Discuss about Discounted cash flow analysis
To calculate a Return of Investment, we use NPV-Net Present Value and IRR- Internal rate return as they are 2 primary capital budgeting metrics that have been traditionally used for this process: the net present value (NYSE:NPV) and the internal rate of return (NYSE:IRR).
The advantage of NPV is that is increases the wealth of the share holders where IRR is indicating a rate of return of a project. with the help of IRR one can find the discount rate at which the total amount received on the investment is equal to the investment that is made today. One would be at no risk of loosing the money as the required rate of return should be equal to or higher then the IRR.
1.NPV only gives an indication of the value of the money today but nobody knows the exact rate of return so IRR gives you the rate you are safe where in NPV a discount rate is assumed.
NPV t also tells whether the investment will increase the firm's value based on the time value of money and to considers the risk of future cash flows (through the cost of capital). On the other hand, NPV requires an estimate of the cost of capital in order to calculate the net present value in terms of dollars, not as a percentage. If the discount rate chosen for the NPV assessment of an investment is unrealistic, the decision to accept or reject the investment would therefore be unreliable.
2.IRR tells whether an investment increases the firm's value and to considers all cash flows of the project associated with the risk of future cash flows (through the cost of capital in the decision rule). But IRR requires an estimate of the cost of capital in order to make a decision and IRR can not give the value-maximizing decision when used to compare mutually exclusive projects. IRR can not give the value-maximizing decision when used to choose projects when there is capital rationing. It is not absolute method to be used in situations in which the sign of the cash flows of a project change more than once during the project's life.
What do you guys think about NPV and IRR, could it be justifiable ?