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This posting addresses NPV and IRR equations.

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Differentiate between the equation used to solve for NPV and the one used to solve for IRR? Which method is better or worst and why?

Why is risk analysis so essential to capital budgeting decisions?

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Solution Summary

The solution provides a detailed discussion of the equations for NPV and IRR, and also discusses which method is better or worse and why. Also discussed is why risk analysis is essential to capital budgeting decisions.

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The equation used to solve for NPV:

NPV= -II + (sum of) [OCF/ (1+R(r))t] + [TCF/(1+R(r))n]

Net Present Value can be defined as the difference between the market value of an investment and its cost. It is a measure of how much value is either created or added by the investment being measured. Investments with a positive NPV should be considered for investment purposes.

In the equation above,

II : initial investment
OFC = operating cash flow in the year t
t = year
n = number of years (lifespan) the investment covers
R(r) = required rate of return

The NPV equation takes future cash flows the business is expected to produce if the project is undertaken, and discounts the amounts to the present. NPV is the difference between the cost of the investment, and the future cash flow of the investment.


IRR is the most common alternative to NPV. The ...

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