method. Managers like the IRR method, since they consider it important to know the differential between the proposed investments IRR and the required return. This is a measure of safety that allows an evaluation of the investments return compared to its risk. An NPV measure does not give the same type of information to management. While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the NPV method can evaluate big long-term projects better as opposed to the IRR which gives better accuracy on short term projects with consistent inflow or outflow figures. Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation.

CONCLUSION Both the techniques discussed above i.e. NPV and IRR are important to evaluate capital budgeting proposals. Thus a mix of both should be considered while selecting an investment project. However, NPV is said to have superiority over IRR for the following reasons: 1. NPV shows expected increase in in the shareholders wealth but IRR does not. 2. NPV gives clear cut accept-reject decision rule, while IRR may give multiple results also. 3. The NPV of different projects is additive while the IRRs cannot be added. 4. NPV always provides better ranking in case of mutually exclusive proposals as compared to IRR as long as appropriate discount rate is used. 5. IRR is biased towards smaller projects which are more likely to yield higher percentage of returns over the larger projects.