what a Net Present Value (NPV), Internal Rate of Return (IRR) in cfa
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Net Present Value and Internal Rate of Return are two essential capital budgeting techniques taught in the CFA curriculum. These methods help analysts evaluate investment projects by considering the time value of money and expected cash flows over the project's lifetime.
Net Present Value represents the difference between the present value of cash inflows and outflows over a project's life. It measures the expected increase in firm value from undertaking the project. The decision rule is straightforward: accept projects with positive NPV as they add value to the firm, and reject those with negative NPV as they destroy value.
Internal Rate of Return is the discount rate that makes the net present value of a project equal to zero. It represents the effective annual rate of return that the project is expected to generate. The decision rule compares IRR to the required rate of return: accept projects where IRR exceeds the hurdle rate, as they provide returns above the minimum acceptable threshold.
When comparing NPV and IRR, several key differences emerge. NPV provides the absolute dollar value added to the firm, while IRR gives the percentage return. NPV assumes cash flows are reinvested at the required rate of return, whereas IRR assumes reinvestment at the IRR itself. For mutually exclusive projects, NPV is generally preferred as it directly measures value creation.
In the CFA curriculum, NPV and IRR are fundamental tools for capital budgeting decisions. These methods help analysts evaluate investment opportunities by incorporating the time value of money. NPV provides the absolute value creation, while IRR gives the rate of return. Both are essential for making informed investment decisions in corporate finance and are frequently tested concepts in CFA Level I examinations.