Net Present Value Method
NPV Versus Payback Method
Internal Rate of Return Method
Capital Budgeting Methods
Weighted Average Cost of Capital
Discounted Cash Flow versus Internal Rate of Return (dcf vs irr)
Calculate NPV in terms of currency. Then express IRR in terms of the percentage return a firm expects the capital project to return. Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not.
The IRR Method cannot be used to evaluate projects where there are changing cash flows . For example, an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm. However, the IRR Method does have one significant advantage. Managers tend to better understand the concept of returns stated in percentages. They find it easy to compare to the required cost of capital.
While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows. This is preferable to a larger project that will generate more cash. Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation.
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The Adjusted Present Value (APV) Method is a flexible DCF method that takes into account interest related tax shields. Furthermore, it is designed for firms with active debt and a consistent market value leverage ratio.
The Profitability Index (PI) Method, which is modeled after the NPV Method, is measured as the total present value of future net cash inflows divided by the initial investment. This method tends to favor smaller projects. Therefore, it is best used by firms with limited resources and high costs of capital.
The Real Options Approach allows for flexibility and encourages constant reassessment based on the riskiness of the project’s cash flows. It is also based on the concept of creating a list of value-maximizing options to choose projects from. In fact, management can, and is encouraged, to react to changes that might affect the assumptions that were made about each project being considered prior to its commencement, including postponing the project if necessary. It is also noteworthy that there is not a lot of support for this method among financial managers at this time.
Both IRR and NPV are rates which assign value to your company. If you’re looking to sell your company, then download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.
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