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Free Example of Capital Budgeting Valuation Essay

Net present value is the difference between the present value of cash inflows and the present value of cash outflows while internal rate of return is the discounting rate that equates the net present value to zero. The investors in any given company require returns from their investments and hence the more risky the investments, the more returns expected by the investor from the company and this forms the base upon which the capital budgeting decisions are made. IRR uses only a single discount rate that does not put into consideration the varying discount rates and hence the long term projects with changing discount rates cannot be evaluated effectively since their discount rates are expected to change with the passage of time. NPV, on the other hand, accounts for all the cash inflows generated in the entire lifetime of a project and hence it is the best method to use in the appraisal of the long term projects.

 The internal rate of return cannot be used to rate mutually exclusive projects unlike the net present value that can rate all projects. An IRR calculation is also ineffective in situations where there are multiple negative and positive cash flows. This is because more than one internal rate of return will have to be used and hence there will be two solutions instead of one. This is attributed to the changing conditions in the market that require different discount rates to be used instead of one. Multiple rates of return used to evaluate a project will generate multiple IRR’s unlike when using the net present value that has no problems and can discount each cash flow separately from the others.

Another problem arises when using the IRR if the discount rate is unknown or cannot be used to evaluate a specific project. In such cases, the IRR method is of limited value since the IRR is compared to a discount rate whereby if the IRR is above the discount rate, then the project is viable and if it is below the discount rate, the project is infeasible. In cases whereby a discount rate is unknown, the use of NPV is superior since the project is considered worth undertaking if the NPV is above zero. Based on my opinion, the NPV is a better method in capital budgeting unlike the IRR since it can be applied in all the situations where use of the IRR method is futile.

Code: Sample20

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