Netpresent value (NPV) is a financial technique used to analyze mutuallyexclusive capital projects. It is adopted in investment proposalsusing the present values based on the future cash flows. These valuesare discounted at the total cost of capital. NPV is calculated, andif it is zero, it signifies that the cash flows made are sufficientto meet the rate of return and also pay off the principal capitalinvested. The method is used in analyzing mutually exclusive projectsand since NPV can be expressed in dollar value it can be used tomeasure profitability and the shareholder wealth growth.
TheIRR on the other hand, is the method used to discount cash flow andapplied in making decisions on capital budgeting. IRR is obtained byfinding the discount rates that relate with the present values basedon the future cash flows. In this case projects are termed as viableif the discounted rate exceeds the cost of capital. An excess of IRRshows the returns attained from a project and increases shareholders’wealth (Abor, 2016).
Thereinvestment of capital using the two methods differs. NPV takes intoperspective of the fact that cash flows can be properly reinvested attheir current costs. The IRR method holds that cash flows can bereinvested based on the rate of returns. The NPV assumption is morerealistic it suggests that a firm can reinvest cash flows at itsexisting cost of capital unlike the reinvestment of cash flows fromprojects following the IRR method. This may not show the rate ofreinvesting cash flows unless if the cost of capital is incorporated(Clemen, & Reilly, 2013).
Inconclusion, NPV is the most appropriate method for evaluatingmutually exclusive projects as compared to IRR. This is mainly due toits realistic reinvestment assumption that reflects the profitabilityand creation of wealth. Finally, it will help in making a decision onaccepting or rejecting a project.
Abor,J. Y. (2016). Evaluating Capital Investment Decisions: CapitalBudgeting. In Entrepreneurial Finance for MSMEs (1st ed.), (pp.293-320). Springer International Publishing.
Clemen,R. T., & Reilly, T. (2013). Making hard decisions with DecisionTools (1st ed.). New York, NY. Cengage Learning.