Explain how a net present value (NPV) profile is used to compare capital projects

NPV (NET PRESENT VALUE ):

The difference between the present value of cash inflows and the present value of cash outflows. NPV profile uses a discount rate for calculating the present value. NPV is used in capital budgeting to analyze the profitability of an investment or project.

If a firm has excessive cash then all the Projects with positive NPV are accepted. However if there are mutually exclusive projects then project with higher NPV would be selected.

NPV profile had certain limitations when selecting two projects with difference in life and investment. In such cases,we need to use derivatives of NPV, i.,e EUAPV - Equivalent uniform annual present value for difference in life and Profitability Index for difference in investment.

In NPV profile if NPV is higher than 0 then project should be accepted and if NPV of project is less than 0 the project should be rejected.

A positive NPV indicates that the company will be able to earn more than it requires in the project.

IRR (INTERNAL RATE OF RETURN):

IRR of the project is the rate at which the net present value of the project is Zero. IRR on the contrary is the rate at which PV of cash inflows is equal to PV of cash outflows.

Assumes that cash flows generated by the project are reinvested at same rate this project can earn. This is unrealistic asumption. Because of this IRR and NPV some times show contradicting selections.

 if IRR of the project is more than cost of capital the project should be accepted and if IRR is less than cost of capital then project should be rejected.

In case of mutually exclusive project, project with Higher IRR is selected. But sometimes result of IRR and NPV may differ in case of mutually exclusive projects.

The formula for IRR is:

0 = P₀ + P₁/(1+IRR) + P₂/(1+IRR)₂ + P₃/(1+IRR)₃ + . . . +P_n/(1+IRR)ⁿ

where P₀, P₁, . . . P_n equals the cash flows in periods 1, 2, . . . n, respectively

IRR equals the project's internal rate of return.

NPV has realistic reinvestment option, .It considers cost of capital and provides a dollar value value added which is logical and conceptual.

If cash flows generated by the project are invested at a rate lower than cost of capital, then the NPV which we calculated goes wrong and decision proves to be a loss.

If reinvestment rate is lower or more than IRR, the calculated rate of IRR becomes a wrong rate

In IRR method it is assume that all cash flow is reinvested at IRR which is not always true.