Numerous approaches are applicable in project evaluation when it comes to capital budgeting. This is simply because every approach has its merits and demerits. For that reason, most managers will prefer a firm’s capital budgeting tool that expresses budgeting and performance in terms of percentages instead of dollar figures. In most cases, they prefer the Internal Rate of Return (IRR) to Net Present Value (NPV). However, it is imperative to highlight some of the advantages and disadvantages of the above two approaches to make an informed decision on which is preferable.
One of the advantages of IRR helps in finding the time value of money. IRR is measured by calculating the interest rate of the present value of forthcoming cash flows equals the essential capital asset. It is advantageous because cash flow’s timing is depicted in future years is determined and this offers each cash flow equal weight by utilizing the time value of money (Warren, Reeve & Duchac, 2009). Secondly, it is also easy to use and comprehend because it is an easy measure in calculating and offering a simple means in comparing the worth of numerous projects under consideration. On the other hand, one of the disadvantages is that it barely considers the project’s size when making a comparison. Secondly, it also ignores the forthcoming potential costs that may have an impact on profit.
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One of the advantages of Net Present Value is that it discounts every cash flow distinctly, which makes it a bit more refined in terms of analysis. NPV accommodates changes that may occur when the rates of return vary over the project’s life. Additionally, when the discount rate is unknown, NPV works better compared to IRR calculation (Weygandt, Kieso & Kimmel, 2011). Conversely, NPV has numerous disadvantages such as difficulty in estimation of opportunity cost, ignoring sink cost, difficulty in determining the required rate of return, and it might not boost ROE and EPS.
The bottom line is that IRR is a better option to NPV because of its simplicity and numerous advantages.
References
Warren, C. S., Reeve, J. M., & Duchac, J. (2009). Financial and managerial accounting . Mason, Ohio: South-Western Cengage Learning.
Weygandt, J. J., Kieso, D. E., & Kimmel, P. D. (2011). Managerial Accounting: Tools for business decision-making . Hoboken, N.J: John Wiley & Sons.
