Difference between NPV and IRR
- The first difference between NPV and IRR lies on their implementation. NPV is calculated in currency terms while IRR is expressed as a percentage a firm projects capital project to yield (Besley & Brigham, 2011, p.521).
- NPV measures in absolute terms project return after a period while IRR measures the actual return from the invested funds.
- NPV perceives its cash flows to be reinvested back into the project at the required rate of return while IRR assumes reinvesting of cash flows back into proposed project at the IRR.
Similarities of NPV and IRR
- Both NPV and IRR take into consideration time value of many while calculating project return.
- Both NPV and IRR use cash flow after tax to calculate the returns on capital throughout the project life cycle.
Examples of opportunity costs and incremental cash flows
Opportunity cost refers to the value of next best alternative resource allocation that a company waives by investing in a given proposed project. The cash flow that a company or a firm forgoes, as a result, of carrying out a specific is an example of opportunity cost. In cases where one project require rental of the premise then opportunity cost is the rental revenue forgone, as a result of investing in the project. The cost that a company incurs in replacing the resource used in the project is an example of opportunity cost (Holtzman, 2013, p.166).
Incremental cash flow, on the other hand, refers to the net after tax cash flow generated by the project. It is derived by subtracting the outflows and taxes from the inflows. When incremental cash flow is a positive value investing in such a project generates increased cash flow for the company (Holtzman, 2013, p.166).
How cash flow impact on whether or not a company should pursue a project
Companies' estimates future streams in cash flow of the project to investigate whether investment decision they want to undertake is worthwhile or not. Companies base their analysis on NPV and IRR to determine if the intended investment will generate net profits or losses for the firm. Management invests only on projects whose NPV is positive since their cash flows will also be positive, projects whose NPV is a negative value, reject it as it is likely to produce negative cash flow (Besley & Brigham, 2011, p.521).
Example of how different capital budgeting techniques are applied in real life situation
Capital budgeting techniques play a greater role in decision making of enterprises as they are used to appraise investment decisions. A proposed project is either accepted or rejected based on the value of its NPV. When the NPV is greater than zero, I will accept the project as it will yield positive returns but reject negative NPV as investing in such venture can lead to business incurring losses. In the scenario involving IRR, I will reject outcome that gives lesser value than proposed capital invested since an organization is likely to experience loss spending on the project (Besley & Brigham, 2011, p.521).
Investment on projects involves utilization of organization resources so as to achieve the goals specified by the management. Prior to acceptance of the project several investigations and analysis take place so as to differentiate and arrive at the best alternative. Projects are differentiated based on project size, the perceived benefits to the firm and their degree of dependence.
References
Besley, S., & Brigham, E. F. (2011). Principles of finance (5th ed.). Mason, Ohio: South-Western.
Holtzman, M. P. (2013). Managerial Accounting For Dummies. Hoboken: Wiley.
