Question

Differentiate Net Present Value Methods, Profitability Index Method and Internal Rate of Return(IRR) technique of capital budgeting?

Answer 1

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, internal rate of return (IRR) is a calculation used to estimate the profitability of potential investments

INVESTOPEDIA  SMALL BUSINESS

Net Present Value vs Internal Rate of Return

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BY CHRIS GALLANT

 

 Updated Feb 15, 2018

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, internal rate of return (IRR) is a calculation used to estimate the profitability of potential investments.

Both of these measurements are primarily used in capital budgeting, the process by which companies determine whether a new investment or expansion opportunity is worthwhile. Given an investment opportunity, a firm needs to decide whether undertaking the investment will generate net economic profits or losses for the company.

Determining Net Present Value

To do this, the firm estimates the future cash flows of the project and discounts them into present value amounts using a discount rate that represents the project's cost of capitaland its risk. Next, all of the investment's future positive cash flows are reduced into one present value number. Subtracting this number from the initial cash outlay required for the investment provides the net present value of the investment.

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