comment and reply on the two sources.
1. The net present value is “the difference between the present value of cash inflows and the present value of cash outflows over a period of time.” (Gallant, 2020). The internal rate of return is “a calculation used to estimate the profitability of potential investments.” (Gallant, 2020). Both the NPV and the IRR are heavily relied on in the capital budgeting world. The NPV and IRR are considered to be discounted cash flow methods that can be useful when it comes to evaluating investments or even capital projects.
NPV is determined when “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 capital and its risk.” (Gallant, 2020). After this, the future positive cash flows of the investment are decreased into a number, that number is the present value number. Decreasing this amount from the initial cash outlay for the investment at hand gives you the NPV of the investment that you are looking into. NPV focuses more on the investment and the IRR focuses on profitability.
Here is an example provided by Investopedia for determining NPV:
“JKL Media Company wants to buy a small publishing company. JKL determines that the future cash flows generated by the publisher, when discounted at a 12 percent annual rate, yields a present value of $23.5 million. If the publishing company’s owner is willing to sell for $20 million, then the NPV of the project would be $3.5 million ($23.5 – $20 = $3.5). The NPV of $3.5 million represents the intrinsic value that will be added to JKL Media if it undertakes this acquisition.” (Gallant, 2020).
Based off of the previous example, we can see that JKL Media has a positive NPV. They also have to take into consideration the ROR by the investment. In order to determine the ROR, “the firm would simply recalculate the NPV equation, this time setting the NPV factor to zero, and solve for the now unknown discount rate.” (Gallant, 2020). The number generated is the IRR. As an example “the project’s IRR could—depending on the timing and proportions of cash flow distributions—be equal to 17.15%. Thus, JKL Media, given its projected cash flows, has a project with a 17.15% return. If there were a project that JKL could undertake with a higher IRR, it would probably pursue the higher-yielding project instead.” (Gallant, 2020).
2. 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, the internal rate of return (IRR) is a calculation used to estimate the profitability of potential investments.The two capital budgeting methods have the following differences:
– Outcome. The NPV method results in a dollar value that a project will produce, while IRR generates the percentage return that the project is expected to create.
– Purpose. The NPV method focuses on project surpluses, while IRR is focused on the breakeven cash flow level of a project.
– Decision support. The NPV method presents an outcome that forms the foundation for an investment decision, since it presents a dollar return. The IRR method does not help in making this decision, since its percentage return does not tell the investor how much money will be made.
– Reinvestment rate. The presumed rate of return for the reinvestment of intermediate cash flows is the firm’s cost of capital when NPV is used, while it is the internal rate of return under the IRR method.
– Discount rate issues. The NPV method requires the use of a discount rate, which can be difficult to derive, since management might want to adjust it based on perceived risk levels. The IRR method does not have this difficulty, since the rate of return is simply derived from the underlying cash flows.
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