Strengths and Weaknesses of Net Present Value and Internal Rate of Return

Discuss the strengths and weaknesses of Net Present Value and Internal Rate of Return as investment appraisal techniques.

Investment appraisal techniques are used to assess the attractiveness of an investment proposal with the use of average rate of return, internal rate of return (IRR), net present value (NPV), or payback period methods.

NPV

Net Present Value is the present value of future cash flows after taking away the initial cash flow – investment. It shows the increase in wealth by undertaking the project in today's money. Present values are achieved by discounting at the opportunity cost of capital by multiplying cash flows by discounting factor. NPV can be positive or negative. Negative NPV represents that the undertaken project will make a loss therefore the investment appraisal should be rejected and vice versa. The larger the NPV, the greater is the increase in wealth.

Advantages

1.One advantage of NPV method is that it shows the contribution of each dollar invested to the investor after completion of the project.

2. Secondly, it takes into account impatience to consume, inflation and risks.

3. Another obvious advantage of NPV method is that it tells the investor whether it will add or deduct value from the business and decisions can be taken of whether to accept or reject the project.

While NPV method is very useful when valuing investment opportunities, it carries some disadvantages too.

Disadvantages

1. NPV method is based on discount rates and the biggest disadvantage of NPV calculation is the sensitivity to them. Discount rates may not be necessarily accurate as inflation rates are never fixed and they always change. A small increase or decrease in discount rate will