1. How are Net Present Value (NPV) and Internal Rate of Return (IRR) related? Wh
ID: 2695271 • Letter: 1
Question
1. How are Net Present Value (NPV) and Internal Rate of Return (IRR) related? Which is the better decision rule to follow for project selection or rejection? Why? 2. There have been two 'modifications' in discounted cash flow metrics. First, the Internal Rate of Return (IRR) has been revised giving a Modified Internal Rate of Return (MIRR). Second, the Profitability Index (PI) has been revised giving a Modified Profitability Index (MPI). Why were the IRR and the PI revised? When are these measures appropriate to use? 3. Some people take a position that the Return on Investment (RoI) is the appropriate measure or decision rule to use. Do you agree? Why or why not? How would the project's RoI be calculated?Explanation / Answer
When a firm is presented with a capital budgeting decision, one of its first tasks is to determine whether the project will prove to be profitable. Thenet present value(NPV),internal rate of return(IRR) andpayback period(PB) methods are the most common approaches to project selection. Although an ideal capital budgeting solution is such that all three metrics will indicate the same decision, these approaches will often produce contradictory results.Depending onmanagements' preferences and selection criteria, more emphasis will be put on one approach over another.
Net present value (NPV) is calculated based on the expected returns and the expected costs of an investment, where these expected returns and expenses are discounted by a rate that reflects inflation and opportunity costs. The process NPV / IRR analysis enables you to determine the net present value of a process. As parameters for this analysis, you can specify initial cost, expected process volume (as an absolute value), number of periods (where each period is one year), and annual discount rate. The analysis then uses the average cost and revenue determined from the process simulation results to calculate the expected future net profits.
In addition to the net present value, this analysis also determines the internal rate of return (IRR) for the process. The internal rate of return is the interest rate received for an investment, based on anticipated expenses and income that will occur at regular periods. IRR is closely related to NPV, the net present value function. The rate of return calculated by IRR is the interest rate corresponding to a zero net present value.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.