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).

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: