NPV and IRR
Published 09 Jun 2017
In theory, the value of a company is related to its future cash flows. If the cash flows are negative, then the company should be paying the investor to take the company away. Net present value and internal rate of return are two of the most common standard methodology measures in the course of production and inventory. NPV is widely known in reflecting the time value of money, thus, business analysts imply that NPV is rather more efficient are particularly important when dealing with high interest rates although not so much in production and inventory as IRR has the capacity to predict and anticipate the cash flow of the company’s finances accurately (Lee, 1997).
Methodologies like long-run average cost and total cost without discounting following the EOQ model are found to deter research that even the use of an Occam’s razor concept would be unlikely. Deterministic demands would help analyze a good approximation in production costs thus helping financial analysts foresee areas that require adept decision making skills (Ittelson, 2009)—the inclusion of average costs and objective functions.
Financial managers use IRR and NPV to serve as a goal in their investments. Cost of capital is a very important concept within financial management, because it is the rate of return that must be achieved in order for the price of the stock to remain unchanged. Therefore, the cost of capital is the minimum acceptable rate of return for the company’s declining NPV or in cases where costs come before profit. Financiers must know the cost of capital (the minimum required rate of return) in making capital budgeting decisions, helping to establish the optimal capital structure, and in making decisions such as leasing, bond refunding, and working capital management. The cost of capital has been used either as a discount rate under the NPV method or as a hurdle (cutoff) rate under the IRR method. Results achieved with IRR may be wrong investments as compared to NPV curves in evaluating investments (Harris & Raviv, 1991).
- Harris, M., & Raviv, A. (1991). The Theory of Capital Structure. The Journal of Finance, 46(1).
- Ittelson, T. R. (2009). Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports (Revised ed.). New Jersey, USA: Career Press.
- Lee, M. H. (1997). Valuing Finite-Maturity Investment-Timing Options. Financial Management, 26(2).