The Net Present Value (NPV) is a formula that is used in determining the current value of an investment following the discounted sum of cash flows that have been received from the project, the initial value usually a negative to indicate that the money is going out. If the investment is to be considered valuable then subtracting the initial value from the discounted sum should be a positive.
The internal rate of return refers to the rate used in capital budgeting to compare or measure the profitability of investments otherwise referred to as the discounted cash flow rate of returns (DCFROR) or rate of return (ROR) dealing with a context of savings the IRR is also known as the effective interest rate. It should be noted that the term internal dictates that the calculations do not incorporate environmental factors such as interest rates or inflation.
In simplified and more specific terms, IRR of any investment gives the interest rate for which the present value of costs equals the present value of benefits. The internal rates of return are used in evaluating the desirability of projects. The higher the returns, the more desirable the project is. There are various ways of applying the Weighted Average Cost of Capital if the manager focuses more on maximizing IRR instead of NPV there is a significant risk whereby the return on investments is beyond the WACC, the managers will not invest in the projects that are expected to earn more WACC but less than the return on the existing assets. IRR should be able to cover the weighted average cost of the project.
The weighted average cost is important in discounting cash flows in the calculation of NPV and valuation for analysis, weighted average cost represents average risk that is faced by the organization, it would require an up adjustment if it is used to calculate NPV project that is a high risk to the company’s average project and a downward adjustment for less risky project.
Companies’ asses feasibility of the project following the two approaches the Net Present Value shows the difference in benefits and costs. It is given as an expression in current monetary terms, it is essential in summarizing a long cash flow t a single figure that helps in easy comparison of value between the different projects. Only projects with a positive NPV are to be developed further negative NPV indicate that the costs are greater than the benefits and the project should be terminated.
In terms of IRR the feasibility of the project is legit if the IRR is greater than WACC of the project. The equity of IRR should cover the cost of equity if the project is to provide reliable returns to the equity holders.
It is important to note that information presented by IRR alone is not enough to dictate whether the project should be pursued or not rather NPV should also be used to compare the various projects. Cash flows in project IRR are taken to be the ones directly benefiting the project.
References
Jan, O.(2013), Weighted Average Cost of Capital:.Retrieved from http://accountingexplained.com/misc/corporate-finance/wacc
PPP TOOLKIT for improving PPP Decision-Making Processes, work through the PPP process: state highway. (2013). Retrieved from http://toolkit.pppinindia.com/highways/module2-fgost-nai.php?links=fgost5
Value based management, internal rateof return: (2013). Retrieved from http://www.valuebasedmanagement.net/methods_irr.html
