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Internal Rate of Return (IRR) is calculate as a rate of return which is offered by any specific project no matter the expected rate of return and any other parameters. It is also refers to discounted cash flow rate of return where the Net Present Value of cash flows are equal to zero. It can be calculated using trial and error until the discount of NPV=0. Also, the higher a projectΒs internal rate of return is the more likelihood the project could be chosen for implementation subject to the NPV is greater than zero.
The main advantage of IRR is that it is based on discounted cash flow and measure of higher return, also, it accounts for time value of money. The disadvantages of IRR are that of Multiplicity of Rate of Return when a project is been evaluated with streams of cash flows then the project will have multiple cash flows. Changes in discount rate, the IRR rules is to accept projects where the IRR is greater than the opportunity cost of capital. If the discount rate changes each year then itΒs impossible to make comparison.
Net Present Value
This method is the most popular and acceptable cash flow technique. NPV technique is the evaluation of a project in the procedure of discountedcash flows when it is greater than zero and been positive NPV as well. Such project will be accepted. NPV compares the value dollar today to the value of that same dollar in the future, but must take inflation into consideration. Furthermore, if the NPV is is begative, the
project should be rejected, because cash flows will also be negative.
Advantages of NPV are it takes into consideration risk associated with future cash. It also recognizes the dollar of today is better than the dollar of tomorrow.
Disadvantages of NPV. It does not give information how long the project will take to generate positive NPV. This is due to the fact that it does not inform us when NPV is achieved. Will it be 10 years?. Also, NPV assumed that the capital is in abundant. if there is scarce resources, the project analyist must seek for other means not only NPV.
Payback Period
This evaluation technique measures when a project will pay itself back the initial capital invested. This is also referred to as cutoff period. A typical example is a project worth $40,000 programmee for 4 years.
Advantage of PBP is that it is easy to calculate
Disadvantages of PBP are: It does not consider the cash flows after the PBP. PBP ignores the time value of money,
Which of these cash flow technique is the best?
Net Present Value is the best due to the following reasons:
1. Value of future project could be determine today, unlike IRR is measured using trial and error which may not be reliable.
2. NPV is more powerful because better condition is applicable.
3. Internal Rate of Return may not be be stable due to unforseen changes but NPV gives more reliable cash flow value
4. Pay Back Period does not take into consideration the time value of money but NPV does because future cost or value of investment can be determine presently.
Berk, J.B., DeMarzo, P.M., & Hartford, J.T. (20210. Fundamentals of Corporate Finance (5th.ed). Pearson