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The discount rate often used in capital budgeting that makes the net present value of
all cash flows from a particular project equal to zero. Generally speaking, the higher a
project's internal rate of return, the more desirable it is to undertake the project. As
such, IRR can be used to rank several prospective projects a firm is considering.
Assuming all other factors are equal among the various projects, the project with the
highest IRR would probably be considered the best and undertaken first.
2) Another way to understand the superiority of the NPV rule is that the
discounting process inherent in both the IRR and NPV techniques
implicitly assumes the reinvestment of the cash flows at whatever
discount rate is used, either IRR or the cost of capital. When the IRR is
very high relative to the cost of capital it is unrealistic to assume
reinvestment at that high rate. This is especially damaging when
comparing
two investments with very different timing of cash flows. We will revisit
this reinvestment assumption later, under our discussion of yield to
maturity on coupon bonds, where its meaning will become clearer.
3) NPV is better than IRR because a postive NPV indicates addition to shareholder's
wealth and negative NPV indicates vie versa. This thumb rule cannot be applied to
IRR.
4) Term structure of interest rates raises bigger problems for IRR than NPV
Considers all the cash flows With the NPV method, the disadvantage
is that the project size is not measured
Considers the time value of money
Considers the risk of future cash flows
(through the cost of capital)
Advantages
Disadvantages