The IRR ignores the initial investment amount.

The net present value allows for an investor to know rather
or not the investment is achieving a target yield at the initial investment and
quantifies how much the initial investment must be adjusted to achieve the
target yield assuming everything stays the same (Schmidt,
2013).  The net present value is the sum of the cash
flows for each period in the holding period, discounted at the investors
required rate of return (Schmidt, 2013).  The internal rate of return is percentage of
an investment rate earned on each dollar invested for each period it is
invested.  It can be found by setting the
NPV to zero and then solving for the internal rate of return, and give a
comparison for alternative investments beast on their yield (Schmidt,
2013).
 The difference between the net present
value and the internal rate of return is the NPV formula solves for the present
value of stream of cash flows with a given rate, while the IRR solves for a
rate of return when setting the NPV equal to zero (Schmidt,
2013).   The IRR is trying to find out what the rate
of return would be when given a stream of cash flows, while the NPV answers the
question of what the stream of cash flows are worth at a particular discount
rate in the present dollars (Schmidt, 2013).

There are limitations both with the NPV and the IRR.  The IRR ignores the initial investment
amount.  This limitation can be seen when
one is trying to compare the alternative investments and the decision is
between deciding if a 50% return on a $1,000 investment is better than a 10%
return on a $50,000 investment, and one does not consider the initial investment
when using the IRR causing the analysist to opt for the first option rather
than the second even if the second might be the one needing to be chosen (Schmidt,
2013).  Another limitation of the IRR is that always
equal the return on the initial investment over the period of holding time (Schmidt,
2013).  Sometimes there might be capital recovery the
IRR does not make assumptions about when one is in the interim of cash flows,
and does not figure in what one might do with the cash flows, such as putting
the cash flows in a lower yielding bank account that what the IRR is yielding causing
the true return for an investment to be erroneous (Schmidt,
2013).

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!


order now

There are limitations for the net present value.  One limitation is the timing and variability
of cash flows is not taken into consideration (Schmidt, 2013).  For example, which is better a project yielding
even cash flows every year for ten years or receiving a lump sum on a project
at the end of ten years?  These two
investments are different even though the NPV might be the same, but the needs
of the business might differ making these projects vary in the options (Schmidt,
2013).
With the NPV, it is also difficult to estimate the discount rate.  Without being able to estimate the discount
rate accurately, it is difficult to account for how risky the projected cash
flow is within the projects (Schmidt, 2013).  When deciding rather or not to bump up a
discount rate for a rollover risk for a building with short term risk, it might
be difficult to know how much higher the discount rate should be (Schmidt,
2013).
 The decision is very subjective to begin
with and the NPV cannot easily account for a given answer (Schmidt,
2013).

References

Gitman, L. J., & Zutter, C. J. (2015). Principles
of Managerial Finance (14th ed.). Boston: Prentice Hall.
Schmidt, R. (2013, June 28). Understanding the
Difference Between NPV vs IRR. Retrieved from Propertymetrics:

Understanding the Difference Between NPV vs IRR

Go Top
x

Hi!
I'm Eleanor!

Would you like to get a custom essay? How about receiving a customized one?

Check it out