What is the meaning of:
a. Net present value? The net present value of a proposed investment project is the anticipated increase (if positive or decrease if negative) in the financial worth of an organization from investing in that project.
b. Internal rate of return? The internal rate of return of a proposed investment project is the anticipated interest rate an organization would earn on the money invested in that project. (Analytically, a proposed project’s IRR is the discount rate that makes NPV=0.)
In what ways are they the same, and how do they differ? They are the same in that they both begin with the projected cash flows from the investment. They differ in the way they match the cash flows against the organization’s cost of capital. NPV incorporates the cost of capital directly in the analysis as a result, an NPV number is valid only for an organization with that specific cost of capital. IRR first analyzes the investment’s projected cash flows without regard to a cost of capital, making the IRR number valid for any organization with the same cash flow estimates. Cost of capital enters in a second step to test whether the IRR is sufficiently high to add financial value.
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