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NPV v/s IRR

In today’s post of our series on NPV v/s IRR we will take a minor detour from our main topic and try to understand the background and the reason we use these evaluation techniques.

 

NPV and IRR are evaluation techniques used under Capital Budgeting to make an investment decision regarding selection of an asset or investment proposal or course of action whose benefits are likely to be available in future.

 

Confused?

 

Fear not, for the aim of this post is to make you understand this single line. So, if you just opened another tab to google some word you didn’t understand and sighed after not getting any reprieve, then this post is a must read for you.

 

Corporate Finance (also called Financial Management and Managerial Finance) is a subject matter that seeks to answer 3 dilemmas that every business, be it profit- seeking or not- for- profit, faces in its financial operations.

 

The 3 Dilemmas:

 

1) the Investment Decision

AKA selection of assets for investing funds

 

2) the Financing Decision

AKA deciding proportion of debt to be used to finance the investment requirements

 

3) the Dividend Policy Decision

AKA deciding whether to distribute profit or retaining it in the business itself

 

The main objective of Corporate Finance is to answer these interrelated questions, so that optimal financial decisions are taken.

 

The Investment Decision

Under investment decisions a choice has to be made, regarding selection of long- term assets as well as short term assets. While making a choice, different criterias are used for these 2 broad categories of assets as long- term assets yield a return over a period of time whereas short- term assets are usually convertible to cash within a year. Thus, different sets of variables are required to be handled in the two cases. Capital Budgeting relates to selection of long- term assets whereas, working capital management is used for long- term assets

 

Evaluation Techniques under Capital Budgeting

 

We use various evaluation techniques for Capital Budgeting, The purpose of these techniques is to estimate a proposal based on economic costs and benefits.

 

These Evaluation Techniques can be classified into 2 broad categories:

  1. Traditional Techniques

  2. Discounted Cash Flow Technique 

 

Traditional Techniques are generally deemed unsatisfactory due to a number of drawbacks but the major drawback is its ignorance of time value of money (Don’t worry! We will be discussing this shortly).

 

Here, DCF Techniques comes to our rescue. NPV and IRR are some of the techniques that come under this category. Although these techniques are more objective as compared to the traditional techniques, they come with their own set of drawbacks (which would be dealt with in future posts).

 

Summing it up!

 

 

 

Time Value of Money

 

A basic saying of financial planning is, “the earlier the better”.

 

In other words, benefits received sooner are more valuable than benefits received later. The basic reason behind this lies with the fact the former can be re- invested to earn a return. This is what is referred to as the time value of money which forms the basis of the mathematics of finance.

 

 

 

Let’s try to understand this further by a simple question-

Would you rather receive

  1. $1000 now or

  2. $1000 one year from now

The answer would obviously be a)

 

Now, let’s make a little tweak to our simple question-

Would you rather receive

  1. $1000 now or

  2. $1200 one year from now?

 

Stumped?

 

Well, you cannot answer this question until you know the ongoing reinvestment rate.

The term is quite self- explanatory. It refers to the interest you will receive per $100 in a given period of time.

 

If the reinvestment rate is such that, if you invest $1000 now, you will receive at least $1200 one year from now, them the answer will remain the same, otherwise you will opt b)

 

Now, you are equipped with the basis behind NPV and IRR and the mathematics behind these techniques.

 

 Note from the Author:

A number of terms like Working Capital Management has been mentioned but not discussed in detail as they were out of scope of this post’s objective(NPV V/S IRR). If you wish to know more about them, kindly check our other posts.