The text book favors Internal rate of return and Net present value. Internal rate of return because this method does consider the time value of money and looks at the cash flows over the entire life of the project. It computes the rate that will discount the future cash flows to be equal to the cash outlay for the project. Capital investment appraisal techniques define IRR as discount rate that gives a value of zero to NPV or net present value. All capital investment appraisal techniques, IRR is generally considered to measure the efficiency of the capital investment. Thus, if cost of capital investment in company works out to be greater than the IRR value, the project is highly likely to be rejected. On the other hand, a low cost of capital has more chances of being accepted. IRR is calculated by equating NPV to zero and then deriving the discount rate. Even though IRR and NPV are related capital investment appraisal techniques they are different from each other.Net Present value because this method discounts the project's future cash flows by a predetermined rate, such as the targeted or needed rate. If the cash flows discounted by the targeted rate exceed the cash investment, the project is accepted. That is, the project provides the targeted return or more. All capital investment appraisals have a single objective – drive towards a positive NPV. The NPV is a mathematical calculation involving net cash flow at a particular present time 't' at discount rate at the same time, i.e. (t – initial capital outlay). Thus there is an inverse proportional relation between discount rate and NPV. A high discount rate would reduce the net present value of capital. A high interest rate increases discount rates over a period of time and most capital investment appraisals are wary of such an increase.
1) Which method is MOST preferred (and why)?
2) Not really a question, but more of a comment, think about each of your answers in your write-up above when answering question 2. This has to do with changing risk across projects. So, if I have 2 projects, and each deserves a different risk rating, how do I handle it (Don't answer here, save that for DQ2).
3) What if I have 2 projects. Will there be a case where NPV is better for the one and IRR better for the other? Can you think of why/when this might happen?