The net present value of a project is simply the difference between the present value of future cash flows and the purchase price. Discounted cash flows are commonly measured by the NPV method, and are a standard method for calculating the time value of money. This measurement of time value of money is important when appraising long-term projects. Furthermore, the NPV aids in indicating the value the investment would create for the firm. A negative or positive cash flow is not the determinant while accepting a project. Calculated risk is the over powering factor when making a decision. NPV falls short in decision making because it does not account for the opportunity cost of investing in one project. If a decision is made solely based on NPV then the project giving the higher NPV would be selected.
Internal rate of return or the economic rate of return measures and compares profitability of two or more investment projects. As the name suggests the IRR does not incorporate the impact of external influences. If the IRR is greater than the cost of capital, then the project should be accepted and reject the investment decision if IRR is below the cost of capital. However, managers must not use the IRR to rate mutually exclusive projects, rather they should use it in deciding if a single project is worth the investment or not.
The IRR and NPV mostly generate similar results while evaluating projects. IRR uses a single discount rate for all investments regardless of the nature of the investment project. The NPV is a more useful method for several reasons. The NPV requires assumptions to be made at every stage; whereas, the IRR uses a single number in determining the economical viability of the project. For complex decisions, basing the decision on a single factor is not appropriate (Wilkinson, 2013).
References
Wilkinson, J. (2013, July 24). NPV vs IRR. Strategic CFO. Retrieved February 23, 2014, from http://strategiccfo.com/wikicfo/npv-vs-irr/
