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Net Present Value (NPV)

NPV is defined as the total present value of individual cash flows within a financial entity

such as a project or investment. It may also be considered to be the present value of cash

outflows subtracted from the present value of cash inflows (Higgins 58). NPV is a capital

budgeting tool that is used to evaluate the financial viability of a project or investment. In

addition, NPV is an integral tool in the analysis of discounted cash flows (DCF) where it is used

to evaluate long-term projects using the time value of money. In general, NPV is applied in the

analysis of the present value of cash flows, in deference to the capital or investment costs.

NPV is obtained by discounting the cash flows to a specific period in the future using a

discount rate, while factoring in inflation and project or investment returns. The sensitivity of

NPV analysis to future cash flows makes it an accurate tool in determining the yield of capital

expenditure, allowing investors and businesses to determine the investments or projects that

have the highest profits potential (Higgins 58). This is because NPV compares the current value

of one currency unit against the future value of the same currency unit, effectively quantifying

the inherent risk in a project or investment. According to the NPV Decision Rule, if a project or

investment has a positive NPV, then it should be accepted since it will yield returns, but projects

or investments with a negative NPV should be rejected since they will have negative cash flows

(Higgins 59).

Internal Rate of Return (IRR)

Similar to the NPV, the IRR is a capital budgeting tool used in measuring the profitability

of a project or investment, but unlike NPV, IRR does not factor external variables such as

inflation or interest rates. By converting the NPV of all cash flows to zero where the present
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values of future cash flows is equated to the initial investment, the IRR effectively annualizes the

compounded rate of return for a project or investment (Higgins 62). Consequently, the NPV of

investment costs in IRR is equal to the NPV of the future cash flows. IRR serves the same

functions as NPV which is to determine the viability and profit potential of an investment or

project. However, unlike the NPV which largely quantifies the value of an investment, the IRR

measures the quality and efficiency of an investment.

A project or investment is regarded to be acceptable when its IRR is higher than the cost

of capital or a predetermined acceptable rate of return. This is in line with the IRR decision rule

which states that a project or investment with an IRR that is higher than the required rate of

return or the cost of capital should be accepted whereas a project or investment with an IRR

that is lower than the required rate of return or cost of capital should be rejected (Higgins 64).

Projects with the highest IRR are considered more attractive when selecting between projects

that require a similar amount of investment capital. However, it is recommended that all

available projects or investments with IRRs higher than the cost of capital be undertaken,

although this might be limited by access to funds, capacity or resources (Higgins 64).

Reinvestment of Intermediate Cash Inflow

The assumption concerning the reinvestment of intermediate cash inflow tends to favor

NPV since NPV analysis assumes that reinvestments are made at the existing discount rate or

the cost of capital (Higgins 71). The IRR approach on the other hand assumes that all

intermediate cash inflows are reinvested at the existing IRR. The IRR assumption is inaccurate,

contingent on the fact that projects are selected based on their returns, yet even the project

with the highest cash inflows is not guaranteed to have equal reinvestment prospects to
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generate similar profitable inflows in future (Higgins 71). Consequently, predicating the

reinvestment of intermediate cash inflows on the assumption postulated by the IRR approach

can result in the inadvertent bias towards short-term profitability projects such as projects with

higher short-term cash inflows (Higgins 71). In practice, the NPV technique is preferred based

on the assumption that the cost of capital is applied in the reinvestment of intermediate cash

inflows. In addition, the NPV approach allows for adjustment of the reinvestment rate based on

external variables such as economic conditions, in order to accurately discount the future cash

inflows to their present values (Higgins 72).

Conclusion

NPV and IRR perform similar functions in capital budgeting which is to evaluate the

financial viability of a project or investment. The NPV however measures the value of an

investment while the IRR is used to measure the quality and efficiency of an investment. In the

analysis of the reinvestment of intermediate cash inflows, the NPV assumption posits that

reinvestments are made at the existing discount rate or the cost of capital. This makes the NPV

technique the preferred reinvestment method since the cost of capital and other discount rates

such as the weighted average cost of capital (WACC) can be used as the reinvestment rate. In

addition, the discount rate can be adjusted to factor in external variables, with the variable

discount rate being practical when controlling for future risk to the cash flows.
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Works Cited

Higgins, Robert. Analysis for Financial Management. New York: McGraw-Hill, 2011. Print.