--%>

Evaluation of net present value

Explain evaluation of net present value (NPV) and internal rate of return (IRR) in brief?

E

Expert

Verified

The evaluation of net present value (NPV) and internal rate of return (IRR) is well developed and documented in many publications, some representative ones of which are Muro’s and Lang and Merino’s. IRR and NPV are the most common and important indicators in investment decisions. Although ARR (accounting rate of return), as reported by Lefley, is also a common indicator, whose role was fully discussed by Brief and Lawson, both Muro and Lefley and Morgan opined that ARR has shortcomings and that the discounted cash flow methods, such as IRR and NPV, the so-called more “sophisticated” and “scientific” methods, should be preferred in capital investment appraisals.

Although IRR and NPV both are discounted cash flow methods, they have intrinsic differences from one another. Tang and Robinson and Cook illustrated that the ranking of investment alternatives is not necessarily the same obtained by the two methods. Differences in rankings between NPV and IRR are further exhibited in Asquith and Bethel, who reported that IRR might be preferred to NPV under certain circumstances. Evans and Forbes also reckoned that IRR is more cognitively efficient than NPV because IRR is expressed as a percentage (or a rate of return) while NPV was just a monetary value cognitively inefficient to decision makers, and hence the use of IRR should be promoted. Other researchers, such as Lefley and Morgan, and particularly the academicians, however, took the view that NPV is more conceptually “correct” despite the fact that the IRR is more popular than the NPV, and that NPV is more theoretically sound as the IRR may be too “capricious” or “fickle” and may not rank some projects in the same order as the NPV.

The definition is: IRR gives the private investor’s point of view and NPV the society’s point of view. In other words, the IRR is a financial indicator and the NPV, an economic indicator. Because the IRR functions as a financial indicator, its value varies with the change of financial arrangements (e.g. change of equityloan ratio, change of taxation rate, etc.) of a capital investment. The NPV, however, does not vary when financial arrangement varies, because it functions as an economic indicator. In this paper, the authors will use an illustrative example to show the basic differences of IRR and NPV. They will also show a mathematical proof to substantiate these intrinsic different natures of the IRR and the NPV.

   Related Questions in Macroeconomics

  • Q : Cost-push inflation Describe cost-push

    Describe cost-push inflation and its major source.

  • Q : Declines of percentage of income paid

    Since the percentage of income paid in taxes generally declines as taxpayer income increases, standard sales taxes and “sin” taxes [for example, excise taxes upon liquor or tobacco] are illustrations of: (1) proportional t

  • Q : Estimating rational income How will you

    How will you treat the given in estimating rational income of India? Provide reasons for your answer. (i) The value of bonus shares received by the shareholders of a company.(ii) Interest received on loan pro

  • Q : Okuns law Describe Okun's law ? Give an

    Describe Okun's law? Give an illustration of how it works.

  • Q : Nominal GNP problem The value of

    The value of nominal GNP of an economy was Rs. 2,500 crores in a specific year. The value of GNP of that country throughout the same year, computed at the prices of some base year was Rs.3000 crores. Evaluate the value of GNP deflator of the year in terms of percentag

  • Q : Tax shifting backward totally A tax

    A tax will be backward-shifted totally when the: (i) demand curve is vertical and the supply curve is slopes up. (ii) demand curve slopes down and the supply curve is vertical. (iii) supply curve is perfectly elastic and the demand cu

  • Q : What is Time Bound-Banking Industry

    Time Bound: It is essential for bank to lay goals and also have the deadline for the completion of each goal. To be a market leader bank needs to work hard. They need to dedicate more time and resources to attain required success. A time associated wi

  • Q : Problem on equivalent Consumer Surplus

    Tom reimburses $5.00 for a ticket to see a present hit movie. If Tom was willing to reimburse up to $7.00 for that ticket, his consumer surplus equals: (1) $5.00 (2) $2.00 (3) $7.00 (4) Tom does not receive any consumer surplus as he purchased the ticket.

  • Q : Poorer good for American families The

    The most probable of the following to be a poorer good for most American families who purchase some of each of such products throughout a given year would be: (i) Plastic surgery. (ii) College textbooks. (iii) Films on DVD. (iv) Cup-a-Noodles soup. (v) Downloads for t

  • Q : Base of categorizing receipts into

    What is the base of categorizing receipts into revenue and capital receipts?