NET PRESENT VALUE METHOD VS INTERNAL RATE OF RETURN ( COMPARISON)

• COMPARISON BETWEEN NET PRESENT VALUE AND INTERNAL RATE OF RETURN
  FINANCIAL MANAGEMENT
• NET PRESENT VALUE METHOD

1. IS A MODERN METHOD OF EVALUATING INVESTMENT PROPOSAL. IT TAKES INTO CONSIDERATION THE TIME VALUE OF MONEY.IT RECOGNIZE THE FACT THAT RUPEE EARNED TODAY IS MORE IMPORTANT THAN IN THE FUTURE.
2. THE NET PRESENT VALUE OF AN INVESTMENT PROPOSAL MAY BE DEFINED AS THE SUM OF PRESENT VALUE OF THE CASH INFLOWS LESS THAN SUM OF PRESENT VALUES OF ALL THE CASH OUTFLOW ASSOCIATED WITH THE PROPOSAL.
3. NET PRESENT VALUE IS THE NET SUM OF THE DISCOUNTED VALUES OF THE CASH FLOW OF A PROPOSAL. IN CASE THE CASH OUTLAY IE THE CASH OUTFLOW OCCURS IN THE BEGINNING AT TIME 0 THE NPV IS DEFINED AS SUM OF THE PRESENT VALUE OF CASH INFLOWS LESS THE INITIAL INVESTMENT.
4. THE PRESENT VALUES ARE FOUND WITH THE HELP OF DISCOUNT RATE WHICH IS THE MINIMUM RETURN EXPECTED BY THE SHARE HOLDERS.IT IS EITHER THE ACTUAL RATE OF INTEREST IN THE MARKET ON LONG TERM LOANS OR IT SHOULD REFLECT THE OPPORTUNITY COST OF CAPITAL,

• FORMULA
• PV= 1/(1+r)ⁿ
• ^PV = PRESENT VALUE
• r= RATE OF RETURN/DISCOUNT FACTOR
• n =NUMBER OF YEARS
• PV= A₁/(1+r) ⁺ A₂/(1+r)² +A₃/(1+r)^3------- A_n/(1+r)ⁿ
• A_1, A_2, A_3----- A_n FUTURE NET CASH FLOWS
• FUTURE ANNUAL NET CASH FLOWS MEANS NET PROFIT AFTER TAX BUT BEFORE DEPRECIATION.

• INTERNAL RATE OF RETURN

1. ALSO A MODERN TECHNIQUE OF CAPITAL BUDGETING THAT TAKES INTO ACCOUNT THE TIME VALUE OF MONEY. ALSO KNOWN AS TIME ADJUSTED RATE OF RETURN,DISCOUNTED CASH FLOW,DISCOUNTED RATE OF RETURN,YIELD METHOD AND TRIAL AND ERROR METHOD,
2. THE INTERNAL RATE OF RETURN CAN BE DEFINED AS THAT RATE OF DISCOUNT WHICH EQUATES THE PRESENT VALUE OF CASH INFLOWS TO THE PRESENT VALUE OF CASH OUTFLOW.
3. THE IRR OF PROPOSAL IS DEFINED AS DISCOUNT RATE WHICH PRODUCES A ZERO NPV
4. HERE THE DISCOUNT RATE IS CALCULATED BY HIT AND TRIAL METHOD.
5. THE SPECIFIC PROCEDURE TO FIND OUT THE VALUE OF r IMPLIES FINDING OUT THE NET PRESENT VALUE OF THE PROPOSAL AT TWO DIFFERENT ASSUMED VALUES OF r WITH IN WHICH THE IRR IS EXPECTED TO LIE. TWO RATES ARE INTERPOLATED TO MAKE THE NET PRESENT VALUE EQUAL TO ZERO.

• FORMULA
• C= A₁/(1+r) ⁺ A₂/(1+r)² +A₃/(1+r)^3------- A_n/(1+r)ⁿ
• A_1, A_2, A_3----- A_n FUTURE NET CASH FLOWS AT DIFFERENT PERIOD
• C = INITIAL OUTLAY AT TIME ZERO
•   r= RATE  OF DISCOUNT OF INTERNAL RATE OF RETURN
• ACCEPT THE PROPOSAL IF THE INTERNAL RATE OF RETURN IS HIGHER THAN OR EQUAL TO MINIMUM RATE OF RETURN I.E THE COST OF CAPITAL OR CUT OFF RATE AND REJECT THE PROPOSAL IF THE INTERNAL RATE OF RETURN IS LOWER THAN COST OF CAPITAL
• IN CASE OF ALTERNATIVE PROPOSAL SELECT THE HIGHER RATE OF RETURN
• IN BOTH THE TECHNIQUES NET ANNUAL CASH INFLOWS MEANS ANNUAL CASH INFLOW AFTER TAX BUT BEFORE DEPRECIATION FOR EXAMPLE NET PROFIT AFTER TAX AND AFTER DEPRECIATION IS 100 . THEN WE WILL ADD BACK THE DEPRECIATION  TO MAKE IT ANNUAL CASH INFLOW AFTER TAX BUT BEFORE DEPRECIATION

