Compare merits & demerits of Net Present Value Method & Internal Rate of Return Methods
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While useful NPV and IRR methods are useful methods for determining whether to accept a project, both have their advantages and disadvantages.
Advantages:
With the NPV method, the advantage is that it is a direct measure of the dollar contribution to the stockholders.
With the IRR method, the advantage is that it shows the return on the original money invested.
Disadvantages:
With the NPV method, the disadvantage is that the project size is not measured.
With the IRR method, the disadvantage is that, at times, it can give you conflicting answers when compared to NPV for mutually exclusive projects. The 'multiple IRR problem' can also be an issue, as discussed below.
The Multiple IRR Problem
A multiple IRR problem occurs when cash flows during the project lifetime is negative (i.e. the project operates at a loss or the company needs to contribute more capital).
This is known as a "non-normal cash flow", and such cash flows will give multiple IRRs.
Why Do NPV and IRR Methods Produce Conflicting Rankings?
When a project is an independent project, meaning the decision to invest in a project is independent of any other projects, both the NPV and IRR will always give the same result, either rejecting or accepting a project.
While NPV and IRR are useful metrics for analyzing mutually exclusive projects - that is, when the decision must be one project or another - these metrics do not always point you in the same direction. This is a result of the timing of cash flows for each project. In addition, conflicting results may simply occur because of the project sizes.
Read more: Advantages and Disadvantages of the NPV and IRR Methods https://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/advantages-disadvantages-npv-net-present-value-irr-internal-rate-of-return.asp#ixzz5Z5z5ue00
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Advantages:
With the NPV method, the advantage is that it is a direct measure of the dollar contribution to the stockholders.
With the IRR method, the advantage is that it shows the return on the original money invested.
Disadvantages:
With the NPV method, the disadvantage is that the project size is not measured.
With the IRR method, the disadvantage is that, at times, it can give you conflicting answers when compared to NPV for mutually exclusive projects. The 'multiple IRR problem' can also be an issue, as discussed below.
The Multiple IRR Problem
A multiple IRR problem occurs when cash flows during the project lifetime is negative (i.e. the project operates at a loss or the company needs to contribute more capital).
This is known as a "non-normal cash flow", and such cash flows will give multiple IRRs.
Why Do NPV and IRR Methods Produce Conflicting Rankings?
When a project is an independent project, meaning the decision to invest in a project is independent of any other projects, both the NPV and IRR will always give the same result, either rejecting or accepting a project.
While NPV and IRR are useful metrics for analyzing mutually exclusive projects - that is, when the decision must be one project or another - these metrics do not always point you in the same direction. This is a result of the timing of cash flows for each project. In addition, conflicting results may simply occur because of the project sizes.
Read more: Advantages and Disadvantages of the NPV and IRR Methods https://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/advantages-disadvantages-npv-net-present-value-irr-internal-rate-of-return.asp#ixzz5Z5z5ue00
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