Question

How would you decide between two capital project choices if the different analysis methods (NPV, IRR, etc.) were pointing to different options? What are the relative strengths and weaknesses of each?  

Answer 1

There are a number of different approaches that can be used to evaluate a project. Each approach has its own advantages and disadvantages. Most managers and executives like methods that look at a company's capital budgeting and performance expressed in percentages rather than dollar figures. In these cases, they tend to prefer using IRR or the internal rate of return instead of the NPV or net present value. But using IRR may not produce the most desirable results.

IRR (internal rate of return): It estimates the profitability of potential investments using a percentage value. It is also referred to as the discounted flow rate of return or the economic rate of return. It excludes outside factors such as capital costs and inflation. IRR will probably work for shorter time duration projects because discount rates change over time.

NPV (net present value): is expressed in a dollar figure. It is the difference between a company's present value of cash inflows and its present value of cash outflows over a specific period of time.The NPV method is complex and requires many assumptions at each stage such as the discount rate or the likelihood of receiving the cash payment. NPV can handle multiple discount rates without any problems. Cash flow can be discounted separately from the others making NPV the better method.

The NPV can be used to determine whether an investment such as a project, merger or acquisition will add value to a company. Positive net values mean the shareholders will be happy, while negative values are not so beneficial.