Net Present Value (NPV) and Internal Rate of Return (IRR) are approaches used in capital budgeting decision making. NPV is the difference in the present value (PV) of cash inflows and the present value (PV) of cash outflows while IRR is used to calculate the rate of return on investment. IRR is also a discount rate which makes NPVs of all cash flows equal to zero and consequently makes a project break even. If the NPV is positive, inflows discounted at opportunity cost are more than the outflows. Hence the net benefit of the project is obtained, and the organization will increase its value and the shareholder wealth as well.
Moreover, use of NPV and IRR in the evaluation of projects often gives the same results hence identical decisions made on the viability of the project. However, use of both NPV and IRR may differ in some projects, especially those that have varying discount rates since IRR uses one single discount rate at a time to evaluate each project. IRR works well when analyzing short-term projects with same discount rate and cash inflows but not projects with longer maturity since discount rates tend to vary with time.
The profitability index gives the relationship between the Present value of future cash flows and the initial investment. Hence it is vital to the financial decision maker as a ratio more than shows the profitability of the project is high since the future anticipated discounted cash inflows of the project is more than the anticipated discounted cash outflows.
I, therefore, agree with the classmate decision that NPV as a tool in capital budgeting decision making, its goal is to increase shareholder value and wealth. NPV and IRR are also affected by discount rates, where IRR works well in the evaluation of short-term projects.
It’s also true that IRR does not assess the financial impact of the firm but the minimum returns the project can achieve. The profitability index helps the decision maker to choose which investment is worth capitalizing.