Evaluating investment opportunity is something all entrepreneurs come across regardless their line of business. One of the most common techniques used in analyzing proposals is the discounted cash flow analysis or the DCF. This shows investors weather or not a business lead is worth following in terms of generated cash flow.
Most commonly used DCF methods for ranking business investment are the NPV and IRR method.
NPV stands for net present value and represents the standard method for assessing the appraisal of a proposal. It presents the present value of future cash flows generated by an investment and can be calculated using the following formula [Harry F. Campbell, Richard P. C. Brown “Benefit-cost analysis: financial and economic appraisal using spreadsheets”, pg. 42]:
NPV = PVb – PVc, where
PVb = present value of benefits
PVc = present value of costs
Present value is calculated taking into account the discount rate and the number of years considered in the analysis. It can be determined as follows:
PV = 1/(1+i)n
i = discount rate (it can vary between 1and 50% depending on the industry for which the analysis is conducted)
n = number of years for which the analysis is conducted
IRR stands for internal rate of return and represents the second most used method of evaluating investment proposal. Unlike NPV which gives decision makers a present value for their future pursuits IRR reveals the efficiency of an investment in terms of percentage return per unit invested. A high value indicates a profitable investment.
The question most analysts find themselves asking when using these two methods is which is the most accurate in terms of capital budgeting measurement.
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