Net present value vs Internal rate of return Essay

How do the results of the NPV technique relate to the goal of maximizing shareowner riches? The NPV technique measures the present value of the future silver flows that a take in will produce. A optimistic NPV means that the investment should increase the value of the firm and lead to maximizing shareholder wealthiness. A positive NPV design provides a sire that is more than enough to compensate for the needed return on the investment. Thus, development NPV as a guideline for superior investment decisivenesss is consistent with the goal of creating wealth.In theory, wherefore is NPV the most appropriate technique for making capital budgeting decisions? The NPV rule is theoretically the most appropriate method acting for making capital budgeting decisions because it measure wealth installation, which is the assumed goal of financial management. NPV is an absolute measure of a projects profitability and indicates the expected change in owners wealth from a capital investm ent. As an evaluation technique, NPV considers all expected future currency flows, the sequence value of money, and the risk of the future cash flows.Thus, NPV can help identify projects that maximize shareholder wealth. If a firm selects a project with an NPV of $75,000, what uphold should this decision fuck off on shareholder wealth? If the estimated cash flows and discount site are accu regularise, this project should increase shareholder wealth by $75,000. If a projects NPV is positive, what does this suggest about the required versus estimated return on the project? What does this suggest about accepting the project? A positive NPV suggests that the estimated return on the project is greater than the required return for the project.The NPV decision rule is to accept a project whose NPV is greater than zero because this investment should increase shareholder wealth. The IRR measures a projects yield or expected count of return. This return does not depend on anything excep t the cash flows of the project. Thus, the IRR provides a superstar number summarizing the merits of a project. Mathematically, the IRR is that rate of return (discount rate) that makes the present value of all expected future cash flows equal to zero. That is, the IRR is the discount rate that causes a projects NPV to equal zero.Why may using the IRR method as a decision criterion not lead to maximizing shareholder wealth? What factors can lead to misleading results when comparing the IRR with the NPV? If projects are independent and are not subject to capital rationing, using the IRR method in evaluating projects indicates the ones that maximize shareholder wealth. However, using the IRR method as a decision criterion may sometimes lead to selecting projects that do not maximize wealth if the projects are inversely exclusive or capital rationing exists.When evaluating mutually exclusive projects, the IRR may indicate a divergent decision than the NPV because of the reinvestmen t rate assumption. The IRR implicitly assumes reinvestment of all medium cash inflows at the IRR, whereas the NPV implicitly assumes reinvestment of all intermediate cash inflows at the cost of capital. This reinvestment rate assumption may lead to different decisions in selecting among mutually exclusive projects when any of the following factors apply (1) differences in timing of cash flows among the projects, (2) differences in scale, and (3) differences in the useable lives of the projects.What are the similarities and differences in decision rules when using NPV versus IRR? For independent projects with conventional cash flows and no capital rationing, the NPV and IRR dedicate the same accept-rejected decision. Thus, the decision rules are similar for investment projects. The decision rule for NPV is to accept the project if the NPV is positive and reject the project if the NPV is NPV is negative. The decision rule for IRR is to accept the project if the IRR equals or is grea ter than the required rate of return and reject the project if the IRR is less than the required rate of return.Technically, the firm should be indifferent among accepting and rejecting a project with an NPV equal to zero or an IRR equal to the cost of capital because such(prenominal) an investment would not change shareholder wealth. The cost of capital is the discount rate for the NPV and the hurdle rate for the IRR. The firm should accept the project because it has a positive NPV. However, the discounted payback method is inconsistent with shareholder wealth maximization because the method ignores some cash flows that contribute to the present value of investment.What are two reasons for the superiority of the NPV method in evaluating capital investment projects? The NPV method is the best approach in evaluating projects because it measures the amount by which a capital investment creates wealth. This is because the NPV is an absolute measure of a projects worth. In addition, NP V has a more realistic reinvestment rate assumption than IRR. It implicitly assumes reinvestment of intermediate cash inflows at the required rate of return.Both reasons supporting the superiority of the NPV method assume that managers invest the cash flows from the investment for the benefit of shareholders. In summary, no other capital budgeting technique does a better job of measuring wealth creation than the NPV method. Which capital budgeting techniques are increasing in popularity? Which are decreasing in popularity? Survey results suggest an change magnitude use of more sophisticated capital budgeting techniques. The use of discounted cash flow techniques, specifically NPV and IRR, has increased in popularity over time.Several reasons may explain increasing popularity of these methods such as the widespread use of in-person computers with spreadsheet programs that reduce the knowledge and effort required to calculate discounted cash flow measures and increased familiarity o f managers with these techniques. NPV has been the dominant method taught in business schools for many years and many financial managers hold business degrees, especially MBAs. The popularity of the IRR is more often than not likely because it is a measure of yield and is easy to explain to people who do not have formal training in finance.Since financial managers often deal in yields, some may be slightly more comfortable dealing with the IRR than NPV. Methods declining in popularity include the use of the payback period, although still popular, and the write up rate of return. The rationale for this decline in popularity likely results from several factors including their simplicity and failure to consider the time value of money. In addition, the accounting rate of return uses accounting income instead of the cash flows.