Type: Management
Pages: 2 | Words: 494
Reading Time: 3 Minutes

Net present value (NPV) method discount all the business’s cash flows considering the opportunity cost of capital. According to the rule of most businesses, projects that are accepted are only those that have a net present value of more than zero while projects whose net present value is negative are rejected(Stanley, 2009). Therefore, such conflicting situations might occur because if the net present value of the business’s project is negative, such project must be rejected to avoid affecting the cash flow of the business.

Payback method is used in determining the period it may take to recover the initial investment back to the company. Companies set their own rules when applying this method in the evaluation of a project. For instance, a company might make decisions that require all projects to have a payback of less than 4 years. Therefore, conflicting situations may arise if the management or share holders do not accept the payback period.

On the other hand, IRR (internal rate of return) method provides analysts with a proper way of quantifying the rate of return offered by an investment. In this method, the higher the internal rate of return of a company’s project, the more desirable it becomes to implement the project. Therefore, NPV can be rejected, and IRR method adopted if there is higher internal rate of return from a company’s project.

Therefore, analysts should reject NPV because according to the NPV rule, a company is supposed to implement only projects whose NPV is more than Zero and reject projects that have negative NPV since the cash flow will be negative (Samuels, & Wilkes, 1995). Other reasons as to why the company should adopt payback method and IRR are because if the management and shareholders do not accept the payback period the project cannot be implemented. Also, according to IRR method rule, companies implement projects whose IRR is high.

Payback method provides easy understanding by shareholders and management of the company on when the initial investment of the company will be recouped. This provides a good platform through which the company’s management and shareholders make a decision on whether the project should be implemented with regard to the cutoff date rules. However, this method does not consider the time value of money, and it also fail to put into account all the cash flows occurring after the end of payback period.

On the other hand, IRR puts into account the time value of money. This implies that, when IRR method is used appropriately, the measure can provide appropriate guidelines on the value of a project and risks associated of a project. However, this method fails to put into account discount rate changes over years. Another shortcoming of this method is that when evaluating a company’s project, it may have no IRR or have multiple IRR’s.

However, NPV is the most appropriate method of evaluating a project since it identifies the risk associated with the company’s future cash flow, and it ascertains the time value of money.

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