• COMPARISON
• SIMILARITIES:-

1. BOTH ARE MODERN TECHNIQUES OF CAPITAL BUDGETING
2. TAKE INTO CONSIDERATION THE TIME VALUE OF MONEY
3. DISCOUNTED CASH FLOW TECHNIQUE

• DIFFERENCE BETWEEN NPV AND IRR
• NET PRESENT VALUE

1. PRESENT VALUE IS DETERMINED BY DISCOUNTING THE FUTURE CASH FLOWS OF A PROJECT AT A PREDETERMINED OR SPECIFIC RATE CALLED CUT OFF RATE BASED ON COST OF CAPITAL
2. RECOGNIZES THE IMPORTANCE OF MARKET RATE OF INTEREST OR COST OF CAPITAL
3. THE BASIC PRESUMPTION OF NPV IS THAT INTERMEDIATE CASH INFLOWS ARE REINVESTED AT THE CUT OFF RATE
4. MORE RELIABLE

• INTERNAL RATE OF RETURN

1. INTERNAL RATE OF RETURN DISCOUNT IS RATE IS CALCULATED BY HIT OR TRIAL METHOD
2. DOES NOT CONSIDER THE MARKET RATE OF INTEREST AND SEEKS TO DETERMINE THE MAXIMUM RATE OF INTEREST AT WHICH FUNDS INVESTED IN ANY PROJECT COULD BE REPAID WITH THE EARNING GENERATED BY THE PROJECT.
3. INTERMEDIATE CASH FLOWS ARE PRESUMED TO BE REINVESTED AT  THE INTERNAL RATE OF RETURN.
4. IN CERTAIN SITUATIONS THE RESULTS SHOWN BY BOTH ARE SAME

• SIMILARITY OF RESULT

1. INDEPENDENT INVESTMENT PROPOSALS WHICH DO NOT COMPETE WITH ONE ANOTHER AND WHICH MAY BE EITHER ACCPETED OR REJECTED ON THE BASIS OF MINIMUM REQUIRED RATE OF RETURN

1. CONVENTIONAL INVESTMENT PROPOSAL WHICH INVOLVE CASH OUT LAY IN THE INITIAL PERIOD FOLLOWED BY SERIES OF CASH INFLOWS

1. NET PRESENT VALUE : RULE IS ACCEPTANCE OF THE PROJECT WHICH GIVES HIGHER NET PRESENT VALUE
2. IRR : ACCEPTANCE RULE IS HIGHER INTERNAL RATE THAN COST OF CAPITAL

• CONTRADICTING RESULTS BETWEEN NPV AND IRR

1. IN CASE OF MUTUALLY EXCLUSIVE INVESTMENT PROPOSAL WHICH COMPETE WITH ON ANOTHER IN SUCH A MANNER THAT ACCEPTANCE OF ONE AUTOMATICALLY EXCLUDES THE ACCEPTANCE OF OTHER
2. BOTH THE METHODS CAN GIVE CONTRADICTORY RESULT DUE TO THE FOLLOWING:_
3. SIGNIFICANT DIFFERENCE IN THE SIZE ( AMOUNT ) OF CASH OUTLAY OF VARIOUS PROPOSALS UNDER CONSIDERATIONS
4. PROBLEM OF THE DIFFERENCE IN THE CASH FLOW PATTERN OF TIMING OF THE VARIOUS PROPOSAL
5. DIFFERENCE IN THE SERVICE LIFE OR UNEQUAL EXPECTED LIVES OF THE PROJECT

6.     THE NET PRESENT VALUE METHOD IS MORE RELIABLE AS COMPARED TO IRR METHOD IN RANKING THE MUTUALLY EXCLUSIVE INVESTMENT PROPOSAL. ACCEPTANCE SHOULD BE ON HIGHER THE NPV BECAUSE THE PROJECT WITH THE LARGEST NPV HAS THE MOST BENEFICIAL EFFECT ON SHARE PRICES AND SHAREHOLDER’S WEALTH.