This page covers practice CPA questions that covers comparison of the net present value and internal rate of return method.
Comparison of Capital Budgeting Methods
Comparison of the Net Present Value and Internal Rate of Return Methods
This section compares the net present value and internal rate of return methods in three ways. First, both methods use the cost of capital to screen out undesirable investment projects. When the internal rate of return method is used, the cost of capital is used as the hurdle rate that a project must clear for acceptance. If the internal rate of return of a project is not high enough to clear the cost of capital hurdle, then the project is ordinarily rejected. When the net present value method is used, the cost of capital is the discount rate used to compute the net present value of a proposed project. Any project yielding a negative net present value is rejected unless other factors are significant enough to warrant its acceptance.
Second, the net present value method is often simpler to use than the internal rate of return method, particularly when a project does not have identical cash flows every year. For example, if a project has some salvage value at the end of its life in addition to its annual cash inflows, the internal rate of return method requires a trial-and-error process to find the rate of return that will result in a net present value of zero. While computer software can be used to perform this trial-and-error process in seconds, it is still a little more complex than using spreadsheet software to perform net present value analysis.
Third, the internal rate of return method makes a questionable assumption. Both methods assume that cash flows generated by a project during its useful life are immediately reinvested elsewhere. However, the two methods make different assumptions concerning the rate of return that is earned on those cash flows. The net present value method assumes the rate of return is the discount rate, whereas the internal rate of return method assumes the rate of return earned on cash flows is the internal rate of return on the project. Specifically, if the internal rate of return of the project is high, this assumption may not be realistic. It is generally more realistic to assume that cash inflows can be reinvested at a rate of return equal to the discount rate—particularly if the discount rate is the company’s cost of capital or an opportunity rate of return. For example, if the discount rate is the company’s cost of capital, this rate of return can be actually realized by paying off the company’s creditors and buying back the company’s stock with cash flows from the project. In short, when the net present value method and the internal rate of return method do not agree concerning the attractiveness of a project, it is best to go with the net present value method. Of the two methods, it makes the more realistic assumption about the rate of return that can be earned on cash flows from the project.